March, 2012
By Michael Kalscheur, CFP®
Senior Financial Consultant, Castle Wealth Advisors, LLC

Every March it is the same. You stare at that big stack of tax paperwork on your kitchen counter or the desk in your office. You reassure yourself that it’s too early to start working on your taxes because some additional papers will soon arrive. Unfortunately, you know that everything you are going to receive has already come, and it’s time to bite the bullet.

Next comes the task of gathering up the shoebox full of statements and receipts and either dropping it off at your accountant’s office or wrestling with the tax software yourself, killing a full weekend (or more).

Then the apprehension of not knowing what the final number will be sets in. Hopefully it’s a refund, but what if it isn’t? How much more will I have to pay? Do I have the cash readily available?

Fortunately, there is a way to alleviate some of this burden (in both time and money) by taking some steps throughout the year. It all starts with a simple change in approach – focus on tax planning, not just tax filing.

Tax planning involves much more than just filling out forms and sending in checks. It means taking deliberate steps over the course of the year to organize and structure your taxes. It means taking advantage of what the tax code offers and allows, which is not necessarily just paying the smallest amount this April 15th.

Step 1 – Know what is deductible and what is not. One of the most frustrating things about the federal tax code is that not everything that can be deducted is actually deductible for everyone. Phase-outs reduce deductions if your earnings are too high. Some deductions have floors – for example, some can only deduct medical expenses that exceed 7.5% of your adjusted gross income. Mortgage interest is capped, as is interest on Home Equity Lines Of Credit (HELOC’s). This is what makes giving general tax advice so difficult; next door neighbors with relatively similar incomes can have vastly different tax deductions.

Here are some common deductions and the likelihood that you will actually be able to write them off your taxes:

  • 401k/403b Contributions – Very likely. Contributing pre-tax earnings to your firm’s 401k or 403b plan never even shows up on your taxable income (unless there is a problem). Always take advantage of this, at least up to the company match (but 10-15% is better for your future).
  • Traditional IRA – Maybe. If you or your spouse has a 401k/403b at work, you must earn less than the phase-out range to deduct contributions: For 2012 it’s $58,000 - $68,000 for singles and $92,000 - $112,000 for married couples.
  • Mortgage Interest – Probably. Mortgage interest is an itemized deduction (like state income taxes and charitable donations) and is only useful if your total itemized deductions exceed the standard deduction of $11,900 in 2012. Just remember that you cannot deduct interest on mortgage balances over $1M or HELOC balances over $100,000.
  • Medical Expenses – Unlikely. As mentioned previously, medical expenses are subject to a 7.5% of adjusted gross income floor, meaning only expenses above the floor can be deducted. Unless you had a significant out-of-pocket expense (monthly premiums don’t count), your chances for a deduction here are slim.
  • Roth IRA – No way. Roth IRA’s are always funded with after-tax dollars, so by their very nature you cannot receive a tax deduction. However, you never have to pay taxes on the earnings, so paying some tax now could save much more in taxes down the road. That’s tax planning.

Step 2 – Plan your investments for maximum tax efficiency. When selecting your investments, tax ramifications should be taken into consideration. After all, you only get to keep the after-tax returns, so plan ahead. Ask some simple questions:

  • When? – Investments inside 401k/403b plans and Traditional IRA’s are tax deferred, meaning that these are ideal for people in a high tax bracket and expect to be in a lower bracket later (i.e. at retirement).
  • Where? – Earnings on investments in a traditional brokerage account (say at Charles Schwab) are taxable annually, while the exact same investment in a Roth IRA is never taxed. In other words, where you invest can be just as important as what you invest in.
  • What? – Interest, dividends and capital gains all can have different tax rates. Interest and short-term capital gains are almost always taxed as ordinary income (max of 35%), while qualified dividends and long-term capital gains are taxed at lower rates (max of 15%). Municipal bond interest isn’t taxed at the federal level at all, and may not be taxable at the state level, if your muni bond is from your home state.

Step 3 – Take advantage of company benefits. Many companies offer ways to save money for common costs through pre-tax savings plans. Childcare, medical expenses, adoption costs, group term life insurance and other things can all be paid for or set aside pre-tax. The rules and limits are too numerous to go into here, but can be very beneficial. If your company offers them, take advantage of them. If not, ask if a plan can be started.

Step 4 – Consider both state and federal taxes. Up until this point we have only been focused on federal income taxes, but for people who also have state and local taxes, there are additional opportunities.

  • In Illinois, there is a tax deduction (up to $20,000) for contributions to the state’s 529 plan.
  • In Indiana, there is a tax deduction (up to $1,000) for money spent on insulation or other energy saving investments in your home.
  • Arizona, Michigan, Kentucky, Montana, North Dakota and Iowa all have tax credits for donations to scholarship programs for disadvantaged youths.

You get the idea. Look for things that will cut your total tax bill – federal, state and local combined.

Step 5 – Review taxes with your advisors several times a year. CPA’s can be a big help in March and April, but that is just with tax filing. Make a point to talk to your CPA at least 1 or 2 other times during the year, especially before year end. Certain deductions must be done before December 31st (or even sooner), while very few can still be taken advantage after the year is over.

Likewise, be sure to talk to your financial and investment advisors about other deadlines and opportunities. If your firm wants to start a retirement plan, a SIMPLE IRA must be set up by October 1st, a 401k plan has until December 31st and a SEP has until April 15th of the following year (maybe longer).

Also, if any of your investments declined in value, you may be able to deduct the loss; this is known as tax loss harvesting. Lesser known is that IRA losses can also be deducted, but only if the entire IRA is liquidated and distributed. This means that a risky asset in taxable brokerage account is deductible, but the same investment inside an IRA may not be. A good advisor will help make the most of this.

Step 6 – Take “Tax Tips” with a grain of salt. You always see these articles come out around this time of year. “Top 10 Ways to Cut Your Taxes.” Half of the time they reference common, routine tax deductions that most people already take advantage of, and the other half are usually things that very few people can actually use or change.

When you change from tax filing to tax planning, you won’t have to worry about tax tips because you will be confident that you have already covered your bases. Stick with tax planning (steps 1 – 5) and you will have a much more enjoyable month of March.

Michael Kalscheur, CFP®, is a Senior Financial Consultant at Castle Wealth Advisors, LLC. Castle specializes in helping families and closely-held business owners with strategies to protect and transition family assets from one generation to the next. Castle’s senior partners also work with clients throughout the country in making logical decisions to help them fulfill their personal and business financial goals. For more information visit, call 1-888-849-9559 or contact Michael directly at .