The difference between death and taxes is death doesn’t get worse every time Congress meets. — Will Rogers
by Lisa St. Claire
Simplicity is underrated in our “more is always better” culture. And nowhere is the need for simplification more apparent than in our voluminous, broken tax policy. The U.S. income tax system as we know it today was created in 1913 with the passage of the 16th Amendment to the Constitution. At its inception, our entire tax law was 27 pages long. That’s correct: 27 pages. Today it’s more than 9,000 bloated pages — more than four million words. How did things get so complicated?
Most people buy into the idea that taxes should be fair and conducive to good governance — as well as simple. If the only purpose were to raise revenue, perhaps our tax system could be simple. But it has other goals, including efficiency and enforceability. The tax system is also used by Congress to influence social policy and deliver benefits for specific groups and industries. It’s no wonder that simplicity has lost out to these competing goals. Unfortunately, the resulting tax burden has turned into a hyper-politicized and divisive ball of confusion. In short: a hot mess.
As an antidote to this thorny and complex morass, here are my favorite tax moves — and they’re simple and ethical. There are a million tax tips out there, but in order to qualify for this list, the strategy had to meet three distinct criteria:
1) Provide high impact: The results of using the strategy could result in significant tax savings for taxpayers of all brackets.
2) Be easy and inexpensive to implement: No fancy expensive legal structure needed.
3) Benefit not just the taxpayer but also others and/or the greater good of humanity.
Start a Donor Advised Fund
Don’t let the fancy name fool you: Donor-advised funds are the fastest-growing charitable giving vehicle in the U.S. because they are easy, flexible, and one of the most tax-advantaged ways to give to charity. I’ve seen this vehicle used successfully with a pool as small as $5,000 and as large as $100 million. What makes these funds so great is that when you start them, you’re making a tax-deductible donation to the organization sponsoring the fund. You advise the organization on how to grant the money to your favorite charities. And while you get a tax deduction in the year you make the contribution, you can take your time directing donations and spread them over several years. Your donation remains invested and has the potential to grow, tax-free, while you’re deciding which charities to support. If you have a large chunk of stock or mutual funds that have appreciated significantly, you can amplify the tax benefit of the fund by removing capital gains from your portfolio (as well as your estate). There are a number of places to set up donor advised funds; Schwab Charitable and Vanguard are good, low-cost options.
Convert all or part of your IRA to a Roth
By now you’ve probably heard that a Roth is a turbo-charged IRA. Why? Unlike traditional IRAs, there are no required distributions from Roth IRAs. You can enjoy tax-free growth throughout your lifetime, avoiding the tax imposed on distributions from conventional IRAs. While the IRS limits allowable contributions to a Roth IRA, there are currently no restrictions on conversions from traditional IRAs.
There’s a catch: You do have to pay taxes on the conversion as if it were a regular distribution. The resulting tax bill can be sizable, particularly for large balances. The initial shock of the tax bill often puts people off from conversions. But over the long-term, a Roth conversion can pay for itself many times over. This is particularly true if you are under age 70 or have children or younger heirs; the long-term benefit of all that compounding (tax deferred) really adds up. The beauty of the Roth is that after the huge initial tax hit, you never have to take an additional distribution in your lifetime. The funds grow tax-free, and all future distributions (even when your heirs inherit it) are tax-free.
If you pursue a Roth, there are ways to minimize the tax hit of conversion: If you anticipate your income dropping significantly in a certain year (and increasing in following years), you can do a conversion in the low-income year.
I particularly like the Roth as an inheritance vehicle because it gives your children an incentive to keep their grubby hands off the money. Why? Because during their lifetimes, the Roth will continue to grow tax-free, and while they will be required to take a minimum amount each year, the more they leave in the account, the greater the benefit of the tax shield. Never mind that you won’t be around to enforce this restraint, it’s still a good idea.
Avoid gift tax by paying tuition and health care bills directly for your kids (or anyone you choose).
While the IRS requires that you record plain old cash gifts of more than $14,000 per person per year, any money you spend directly to pay for someone’s medical bills or school tuition is not subject to federal gift or estate taxes, no matter the amount. It’s a fantastic way to give loved ones and friends (the recipient need not be a relative) the help they need while simultaneously reducing the size of your taxable estate.
In order to qualify for this tax exemption, the money must be paid directly to the school or provider of the medical service. This one makes the list because it offers unlimited support to others in arguably the greatest investment of all — their education.
So if you are interested in ways to reduce taxes and include others as beneficiaries of your strategic planning, consider these tax moves. After all, paying taxes is a reality, but there’s no law that says you have to leave a tip!
Lisa St. Claire is a Certified Financial Planner and a frequent contributor to the Nob Hill Gazette.