The Case of the Seven (7) Million "Missing" Children - How To Tax Plan & How Not To
One spring day in the late 1980s, over seven million American children went missing. Many of you may be scanning your memories trying to remember such a horrific event. But when I share the date these children went “missing”, it will make much more sense. The day was April 15th, the deadline for Americans to file taxes. The year the children went “missing” was 1987, which was the first year the IRS required tax filers to include the Social Security number (SSN) for any claimed dependent(s) for which they received a non-trivial tax deduction. In 1986, when taxpayers only had to provide the names of children, 77 million dependents were listed on tax returns. But, in 1987 when SSNs were required, only 70 million dependents were listed.*
Taxpayers in 1986 received an exemption of $1,900 per claimed dependent. That’s $1,900 that would be subtracted from any taxes owed for each child. That’s a pretty great deduction, at least when you actually have the children to back it up.
Claiming imaginary children was one way some Americans mitigated taxes before the rules changed. However, there are definitely other legal strategies to reduce your lifetime tax liability in 2021 and beyond. Recently, as many of you know, my spring meetings focused on tax mitigation strategies. I’d like to highlight just seven of these strategies and briefly explain who they make sense for, and why they can be so valuable.
TAX MITIGATION STRATEGIES:
STRATEGY #1
Roth IRA Contributions — These are after-tax contributions to a retirement account that you will never pay taxes on again when withdrawn during retirement. In 2021 you can contribute $6,000/year, and for those 50 years or older you can contribute an additional $1,000. See details below regarding eligibility.**
Who These Make Sense For - While these are great for anyone that is eligible**, they are especially great during low-income years since your tax rates are lower as well. Also, there are no age limits. All you need is earned income, so even children and teenagers can contribute.
Why they are Valuable — Here’s one example of why they can be a great strategy: If you worked really hard as a 15-year-old one summer and invested the $5,000 you earned into a Roth IRA that subsequently averaged a 10% annual rate of return, your one-time investment would grow to $586,954 dollars by the time you turned 65. Best of all, you would owe ZERO dollars in taxes because you already paid them as a 15-year-old. Roth IRAs also work great any time you have low-income years which can occur with your first job out of college, or when you decide to work part-time in the last few years prior to retirement.
**Single filers whose income (Modified Adjusted Gross Income, or MAGI) is less than $124,000 can contribute the full amount. Those with incomes up to $139,000 can contribute a reduced amount; and Married Filing Jointly, whose income (MAGI) is less than $196,000 can contribute the full amount. Those with incomes up to $206,000 can contribute a reduced amount.
STRATEGY #2
IRA Contributions — These are before-tax contributions to a retirement account. Like the Roth IRA, in 2021 you can contribute $6,000/year, and for those 50 years or older, you can contribute an additional $1,000. You will pay income taxes when the monies are withdrawn in retirement.
Who These Make Sense For — For people that have high income and don’t have a retirement saving option through their work. For example, if some of your income is taxed at 35% or higher, it is very likely to your advantage to make a before-tax contribution as your rates will likely be lower in retirement when you make the withdrawals.
Why they are Valuable — If this money was going to be taxed at 35%, and you instead defer the income until retirement when your tax rates are 25%, you already saved yourself 10% in taxes.
STRATEGY #3
SEP IRA/401k/403b/457 Contributions — These are before-tax contributions to a retirement account. You will be taxed when they are distributed in retirement at ordinary income rates, but unlike IRAs, you are able to put away a lot more. See details below.
Who These Make Sense For — If you are being taxed at one of the highest marginal rates 35% or 37%, it is very likely to your advantage to make a before-tax contribution, as your rates will likely be lower in retirement when you make the withdrawals.
Why they are Valuable — With a SEP IRA/401k/403b/457 you can put away a lot more money before tax than you can in an IRA. For SEP IRAs it’s 25% of your income with a maximum of $58,000. For 401ks, 403b, and 457, each employee can contribute up to $19,500, and if they are 50 years or older they can contribute an additional $6,500. If some or all of this money was going to be taxed at 35% and you instead defer the income until retirement when your tax rates are 25%, you would save yourself 10% just in taxes.
STRATEGY #4
Roth 401k/403b Contributions — These have greatly expanded the eligibility for those who can contribute to a Roth, as there are no income limitations. Additionally, because of the higher contribution limits ($19,500 for those under 50 years of age & $26,000 for those 50 years of age and older), participants in these plans can save a great deal more after-tax retirement funds. However, there are a number of factors you need to consider. It is thereby recommended that you speak with a Certified Financial Planner™ or Tax Professional to understand if these make sense for you.
Who These Make Sense For — Those in lower-income years (recent college graduates, semi-retired workers to name a few).
Why they are Valuable — With a Roth 401k/403b/457 you can put away a lot more money after tax than you can in a Roth IRA.
STRATEGY #5
Roth Conversions — These work just as they sound: you convert portions of your pre-tax accounts to a Roth. There are no income limitations on these conversions, but any transfer is “realized” as income in your current year. Consequently, these could make sense in years when your income is lower, such as the years between your retirement and before you begin taking your Required Minimum Distributions (RMDs).
It should be noted that the money is transferred directly from your IRA to your Roth IRA, and you cannot use any portion of the transferred money to pay the taxes. You must pay these taxes out-of-pocket instead; and therefore, you need to have the money in the bank or a non-retirement account to offset these tax expenses.
Who These Make Sense For — Those in lower-income years, especially those prior to full-retirement when a pension would begin.
Why they are Valuable — It’s straightforward: you contribute funds before-tax when your income tax rates are on the high side, and you convert these funds during low-income years when your tax rates are lower. All subsequent growth is tax-free.
STRATEGY #6
Health Savings Accounts — These are the only accounts that are triple tax-free. Roth, Traditional IRAs, 401ks etc., and 529 college savings accounts are only double tax-free. HSA contributions are tax-deductible, and both the growth and distributions (if used for a qualifying medical expense) are tax-free.
Who they make sense for - Anyone that is eligible (see criteria below***), and anyone who will have medical expenses in the future (just about everyone).
***You must have a qualifying high deductible medical plan. Additionally, the contributions were limited to the following amounts in 2020: Individual $3,550 and Family $7,100. For those 55 years and older you can contribute an additional $1,000.
Why they are Valuable - While you can use the money in the HSA at any time to cover health care expenses, to really see the benefit you will want to let the money compound as long as possible and pay for current health care expenses from personal savings when possible. For more information on why HSAs are a great strategy, please click here.
STRATEGY #7
College Savings Accounts — I save for my own children’s college and help my clients do the same through 529 savings accounts. 529s are investment vehicles to help you pay for college. You invest your after-tax money and don’t pay taxes during the growth period (i.e. tax-deferred). You also don’t pay taxes when you withdraw the money to pay for qualifying college expenses (i.e. tuition, fees, books, even room and board in certain instances).
Who they make sense for - People that would like to help pay for their children or grandchildren’s college. However, they need to be on track for retirement first. See my blog entitled, “Put Your Oxygen Mask on First” by clicking here.
Why they are Valuable - You potentially can pay less for college because of potential growth inside the account. But 529s are more phenomenal than they may initially appear. For more, see my blog on five rather fascinating facts that feature why 529s are so powerful by clicking here.
In Conclusion
These are just seven examples of how you can potentially reduce your lifetime tax liability all while funding your important goals of retirement income, healthcare expenses, and/or college. When it comes to tax mitigation strategies it is imperative one considers their financial plan in its entirety to determine if these may help you with your goals.
If you are not a client and would like a free introductory meeting to discuss these strategies, see details regarding this meeting below and click here to schedule.
Introductory Meeting:
Free, but worth your time - You’ll leave with valuable financial planning information, and all of the money you came in with.
30 minute Meet and Greet - It will be a good time whether virtual or face to face (I’m vaccinated).
No Obligation - Time-Share not included! You come in and leave with ZERO pressure.
Sleep on It - Think about it, dream about it, and decide what is best for you and your goals.
Reach Out - Only if you are interested! I can’t read minds…yet.
