A PRESIDENTIAL TAX RETURN
November is tax planning season at Balanced Capital. I take all of my clients through a planning meeting to look for any near term, and/or long-term planning moves that can be used to lower what I call their lifetime tax bill.
Just for kicks (and because it is publicly available) I thought it would be fun to run President Biden’s 202 tax return through my process to see what opportunities I could find. In all honesty, I did not think I would find much. A large chunk of the reports I do are made from returns done by turbot etc. where errors are common. I assumed that since he is the president and all, he would have top notch tax advisors making sure he saved every penny he could. Or perhaps, even if he didn't have great tax advisors, He of all people ought to know how to maximize the tax code because after all… He helped write it.
When I rolled up my sleeves and dove in, I found not one, not two, but FIVE opportunities that could improve Mr. President’s financial situation. Let’s take a look at what those opportunities are and examine how you could have similar opportunities in your life.
Over Withholding
Americans seem to have an obsession with tax refunds. Every spring people get excited to get their refund check so they can FINALLY go buy a new TV or book a vacation. It makes no sense. It’s as if they have the attitude that those tax refunds are extra money coming from the north pole. Think about the word refund for a second. It means they are giving it back. It means you paid them too much money and they are returning what you never should have given them, and they aren’t paying you any interest. In other words, you could have ALREADY bought that TV or vacation. All you had to do was set your withholdings correctly so that they never took that money in the first place.
The reason so many people withhold too much money is because if you UNDERwithhold, the IRS can slap you with penalties and interest. The average person gets so scared of that, that they end up having extra taken out of their checks “just to be safe”.
There is a simple way to make sure you don’t get penalized by the IRS. In the above graphic, it is in the red box, and it is called your safe harbor. If your AGI is under $150,000 this number is simply your tax bill from last year. If you are over $150,000, the number is 110% of last year’s bill. As long as you have withheld that throughout the year, you will not be penalized. You may still owe taxes. You may still even owe a lot of taxes. But you will not get an extra charge. So, use that number to your advantage, and stop giving the government an interest free loan. Like our president did to the tune of $4,600.
Use Capital Gains to Your Advantage
If you look in the blue boxes in the graphic above, you will notice that Mr. Biden has two different tax rates. His income tax rate is 35%, yet his capital gains tax rate is just 20%. Which would you rather pay? What more astounding, is the President owns a business, which would allow him the flexibility to convert some of his income into a capital gains distribution. This is the strategy Mitt Romney famously used to lower his tax bill.
Where this factor really starts coming into play is when you hit retirement and being living off of savings. If you have done a good job of accumulating savings, you will have a plethora of opportunities to delegate which type of taxes you want to pay, and thus have a large amount of control over the rate you pay.
It can also start to factor in as you grow that account throughout your working years. Any investment gains on an investment that you have owned for less than a year, is referred to as a short-term gain, and is taxed at income tax rates. If you have owned the investment for more than a year, it will fall into the lower capital gains rates. Make sure you are working with a financial advisor who incorporates this difference into your overall investment strategy.
The Backdoor Roth Contribution
As a quick refresher, there are two types of IRA accounts. Traditional IRA accounts resemble 401k etc. in that contributions are made on a pre-tax basis, meaning you can get a tax deduction now, but your withdrawals in retirement are subject to income tax. A Roth IRA is the exact opposite. Contributions are made post tax, and you get no tax deduction now, but retirement withdrawals are completely tax free.
If you look in the pink boxes above, you will notice two things.
First, The Biden’s household income was far above the adjusted gross income limits that would have allowed them to contribute to Roth IRA accounts. In order to contribute directly to a Roth a married couple would need to have a household income under 196K.
Secondly, The Biden’s AGI was also significantly above the limit for IRA contribution deductibility. While that does not mean that they are unable to contribute money into a traditional IRA, it means they will not get a deduction for doing so. Meaning they will be taxed on the money now, AND taxed when they withdraw it in retirement. So long story short, putting money into a traditional IRA would be a terrible idea for the Bidens unless….
They have a backdoor Roth strategy in place. Here is how it works. As mentioned above, they cannot contribute directly to a Roth. They are allowed to contribute to a traditional IRA. So, to make a backdoor Roth contribution, they would contribute (up to $7,000 each for the Bidens) into traditional IRAs. At that point they would immediately convert the IRAs into Roth IRAs. Conversions in general are a powerful tax planning strategy any time, but especially in this case they are very effective. When you make a Roth conversion, you are essentially electing to pay the future taxes due on your IRA account NOW. In the case of a backdoor Roth IRA those taxes amount to zero because since you weren’t able to deduct your IRA contribution, the taxes have already been paid. So, when the conversion is made, no taxes are due, and the traditional IRA becomes a Roth IRA.
If you want my honest opinion, this is simply a classic example of the IRA making life hard. If you followed the steps above, you probably noticed that the process could be boiled down to several hoops that have to be jumped through with the end result being the exact same as just making a direct Roth IRA contribution. Your guess is as good as mine as why this process has to be so cumbersome.
However, annoying it may be, backdoor Roth contributions are a huge opportunity for numerous families out there, but many of them simply do not know it exists, or do not know how to do it. Due to their age, backdoor Roth contributions would not change the Biden’s life, but is something they should be doing while they can.
Qualified Charitable Distributions
This is probably the least known strategy of all that are on this page. Once you turn 70, you are able to send money directly from a pre-tax retirement account (401k, IRA, 403b etc.). If you do that, it becomes what is known as an above the line deduction. Meaning it reduces you adjusted gross income. In regular English, not tax speak what that means is that these contributions lower your income in addition to the standard deduction. In the Biden’s case, if they were to make QCD’s their AGI would drop by $30,704, THEN they would claim a standard deduction of $27,400. This would lower their taxable income by about $2,000. Which would in turn save them $700 per year in income tax.
If you are not yet 70, there is another concept I want to explain to you. It is called bunching deductions. Imagine you like the Biden’s max out the SALT tax deduction at $10,000, you paid $7,000 in mortgage interest, and you are a charitable family who gives away $10,000 per year. That would put your total deductions at $27,000. So, you would be itemizing. But not by much as your standard deduction is $25,200.
The bunching strategy employs the idea of using on years and off years when it comes to deductions, generally on an every other year schedule. In an on year, you would do things like pay your mortgage payment for January of the next year, early, in order to get one more month of interest in this year. You would also look at doubling your charitable giving this year, and doing none next year. If you did that, your numbers would look a little bit different.
In an on year, you would have the same $10,000 in SALT taxes, probably somewhere near $7,700 in interest, and $20,000 in charitable giving, totaling up to $37,700. The following year you would take a standard deduction of $25,800. This strategy would result in your AVERAGE deductions being $31,750, or an extra $6300 or so per year. In a 24% tax bracket that saves you $1,500 per year, and all you changed was the timing.
The Mortgage Tax Deduction is Not Worth it
I will say this right off the bat. I am a supporter of paying off your house early. Many financial planners disagree with me, and I will openly admit, that on paper they are right, and I am wrong. BUT life is not lived on paper, and having a paid for house is a huge layer of security and an anchor in a financial plan.
The paper argument for not paying off your house is that the rate of return in the market is likely going to be greater than your interest rate, so you would be better off investing more and paying off less. It’s a solid argument, and it is correct.
There is also another argument that gets made for not paying off your house early, and it has to do with taxes. Most of the time its mortgage brokers you will hear making this argument and it goes like this; “Don’t pay off your mortgage early because you will lose the interest deduction”. This argument is in no uncertain terms wrong. It was wrong before the tax cuts and jobs act, but it is even more wrong now. There are two main flaws with this argument.
First, spending money just to get tax deductions is a losing game. It is certainly nice that the IRS lets you deduct mortgage interest. In many cases this gets back for the taxpayer anywhere between 22 and 35 cents for every dollar they paid in interest. But remember, to get that 22-35 cents, you had to spend a dollar. You can probably see where I am going with this. You would be a lot better off to just not spend the dollar.
Secondly, with the tax cuts and jobs act, the standard deduction was significantly increased. It increased enough that the vast majority of Americans stopped itemizing their deductions and began taking the standard deduction. If a family claims the standard deduction, they will get the same amount of deductions whether they have a mortgage or not.
The Biden’s are actually a perfect example of how little mortgage interest helps in terms of deductions now. Assuming they made the adjustment I talked about earlier and do their charitable giving through qualified charitable distributions, their deductions would now stand at $25,353. Since they are over 65 their standard deduction is $27,400. That means that they will be taking the standard deduction, and they would get that whether they paid mortgage interest or not. Which is to say, they received absolutely zero tax benefit from their interest.
If you have stayed with me all the way until now, congratulations, you are now far better prepared to go out there and take on your taxes. Remember, pay the IRS every cent that you owe, but don’t leave them a tip.
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