August, 2006 Tax Tip
The Importance of Timing in Tax Planning
There is a tax axiom that says it is generally better to defer taxes than to pay them currently because of the time value of money. However, there are times when this strategy may not be prudent. In certain situations by paying taxes now you can avoid paying more later, even when taking the time value of money into account. This month's Tax Tip looks at some of these situations and offers some planning points.
Perhaps the best examples of this are Roth IRA's and Roth 401(k) plans. By making your current contributions in after-tax (nondeductible) dollars, you are paying your taxes now. The tradeoff is that all of the appreciation that you receive from these plans in later years will be tax free.
Sometimes I have a difficult time explaining to clients why a Roth IRA may be preferable to a traditional IRA, inasmuch as you can deduct your contribution to a traditional IRA currently. The answer is that all distributions from tax-deductible IRA's are taxed as ordinary income when they are made. If, at that time, tax rates are higher than at present, you may be better off paying now and considering it a good tax-free investment. The ideal situation is a teenager working a summer job who puts money into a Roth IRA. The income that is taxed may be so low that he or she would not pay tax anyway.
If you had a crystal ball or otherwise knew that tax rates will be higher in the future than they are at present (a real possibility given the federal deficit and the historically low rates today), you may want to consider accelerating your taxes to save in the long run. Based on the information available to you now, try to make a reasonable projection of what your tax rate will be at a target future point, such as ten years from now, retirement, etc. While most people assume their income will go down after retirement, such is not always the case. Often people move from a no tax or low tax state to a high tax state. While the state tax burden is much less than the federal tax burden, it should not be overlooked.
If you will receive Social Security upon retirement, as much as 85% of your benefit may be taxable. This replaces a portion of your reduced earnings after you retire. That, combined with other income you may have deferred, could push you into a higher bracket.
If you, like some of my clients, have a residence you would like to sell now but are obsessed with paying the capital gains tax on the gain that exceeds the exclusion amount of $250,000 ($500,000, if married), I say calm down. Today's capital gains tax rate is only 15%.? Who knows how long that rate will be around. Consider the alternatives of waiting and make your decision. I think it might be obvious.
Are you an investor with capital losses? If you invested this year you probably do. Capital losses offset capital gains and up to $3,000 in taxable ordinary income. This allows you to take $3,000 income currently that you might have otherwise deferred (and paid tax on later) without a tax bite at all.
I suggest you look at your portfolio and identify the investments that have made money for you over time but have not been performing up to your expectations. Why not sell them and pay the 15% capital gains tax and reinvest the proceeds in securities that appear to have a better future?
The strategies discussed in this Tax Tip article are very much the same as those we utilize in making year-end tax planning decisions. The point is that proper tax planning is not just a year- end exercise and that is why I am writing about it at mid-year.
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