Tax season is no longer just from January 1st to April 15th. To legally save money on taxes, it is important to make good tax and financial decisions throughout the entire year.
As an American, it is our duty and legal obligation to pay our taxes. Our taxes pay many important services, including:
· the strongest military in the world, that keeps us safe
· roads, bridges, and interstates that allows us to travel freely throughout the U.S.
· national & state parks
· public schools to educate our youth, regardless of their income, race, or sex
· libraries
· medical & scientific research
· justice system
· police & fire protection, by simply dialing 911
· Social Security, Medicare, and Medicaid
We might not always agree with how our tax dollars are spent, but we can all agree that our taxes provide us with many essential services.
Though we must pay our taxes, we are not required to “tip the IRS” and pay more taxes than what we legally owe. There are many legal ways to reduce or defer taxes, including*:
- contributing to your employer-sponsored retirement plan, such as a 401k, 403(b), or 457 plan
- utilizing a ROTH IRA or a ROTH 401k, in which after-tax contributions grow tax-free
- investing in tax-free municipal bonds
- deferring taxes with annuities
- delaying Social Security, pension, or retirement distributions while still employed
- exchanging properties (farms, rentals, annuities, etc.) for similar assets, by utilizing 1031/1035 exchanges
Everyone’s situation is different. For example, an individual with no earned income cannot contribute to a ROTH IRA. Likewise, a person with too much income also cannot contribute to a ROTH IRA. Those eligible to contribute to a ROTH IRA must be in the “Goldilocks Zone”, in which they have some income, but not too much income. Please consult a professional about your specific situation.
We have seen clients make costly mistakes, in which they paid more taxes than necessary. Here are two examples:
· In 2020, retirees weren’t required to take Required Minimum Distributions (RMD’s), due a law that was passed providing relief to retirees during the coronavirus. One client was required to take $160,000/year from his retirement account, as part of his RMD. We recommended that he not withdraw his $160,000 RMD in 2020 (he had other assets and sources of income), which - if he paid 25% in federal & state taxes - would save him nearly $40,000 in taxes, just in the year 2020. Unfortunately, the client chose not to heed our advice. He paid the IRS $40,000 more in taxes than was necessary.
· Another client withdrew all her money from her 401k-employer retirement account, which required her to pay federal & state taxes on her distribution, as well as an additional 10% penalty to the IRS, since she was under 59.5 years of age. She then wanted to invest what she had left. If she had first visited with us, we would have recommended that she not take this costly distribution from her 401k. She could have kept her money in the 401k, moved it to a new 401k, or rolled the money into an Individual Retirement Account (IRA). These three options would have kept her from having to pay federal and state taxes, as well as an additional 10% penalty. Unfortunately, by not getting professional assistance, she made a costly mistake.
On the other hand, we have helped numerous clients with their retirement plans, IRAs, and inheritances, to ensure that they legally minimize or defer their tax obligations. Here are some examples:
· One client’s husband passed away unexpectedly at age 60. He took care of the family’s finances. His widow came to us with his retirement plan and life insurance statements. She was both shocked and grateful to learn that both his retirement plan and life insurance were worth over $600,000 each. In addition, they had no debt and owned their own home. She then became worried about how much she would have to pay in taxes. Fortunately, we were able to help her move his retirement plan to her IRA (avoiding taxes or penalties) and cash-in her husband’s life insurance policy (generally, there are no taxes on life insurance). She now has over $1.3M in her accounts and paid zero dollars in taxes. Had she “cashed in” the retirement plan, she would have paid $120,000 to $160,000 in taxes.
· We have advised numerous clients to avoid “indirect rollovers”, in which a rollover from a 401k gets paid directly to the client, rather than to the IRA. By avoiding indirect rollovers, our clients are not subject to a 20% withholding requirement for federal income taxes (there is also a deadline, where the check must be deposited into the IRA within 60 days, to avoid taxes and a possible 10% penalty). By instead choosing a “direct rollover”, where the funds go directly from the 401k to the IRA, we ensure that 100% of the client’s 401k goes directly into the IRA and we avoid the 20% withholding requirement, as well as the 60-day deadline.
Recently, in two unrelated cases, an accountant and an insurance executive both discussed taking their money from a former employer’s 401k plan prior to age 59.5. The accountant wanted to move his money to a ROTH IRA, while the insurance executive wanted to fund an early retirement. While they knew that they would pay federal and state taxes on their distributions, they were also going to be subject to an unexpected - and very expensive - 10% early withdrawal penalty. Fortunately, they both discussed the various options with us prior to making an irrevocable – and expensive – early distribution that would cost them an additional 10% tax penalty. There are some limited instances when individuals can take penalty-free 401k distributions prior to age 59.5, but if the rules aren’t followed exactly, the IRS is unforgiving. For example, if a $500,000 401k distribution is incorrectly taken, the individual would have to pay the IRS a 10% penalty of $50,000, in addition to federal and state taxes. This 10% penalty may be avoided by knowing the rules and exceptions to these complicated rules. Knowing the difference between an in-service distribution, Rule 72(t), the Rule of 55, the Rule of 88, Required Minimum Distributions, or a hardship distribution is vitally important, to avoid the 10% early withdrawal penalty. The accountant and insurance executive both wisely chose to share their intentions with us prior to making an irrevocable – and potentially expensive - decision.
At Steele Wealth Management, we feel that our primary role isn’t to “beat the market by 2% or 3%”. Instead, we feel that it is more important to help clients avoid making unwise and costly decisions with their retirement accounts, while mitigating tax, estate, or investment risk that could cost their portfolio 10%, 20%, 30%, or more in taxes & penalties. If you ever find yourself in a tax or financial situation that you don’t fully understand and don’t know what to do, please consult an accountant, a lawyer, and/or a financial advisor.
*Disclaimer: Kelly D. Steele is not an accountant or a CPA. Steele Wealth Management, Inc. is not an accounting firm. Neither Kelly D. Steele nor Steele Wealth Management, Inc. prepares tax returns. Kelly D. Steele and Steele Wealth Management, Inc. limits their tax advice to client’s investments (qualified plans & IRA’s, financial plans, municipal bonds, annuities, RMD’s, etc.). This document is intended as general advice on taxes & tax planning. For tax advice that is specific to your personal situation, please contact an accountant, CPA, lawyer and/or other professionals.