1) Fund a CHET 529 College Savings Plan
529 College Savings Plans are an effective way to save for a child’s or grandchild’s education. The State of Connecticut allows Connecticut Taxpayers to fund a Connecticut Higher Education Trust (“CHET”) 529 College Savings Plan and take a State Income Tax Deduction. Married couples filing a joint income tax return are allowed to deduct up to $10,000 a year on their State of Connecticut Income Tax Return. Single filers can deduct up to $5,000.
While there is no federal income tax deduction with this contribution, the state deduction is very helpful. For a married couple with an adjusted gross income of $100,000, their state of Connecticut income tax rate is 5%. Therefore they save $500 in state income tax every year they make the contribution. Here are 5 Reasons to Fund a 529 College Savings Plan.
2) Manage Your Capital Gains
Investors need to manage their capital gains tax exposure. Capital assets include stocks and bonds. The popular media would have you believe that all capital gains are taxed at 15%. This is not true. Short-term capital gains are taxed at your ordinary income tax bracket. Short-term gains are for capital assets held one year or less. Federal ordinary income tax brackets start at 0% and climb all the way up to 39.6%. In 2016 the highest income tax rate of 39.6% kicks in for married couples filing a joint income tax return with taxable income of $466,950.
Long-term capital assets are capital assets held longer than one year. Long-term capital gains are taxed at 0%, 15% or 20%. The long term capital gains tax rate is dependent on your ordinary income tax bracket. While most folks will pay the 15% long-term capital gains rate lower income taxpayers pay the lower rate and higher income taxpayers pay the higher rate. In 2016 for a married couple filing a joint return with taxable income under $75,300 their long-term capital gains rate is 0%. For married couples filing a joint return with taxable income over $466,950 their long-term capital gains rate is 20%.
Additionally investors need to be aware of the Net Investment Income Tax. Net investment income includes interest, dividends and capital gains. This tax is 3.8% on investment income and kicks in for joint filers with modified adjusted gross income over $250,000. Suffice it to say savvy investors know How To Use The Tax Code to Retire In Style.
3) Adjust Your Withholding and Estimated Taxes
There are penalties for underpaying your income taxes throughout the year. The tax system is designed as a pay as you go system. For employees they will have income taxes deducted from their paychecks. Retirees that are taking distributions from their IRA’s and 401(k)’s can elect to have income taxes deducted from these payments. For folks collecting their Social Security benefits they can also elect to have voluntary federal income tax withheld from these payments. If you are self-employed or retired and not having any income tax withheld you will need to file quarterly estimated income taxes. These payments are due on April, June, September and January 15th. To make a federal estimated tax payment use IRS Form 1040-ES. To make a State of Connecticut estimated tax payment use Form CT-1040-ES. These payments should be sent certified mail return receipt requested to verify timely mailing.
There are two ways to avoid the underpayment of tax penalty. The first way is the so called safe harbor method. For taxpayers with adjusted gross income under $150,000 to pay in 100% of their prior year tax. Taxpayers with adjusted gross income over $150,000 need to pay in 110% of their prior year tax. The second way to avoid the penalty is to pay in 90% of your current year tax.
4) Maximize Your Contributions to Your 401(k) Plan
Employees need to review the funding of their employers 401(k) plan. Employees are allowed to contribute up to $18,000 a year pre-tax into their 401(k) plan. For employees that are age 50 or older they are allowed to contribute an additional $6,000 in a so called catch up contribution for a total of $24,000.
Younger employees should find out if their employer offers a Roth 401(k) plan. If not, they should suggest that their employer offers one. The Roth 401(k) plan has the same annual limits as the 401(k) plan. It’s important to understand that annual limit is for the 401(k) plan, Roth 401(k) plan or some combination of the two. Unlike the 401(k) plan, contributions to the Roth 401(k) plan are made after tax. For younger employees just getting started in their career it’s likely their income tax bracket will be fairly modest. Contributing to a Roth 401(k) plan makes more sense than a 401(k) plan as the income tax they pay by making after tax contributions will likely be at a lower tax rate. All employees need to understand The Difference Between a 401(k) plan and a Roth 401(k) plan.
5) Fund Your Roth IRA
Investors need to maximize their contributions to the Roth IRA. If you are eligible you can contribute $5,500 a year. Taxpayers age 50 and older can contribute an additional $1,000 for a total of $6,500.
The criteria to have a Roth IRA are very straight forward. First you need to have earned income of at least the amount you are contributing to your Roth IRA. Earned income is your wages as an employee or earnings as a self-employed individual. Second your income needs to be below a certain threshold. In 2016 for a married couple filing a joint return if their modified adjusted gross income is below $184,000 they are eligible to contribute to Roth IRA’s. When their modified adjusted gross income exceeds $194,000 they are no longer eligible to contribute. Modified adjusted gross income between these amounts will allow for a partial funding of Roth IRA’s.
Unlike an IRA, there is no income tax deduction with the Roth IRA. There is however a huge advantage with the Roth IRA. If you meet two simple conditions all of the distributions are tax-free, not tax deferred like an IRA. Repeat all of the distributions are tax-free. To have the distributions be tax-free you need to be over age 59 ½ and the account needs to have been open for five years. That’s it. Everyone should take a hard look at funding their Roth IRA, particularly younger people. Decades of tax-free growth are an awesome way to expand your net-worth.
Another benefit to the Roth IRA is that it is not subject to the Required Minimum Distribution (“RMD”) rules like IRA’s and 401(k) plans are. The RMD rules require individuals over age 70 ½ to begin withdrawing from their IRA’s and 401(k) plans. This is not the case with Roth IRAs. RMD’s are not required during the Roth IRA owners and surviving spouses’ lifetime. Non- spousal beneficiaries (children and grandchildren) are required to have RMDs from Roth IRAs however.
You don’t have to fund your 2016 Roth IRA contribution in 2016. You have until April 15, 2017 to fund your Roth IRA for 2016. Here is 3 Proven Reasons You Need a Roth IRA.
6) Take Advantage of Pre-Tax Accounts
Many larger employers will offer pre-tax benefits to their employees. Pre-tax health care is one of the more common benefits. Additionally pre-tax dependent care benefits are another popular benefit. For example, lets’ say your contribution to your health care at work was $500 a month or $6,000 a year. Also assume you are in a combined 30% federal and State of Connecticut income tax bracket. By pre-taxing your health care payments this you would save $1,800 a year in taxes ($6,000 x 30%).
With a dependent care benefit account you are able to pre-tax up to $5,000 a year in eligible expenses for child care. Depending on your tax bracket this is generally a better deal than claiming the credit for dependent care. Many folks would be limited to a credit of 20% of $3,000 paid or $600 for one child. The maximum credit allowed is for two children or $1,200. Assuming a combined 30% federal and State of Connecticut income tax bracket the pre-tax dependent care benefit account would save $1,500 ($5,000 x 30%).
7) Review Your Estate Plan
Connecticut residents need to carefully review their estate plan. The federal estate tax exclusion is $5,450,000 in 2016. For married couples that use ‘portability’ they can shelter twice this amount or $10,900,000 in 2016. The federal exclusion is indexed to inflation. The 2017 exclusion has not been released yet. With this high exclusion and the use of portability by married couples most folks won’t be subject to a federal estate tax. That’s the good news. The less than good news is that if you are subject to the federal estate tax it can be very expensive. The highest federal estate tax is 40%.
The State of Connecticut estate tax exclusion is only $2,000,000 in 2016. There are two key differences between the State of Connecticut and the federal estate tax. First, there is no ‘portability.’ As was just mentioned this allows married couples to effectively double the exclusion amount. This is not the case with the Connecticut estate tax. Additionally the State of Connecticut estate tax exclusion is not indexed to inflation. The State of Connecticut estate tax rate starts at 7.2% and goes up to 12%.
So while many Connecticut Residents won’t have a federal estate tax, they need to plan appropriately to minimize any potential state estate tax. Here is the Estate Planning Lessons From My Moms Estate.
Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Thomas F. Scanlon and not necessarily those of Raymond James.