One Airport Place,
Today Rich and Jag look at ways to keep more of your money and give less of it to Uncle Sam.
First, we look at basic tax terms including
Next, we tackle ways to reduce your W2 income:
We also look at different investment strategies that can lower your tax burden.
John Jag Gay:
Welcome back to Financial Matters with Richard Oring. I am Jon Jag Gay joined again by Richard Oring from New Century Financial Group. Good to be back with you.
It's good to be back, Jag. How have you been going through all this coronavirus, quarantine and all that kind of fun stuff up in Detroit?
It's been five months since my wife started working from home. As you know, I work from home anyway, but we've been five months of working from home together. She has not yet thrown me out, so I consider that a win, and we're getting along pretty well. It's us and the dog and life is good. How are things in New Jersey?
Well, I broke down finally, about three weeks ago, I had to go back to the office.
Okay. I see you're in the office now. Okay.
We've got staff here, but we all quarantine ourselves separate from each other the best we can. We're not really seeing clients in the office yet, but work at home, which is getting to me with three young kids, three dogs and trying to do some work with clients on the phone, always apologizing, I had to get out.
I understand that. We were dog sitting for a couple of days and just having two dogs and no kids, I was having trouble concentrating, so I can completely understand that.
The only thing which is weird is this whole situation feels like the new normal now.
Oh, if I hear the word new normal one more time I'm going to scream. I feel like it's the cliche of 2020.
So in this new normal, Rich, we're talking today about keeping more money in your pocket and giving less to Uncle Sam. That's a goal that everybody has. So where do you want to start with this topic?
Okay. I'm going to assume most of our listeners are not experts in the internal revenue code of taxes. So why don't I go over some basic definitions which everyone should know when they're doing their tax return and reviewing it, but they don't know, I think it's going to help going over some of them. Let me just dig right in.
The first one we always hear about is adjusted gross income, or you might've heard it just call as an AGI. It's basically your gross income, but they threw the term adjusted above line deductions. Most people are familiar with itemized deductions, which I'll explain later, but there's certain deductions which are above the line which you don't have to be itemizing to receive. So it's your gross income minus your above line deductions.
That's a tough stuff that right off the top, before we start doing all the math and all that, that you can deduct right away.
Like traditional IRA, contributions which are deductible as long as you don't have the phase outs, teachers deduction for that $250, they could deduct for office, school supplies, items like that. There's a few of them which are above line item, long-term care deductions.
So after you get your AGI, we already talked about above line deductions. So let's go right to the itemized deductions. This is what everyone is really familiar with. You look at your schedule A, the first box is your medical deductions. Most people do not qualify to deduct their medical expenses because there's a percentage which is excluded based on your AGI. Then you go right down, you got your real estate tax and your state income tax. And as we all know, it's capped at $10,000 now. We have your mortgage interest and your charitable deductions. And probably a few more other itemized deductions I might be missing here or there, like Sharon's premiums and so forth. But for this show, I just want everyone to understand what an itemized deduction is. You're very familiar with, if you own a home, you can probably do itemize.
So really it comes down to when you do your taxes, you're looking at whether you're taking itemized deductions or the standard deduction. I know every year my wife and I look at it and we say, "Okay, if we itemized all of our deductions, where will we be?" And then we compare that to what the general standard deduction would be, and we say which is going to be the better path for us.
The standard deduction is saying, "Hey, if I don't have enough itemized, the government is going to give me a standard deduction." And what's really nice is the standard deduction last year doubled. So it's helped a lot of people, especially retirees who don't have a mortgage anymore and they weren't able to itemize and they weren't getting any benefits from charitable donations or things like that. At least they're able to take a standard deduction which is double from the previous years, which was really nice benefit.
Got it. All right. So next on our list is taxable income.
Okay. So let's take your AGI, your adjusted gross income minus your standard or itemized deduction. And if you qualify for anything else like a qualified business income deduction, most people that's not going to matter unless you own a business, that would be your taxable income. That's where you look up on the schedule, how much taxable income based on your filing status, single, married, joint and it'll give you a grid and that's how you calculate how much of your income is taxed.
So you take your adjusted gross income, take off the deductions and that is your taxable income that tells you what tax bracket you're in.
Again, we're keeping this pretty simple. Yes.
This is credits. Credits are awesome. Credits are better than deductions. Credits is dollar for dollar lowering your tax liability. Giving an example is the lifetime learning credits, you have adoption credits, there's even credits for low income earners who are contributing to retirement plans. There is a credit for there. There is a non-refundable credit which get capped up to the amount of tax you owe.
So if you owe $500 in tax, but you have a credit for 1000, it's going to cap out $500. And then there's credits which are refundable, which actually your TAC could be 500, your credits 1000, and you're going to get a $500 refund also, which is awesome.
The last thing you need to understand on the tax return is total tax. That's what you owe. You might've had some withholding from W-2s or 1099s, but at the end of the day, that's your total tax minus what you already paid. And that's going to tell you if you're going to get a refund or you're going to be writing a check to Uncle Sam.
Got it. So those are the terms, AGI above the line deductions, itemized and standard deductions, taxable income credits, and total tax. Now let's get to the meat of this, Rich, which is how do I pay less taxes?
Jag, you don't want to go back and talk more about tax terminology. This is a lot of fun.
I know Rich, you have that accounting background and that is your area of expertise. But I think for the listeners' sake and well, selfishly for my sake, let's move on to how we can save money and pay less in taxes.
All right. I know you were excited about this partly. Let's talk about W-2 deductions first. What we're trying to do is we're trying to lower our taxable income which is going to be reported on the W-2. All right. So the first thing is participate in a company retirement plan. It could be a 401(k), if you work for a hospital or a school, it might be a 403(b), smaller companies might offer a simple IRAs. You want to participate in that. If you have a traditional 401(k), the maximum contribution for 2020 is 19,500. If you're over 50, there's a catch up of 6,500.
You can tack onto that.
Simple IRAs and other plans might have different maximum contributions. You need to look those up or ask your employer or sponsor who's sponsoring that plan, they'll be able to help you with that.
A lot of times I hear people go, "Rich, why do I want to participate in my 401(k)? My employer doesn't match anything." Again, it's not that we're trying to get something from our employer right now, we're trying to lower our taxable income.
If you don't have a plan at work, you can always look to find a traditional IRA. Health savings accounts for those families who are pretty healthy and don't really go to the doctors that much, these are great medical plans which allow you to fund an account up to $3,500 for a single person and 7,000 for a family. Again, that's pretax. Simple. Let's just say you're putting 19,500 in your 401(k), $7,000 in your HSA. You already lowered your income, 26,500. Then we roll right into the FSAs.
Those flexible savings accounts.
The one downside is either for pretax money, you don't use it, you lose it. So people who have FSAs know this rule and they're very cautious of that, but that's another 2,750 you can do pre-tax dollars. And they let you participate in a dependent care FSA. That's another $2,500 for a single and then joint another $5,000 in deduction. If you just add those benefits right there, and you're able to afford to defer this money, you're reducing your taxable income quite a bit.
If you work in a city and you commute, a lot of employers have a commuter benefit program, which you can have up to $270 a month deferred pre-taxed to help with expenses like train, parking and things like that. You just have to be aware of what the limits are for particular expenses like parking. The IRS is pretty tight on those right now.
Well, and for those that are still actually going into the office, that's another point right now.
A lot of these things we're talking about deductions from your W-2, and that could be great for current tax planning. But tax planning to me is about the current year and the future years. So for your younger client, we have to be careful if I go ahead and put 19,500 a year in a traditional IRA, because it might be better off to blend that with something like a Roth 401(k), where it's after tax dollars, but it comes out tax-free.
So what I've mentioned is ways to lower your taxable income for this year, but that doesn't mean that you want to just jump ahead and go do that. You really need to do some projections for this year and then the future years of what you think your income is going to be when you retire.
I think that's a really good point. For me, I'll be turning 40 this year, so I've still got a little ways to go before I'm going to retire. So I have actually aggressively started putting money into a Roth so that yes, it's after taxes right now, but it's going to be tax-free for growth and it's going to be tax-free for when I pull it out when I'm retired. So I've actually started aggressively putting stuff into a Roth right now.
And it's also great because you're not required to take it out when you're... Well, now with the rule of 72, you have to [inaudible 00:10:37].
The RMDs. You don't have to take the Roth money out, which is great because you can do better tax planning when you're retired to figuring out which buckets of money to take out.
So that's [inaudible 00:10:51] because not everyone has a W-2. People are self-employed, there's other benefits of retirement plans they could take advantage of which allows them to put a lot more money than 19,500. Let's talk about people who have retired or can eliminate tax liabilities through their investments.
So the first thing you want to do, if you can, is minimize short-term gains with your taxable investments. Short-term gains is taxed as ordinary income. That's the same tax rate as your W-2. Long-term gains have a preferred tax rate. For this conversation we're just going to say 15% tax bracket. If you're a high income taxpayer, it can go up to 20%. For this conversation we'll just stick to 15.
So you've got to be careful. If you have mutual funds, mutual funds sometimes have what we call embedded gains. So let's use an example. This mutual fund has been in business for 10 years and let's just say, in January they bought ABC fictitious stock, and they bought it for $10, and three months later, they sell it for a big profit. And then you buy that mutual fund a few months later, and then at the end of the year, when they do their tax reporting to you, you get this short-term gain which you never participated in. You never got that gain, but by requirement, they have to pass 90% of all their gains from their portfolio to their shareholders.
So you're picking up a tax liability as ordinary income and never got the benefit of that gain within that mutual fund. So on taxable accounts with mutual funds, you want to be careful on what you're investing in. Just try not to get into that trap of embedded gains within the portfolio.
Got it. Okay.
Which leads into it. For my clients, when we talk about tax, while it counts, we talk about the tax sensitivity. I do tax projections for clients. So if I want to make sure I'm not putting them in a situation with short-term gains, I don't want to put them into a situation where they're going to lose out on phase outs of deductions like for passive income on rental properties.
I don't want their social security to be more taxed. I'm sensitive to the tax brackets because some of the gains, if they're in a low tax bracket, technically could be 0% on long-term gains, also on their qualified dividends. I don't want to lose that opportunity if I could take advantage of it. So you got to be very careful, you got to look about the tax management on your taxable accounts.
The other thing I personally look for on investments for these taxable accounts are managers who have low turnover. That's a new terminology, turnover. Turnover is how often the mutual fund manager, separately managed account manager is buying and selling within the portfolio. If you have a lot of turnover, you have a great opportunity to have more gains reported to you.
I mentioned taking 0% long-term gains, and that's important because you could do some planning for the future. If I'm able to take some long-term gains and then step up up a new cost basis, when I need to sell that asset, the gains hopefully it's going to be a lot, but normally it'll be less than what you originally sold with the 0% tax liability.
So being able to do some tax planning... Everyone says, "Oh, at the end of the year, let's sell our losses." Well, there is a strategy about selling your gains tax-efficiently. The other big thing is I have a client, every year we look at their taxable income, we estimate it. And we're worried about how much of the Medicare premiums going to be taxed on social security.
So every year it's really close and we have to do some tax planning. And I said to him, "You have this mutual fund which keeps paying dividends and the dividends are being reinvested, and we keep creating a bigger tax liability just on this one investment. So to keep you under that threshold before your Medicare premiums are going to go up, it's getting harder each year."
So we talked about shifting some of that mutual fund into a growth mutual fund, which isn't paying dividends. And what we kept in dividends, we kept it in cash so he could take that as a distribution tax-free and take less from an IRA for his cash flow needs.
There's a lot to all this stuff, Rich. And sometimes it can be a little bit easy to get lost on this. So we're going to give your contact information at the end of the show, people who want to talk to you about their individual situation. But I think what's amazing is you can have the same amount of money as somebody else. You can take the same amount out, but different amounts of money would go to you versus Uncle Sam with the person who's in the same situation as you, because you planned differently, right?
Correct. I use that as an example. I really encourage people to build different buckets of money, tax-free money, retirement accounts, and investment accounts. The tax-free would have been the Roth category we're talking about.
I say, everyone can save the same amount of money, like you said, and at the end of the day, you take the money out from the different buckets and that will calculate to how much is going to you and how much is going to Uncle Sam. It's amazing. And most financial advisors out there, investment advisors, aren't doing this planning right now.
And moreso, you see a lot of clients, they come to me and they retire, and 95% of all their assets are in their 401(k), which means that every single dollar I take out from them is going to be taxable income. There are a lot of different ways to plan the distributions for your retirement income needs. So I'm going to give you one, but it doesn't mean that everyone should be taking this advice and doing it for themselves.
Okay. So make it simple. The client needs X, Y, Z amount of money. First thing I'm looking at is things I can control, pensions. They're taking their pension, they're taking their social security. So these are the guaranteed income streams coming into that household I already know. Then I'm going to look at their qualified assets, their retirement accounts, their non-qualified accounts. Those are your taxable investment accounts and your tax-free accounts.
Before I figure out which accounts I'm taking it from, I'm looking at what tax bracket they're going to be in just with their pension and social security. And if they're in a low tax bracket, maybe I would sell the investment account, the non-qualified with long-term gains, if it's at 0%. Because maybe I'm going to be able to keep some of that social security not to be taxed. My goal is to keep the overall tax rate low because it affects other things like the more you make, the more of your social security is going to be taxed.
And those who are retired know that. If I need a little bit more money from a non-qualified, maybe I'd take it from the Roth or maybe I'm in a 12% tax bracket without taking any money out. And I could take out another 10,000 from the retirement account, the IRA, and still be in a 12% tax bracket. That's called maxing out a bracket.
Okay. Makes sense.
So if you're in a low bracket, how much more can you take out at that 12% before bumping yourself out? So that's how I'm looking at where to take the distributions out for clients who are retired. I'm seeing where I can keep the tax the lowest and without causing more of their other income, like social security to be taxed, taking consideration phase outs and things like that, and Medicare.
The other thing is on a low tax bracket, your 12% tax bracket, your qualified dividends might be at 0%. That's big also. The other thing I'm looking at is, we mentioned that the standard deduction is doubled. There is conversation that Biden gets elected, that he wants to revert the tax code back from what Trump did, but I'm not planning what might happen, I'm going to plan what we know today for this tax year.
So we've mentioned this before, our qualified, charitable distribution, if you're 70 and a half and you're already making charitable donations and you're not getting any tax benefit because you're not itemized, there's a strategy called a qualified charitable distribution or a QCD, which allows you to make a donation directly from your IRA to the qualified charity. This helps you satisfy your RMD, your requirement distribution, but you don't have to pick up the income.
Interesting. That's a nice little strategy, they can be employed for people in that situation.
I hear people going, "Well, why would I make a donation, but get no tax benefit?" And when I used to do tax returns, it's amazing, there was a lot of people who are very charitable in giving. I'm going to say most of the people I interact with on a daily basis aren't doing the donations always because of the tax benefits, they're doing it because they have interest in the organization they're making the charity to.
Sure. They've got an emotional connection to whether it's an animal thing, or something for kids, or you name it.
Churches, synagogues, mosques, anything.
And again, we've talked about this in previous episodes, Rich, and it really is to sum up everything we've talked about today. There are so many different strategies, and so many rules, and so many regulations. If you're not an expert in this stuff, it's really going to make your head spin. But if you employ all the right strategies, unless you said, not every strategy is appropriate for everybody. But if you employ the right strategies for your individual situation, you can really max out what's going into your pocket and minimize what's going to Uncle Sam, which really is the goal, especially now when so many people are struggling with everything going on in 2020.
Jag, this is not simple stuff. It's not stuff you want to go to Barnes & Noble and pick a book up and learn how to do tax planning.
Tax planning for dummies, maybe?
Yeah. This is something you want to hire a professional to do for you. If you have your tax return prepared, some accountants will charge you for tax planning. Again, we talked about this before. I think it was the first or second episode we ever did. We said managing expectations.
And if you remember, I said, you'll hire an accountant to do your tax return, you'll owe money, and next year you owe money you're like, "Why didn't I get any tax planning from my accountant?" Well, you didn't hire him to do the tax planning, you hired him to prepare your tax return. So it's managing that expectation.
In our industry, there are a lot of people who manage money, but does not offer tax planning or financial planning, or insurance planning. That's a specialty. Let's say someone who does financial planning. We're very good at that. In our firm we're very good at the tax projections. We work closely with our clients' accountants, we work up tax projections for our clients and we give it to them to review with their accountant like the blessing.
Richard, the analogy is, and whether or not we have football this year remains to be seen, but-
But baseball now.
Yeah, that's true.
Baseball might go away. How about my season tickets for The Flyers?
It's July 29th, who knows what's going to happen by the time you listen to this podcast? Because it seems to be changing by the hours. But to keep with the sports analogy, you're the quarterback of the team when it comes to your finances. So you want to have people on your team that you are employing for their different skill sets.
So you've got somebody like Rich that can help you on the planning side, and then you've got maybe a CPA that's going to work with you on the tech side. And all of these people can work together. It really is a team effort. And if you have the right team in place, it will make a world of difference in both your stress level, your sanity level, but also in your bank account too.
Absolutely. I like your analogy with the quarterback, but I would say that the client is the general manager, I'm the coach.
All right, Mr. Belichick.
And then we have a whole bunch of players out there working for us.
That works too. But the idea is obviously you have to put together a good team, and it's everybody working together and-
Jag, I'm sorry to cut you off, but it's interesting. When I had a tax practice, there was always surveys out there and say, the most trusted professional is your accountant. And when I started doing the financial planning side of it, I see a lot of what accountants aren't doing, which they're [inaudible 00:23:49] getting that trust. And it goes back to that expectation we talked about where you hired them to do one thing, and they're not doing something, but you didn't hire them to do it.
The person who's a holistic financial planner, who's looking at your overall household, meaning your insurance, your investments, your taxes, everything, should be your mostly trusted advisor you hire.
Absolutely. If you need help with your finances, this is why it's so important to talk to somebody like Rich. I know you're meeting your clients virtually at this point, right?
I am, over Zoom. I think we have a couple a day, which has been great. And clients are actually beginning to like it, they've been asking me, "When this is all over, can we continue?" I'm like, absolutely, I've been doing this for years.
You don't have to get in the car and drive over, you can do it from the comfort of your own home.
It's not just that, the spouses now can participate too. And I even have clients where they're getting their kids involved.
I love it.
Their adult kids. It's great.
Have the whole family be aware of what's going on for sure. So if somebody wants to set up something with you, Rich, and talk to you, what are the best ways to reach you?
Well, you can always call me at (609) 924-2049, my direct extension is 126. You can always email me at email@example.com, or you can go to my website at www.ncfg.com. That's Nancy Charlie Frank George .com. And on there, there's a way to schedule appointment with me over the phone, Zoom for now. Feel free to schedule something, free consultation on the first meeting. Pick my brain.
The other thing I'm going to ask everyone to do is if you're enjoying this podcast, do one or two things for me, share it with your family and friends. And if you can go on to iTunes and rate it or put a review, I'd greatly appreciate it.
Richard Oring from New Century Financial Group, really important and relevant information today. Thanks as always. Stay healthy, stay safe. We'll talk soon.