15.1 Individual Tax Planning Techniques

Individual tax planning techniques are crucial for optimizing your financial situation. From investment strategies to retirement savings options, understanding these methods can significantly impact your tax liability and long-term financial health.

Life events like marriage, homeownership, and starting a business also have major tax implications. By leveraging deductions, credits, and strategic planning, you can minimize your tax burden and make the most of your income and assets.

Tax-efficient investment strategies

Capital gains and dividend taxation

• Long-term capital gains (assets held over one year) taxed at lower rates than short-term gains
• Qualified dividends receive preferential tax treatment compared to non-qualified dividends
• Tax-loss harvesting offsets capital gains by selling investments at a loss (subject to wash sale rules)
• Asset location optimizes tax efficiency by strategically placing investments in different account types (taxable, tax-deferred, tax-exempt)
  • Example: Hold high-yield bonds in tax-deferred accounts, growth stocks in taxable accounts

Tax-advantaged investment vehicles

• Municipal bonds offer tax-exempt interest income at federal level and potentially state level
  • Example: A California resident buying California municipal bonds receives tax-free interest at both federal and state levels
• Exchange-traded funds (ETFs) generally more tax-efficient than mutual funds due to:
  • Lower turnover rates
  • Creation/redemption process minimizing capital gains distributions
• Index funds typically more tax-efficient than actively managed funds due to lower turnover
• Real Estate Investment Trusts (REITs) offer potential tax advantages through depreciation deductions

Investment strategies for tax efficiency

• Buy and hold strategy minimizes frequent trading and short-term capital gains
• Dollar-cost averaging reduces timing risk and potential for large taxable events
• Tax-efficient withdrawal strategies in retirement consider taxability of different account types
  • Example: Withdraw from taxable accounts first, then tax-deferred, and finally tax-free accounts
• Charitable giving of appreciated securities avoids capital gains taxes and provides tax deduction
• Invest in tax-managed funds designed to minimize taxable distributions

Retirement savings options

Tax-deferred retirement accounts

• Traditional Individual Retirement Accounts (IRAs) offer:
  • Tax-deductible contributions (subject to income limits)
  • Tax-deferred growth
  • Distributions taxed as ordinary income in retirement
• 401(k) plans allow for pre-tax contributions, often with employer matching
  • Example: Employee contributes 6% of salary, employer matches 50% up to 3% of salary
• Self-employed individuals can utilize:
  • SEP IRAs with higher contribution limits than traditional IRAs
  • Solo 401(k)s offering both employee and employer contributions

Tax-free retirement accounts

• Roth IRAs provide:
  • After-tax contributions (subject to income limits for direct contributions)
  • Tax-free growth
  • Tax-free qualified withdrawals in retirement
• Roth 401(k) options combine higher contribution limits of 401(k)s with tax-free growth of Roth accounts
• Health Savings Accounts (HSAs) offer triple tax advantages:
  • Tax-deductible contributions
  • Tax-free growth
  • Tax-free withdrawals for qualified medical expenses

Retirement savings incentives and requirements

• Saver's Credit provides tax credit for low to moderate-income taxpayers contributing to retirement accounts
  • Example: Married couple filing jointly with AGI under $41,000 can receive up to 50$4,000 of retirement contributions
• Catch-up contributions allow individuals age 50 and older to make additional contributions to retirement accounts
• Required Minimum Distributions (RMDs) must be taken from most retirement accounts starting at age 72
  • Calculation methods vary based on account type and life expectancy
  • Failure to take RMDs results in 50% excise tax on amount not distributed

Tax implications of life events

Family-related tax considerations

• Marriage can result in "marriage penalty" or "marriage bonus" depending on couple's income levels and filing status
  • Example: Two high-earning individuals may pay more in taxes when married filing jointly than they would as single filers
• Divorce involves tax considerations such as:
  • Alimony payments (no longer tax-deductible for payer or taxable for recipient for divorces finalized after 2018)
  • Division of assets and potential capital gains implications
• Birth or adoption of a child may qualify taxpayers for:
  • Child Tax Credit (up to $2,000 per qualifying child)
  • Adoption Credit (up to $14,440 per eligible child for 2021)
  • Dependent Care Credit for childcare expenses

Home ownership and real estate transactions

• Buying a home introduces potential tax benefits:
  • Mortgage interest deduction (limited to interest on $750,000 of acquisition debt for homes purchased after 12/15/2017)
  • Property tax deductions (subject to SALT deduction limitations)
• Selling a primary residence may qualify for capital gains exclusion:
  • Up to $250,000 for single filers
  • Up to $500,000 for married filing jointly
  • Must have owned and used home as primary residence for at least 2 of last 5 years

Business and inheritance considerations

• Starting a business requires entity selection impacting individual taxation:
  • Sole proprietorship (Schedule C reporting)
  • Partnership (pass-through taxation)
  • S-Corporation (pass-through taxation with potential tax savings on self-employment taxes)
  • C-Corporation (double taxation, but potentially lower corporate tax rates)
• Receiving an inheritance may have tax implications:
  • Estate tax considerations for large estates (federal exemption $11.7 million per individual for 2021)
  • Inherited assets receive step-up in basis, potentially reducing capital gains taxes upon sale
  • Inherited traditional IRAs subject to RMD rules based on beneficiary's age and relationship to deceased

Minimizing individual tax liabilities

Deduction optimization strategies

• Maximize above-the-line deductions to reduce Adjusted Gross Income (AGI):
  • HSA contributions
  • Student loan interest (up to $2,500, subject to income limitations)
  • Self-employed health insurance premiums
• Choose between standard deduction and itemizing based on which method results in lower tax liability
  • Consider state and local tax (SALT) deduction limitations ($10,000 cap)
• Bunch itemized deductions in alternate years to exceed standard deduction threshold
  • Example: Make two years' worth of charitable contributions in a single year to itemize, then take standard deduction the following year

Tax-efficient retirement planning

• Implement Roth conversion strategy during low-income years:
  • Take advantage of lower tax brackets
  • Potentially reduce future Required Minimum Distributions
• Qualified Charitable Distributions (QCDs) from IRAs for individuals over 70½:
  • Satisfy RMD requirements
  • Exclude distribution from taxable income
• Strategically withdraw from different account types in retirement to manage tax brackets
  • Example: Withdraw from taxable accounts to stay within 12% bracket, then use Roth funds for additional income needs

Leveraging tax credits and charitable strategies

• Utilize education credits strategically:
  • American Opportunity Credit (up to $2,500 per eligible student)
  • Lifetime Learning Credit (up to $2,000 per tax return)
• Implement energy efficiency credits for home improvements:
  • Solar panels
  • Energy-efficient windows and doors
• Maximize Earned Income Tax Credit for low to moderate-income workers
• Employ charitable giving strategies:
  • Donate appreciated securities to avoid capital gains taxes
  • Use donor-advised funds to bunch contributions and maximize tax benefits
  • Consider qualified charitable distributions from IRAs for those over 70½