Tax Planning

Here’s what you need to know:

• A capital gain is money you realize for selling an investment for more than you paid to buy it. A capital loss occurs when you sell an investment for less than it cost you.

The most effective way to pay the least tax that you are legally obligated to pay is to make financial decisions with an eye to their tax consequences. For example, one way to reduce your current income tax is to contribute to a tax-deferred retirement account, such as an employer-sponsored plan. Your contribution reduces the income that’s reported to the IRS and as a result, the current tax you owe. Any earnings in the account are also tax deferred.

• If you’ve owned an investment for more than a year before you sell, you have a long-term capital gain or loss. If it’s been less than a year, you have a short-term capital gain or loss.

Of course, when you take money out of the account after you retire, you’ll owe tax on the full amount of your withdrawal. But you may be paying at a lower tax rate when you take money out than you were when you put it in. In some sense it’s a gamble, but thanks to the power of compounding, it’s possible to come out significantly ahead, even if tax rates have increased.

• Long-term gains are taxed at a lower rate than your ordinary income, while short-term gains are taxed as ordinary income. The long-term rate is determined by your adjusted gross income (AGI), and may be 0%, 15%, or 20%. Surcharges may apply, again depending on your AGI.

Or, if you want to avoid mandatory taxable withdrawals from your retirement savings, you might put your retirement money in a tax-free Roth IRA. While you’ll contribute after-tax income, your withdrawals will be completely free of federal income tax provided your account has been open at least five years and you’re at least 59½. Similar tax savings are available for college savings with a Coverdell education savings account (ESA) or a 529 college savings plan.

• You can use long-term capital losses to offset long-term capital gains, or short-term losses to offset short-term gains, on a dollar-for-dollar basis. Unused losses can be carried over from one tax year to the next.

Investment Planning

So, as you make investment decisions, you may want to postpone sales when feasible to qualify for the long-term gain rate and sell some assets with capital losses at the end of the tax year to offset some gains.

Investment decisions have tax consequences, although minimizing taxes should be only part of your overall investment strategy. The investment risk you’re willing to take, the return you can reasonably expect, and the impact of the transaction on your portfolio diversification are all at least as important as the tax implications.

Doing Well by Doing Good

You are entitled to deduct gifts you make to qualified charitable, religious, and educational organizations. The way you make the gift can have tax consequences. For example, you’re likely to save on taxes by giving assets you own directly to the organization you want to benefit rather than selling the assets and making a cash gift.

The tax consequences of bequests you make to individuals, such as those to children and grandchildren, can be reduced as well by making those gifts in certain ways. Among the examples are creating trusts and avoiding the generation-skipping tax. Working with experienced legal and tax advisers as you make your plans is always wise and sometimes essential.

Using Pretax Dollars

If your employer offers a flexible spending account (FSA) as an optional employee benefit, it’s a tax-saving opportunity you probably don’t want to pass up. An FSA lets you set aside pretax income to pay for uncovered healthcare expenses, including copays, deductibles, prescription drugs, and many over-the-counter medications that meet the IRS standards for treating or preventing disease or illness.

An FSA usually works on a calendar year. To participate you contribute, through payroll deductions, as much as you think you’ll spend during the year, up to the maximum annual limit. If you and your spouse are both eligible to participate, each of you can contribute up to the annual limit.

There is one risk: If you don’t use the money during the year for eligible expenses you may forfeit it. However, employers may offer either a two-and-a-half month grace period into the following year or allow you to carry over up to $640 in 2024 of any unspent money, removing some of the pressure of using up your balance.

Using an FSA does involve substantial paperwork, but it can provide real tax savings. For example, suppose you contributed the full amount you could and spent it all on covered expenses. That would represent a tax savings of several hundred dollars, the exact amount depending on your marginal tax rate. If you want more information, check IRS Publication 502, “Medical and Dental Expenses.”