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Be tax-smart: Don’t pay Uncle Sam more than necessary

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When I led mutual fund seminars at local libraries from 1986 to 2016, one of my jokes that dependably produced giggling would it say it was: “It is unpatriotic to pay Uncle Sam more taxes than necessary.” Maybe “unpatriotic” isn’t the correct word, what about substituting “discouraging?”

The issue is, given the complexities of the tax code, it is so natural for anybody to commit errors that end up expanding the taxes he or she will pay. In light of the enormous changes during the current year resulting of the gigantic modify of the tax code in December 2017, more than half citizens who asserted charitable donations to bring down their taxes a year ago won’t have the capacity to do as such this year.

Why? Congress deserves credit for wanting to make taxes simpler by raising the standard deduction to $12,000 for singles and $24,000 for couples. As a result of the higher standard deduction and the new limit of only $10,000 allowed for deducting state and local taxes, a congressional estimate predicts that only 18 million taxpayers will be able to itemize. That is more than 60 percent less than 2017’s 46.5 million itemizers.

Not needing to itemize makes filing taxes much easier, but the downside is that many taxpayers will not benefit from their generosity because their charitable gifts and other deductions will not add up to enough to exceed the standard deduction limits.

There is a simple remedy for those over age 70½ who own traditional IRAs and therefore must take required minimum distributions, or RMDs, each year. As long as the charitable gift goes directly from their IRA to the charity ($100,000 per year is the limit), they can make tax-free donations that count toward meeting their required RMDs.

Of course, if their RMDs are sent to them, they must pay taxes on that money. If they then donate part of all or part of that RMD money to charity they can itemize their charitable deductions to lower their taxes. However, if they don’t have enough charitable and other deductions to exceed the standard deduction, they will then not be able to use their charitable gifts to lower their tax bill!

For taxpayers who have not reached age 70½, one suggestion is to double their charitable deduction one year and then give nothing the next year so they can itemize every other year. Another technique is to donate appreciated stock or even cash to a charitable gift fund to get a tax deduction and then distribute it to charities annually over many years, until the money is all gone.

The donations to a charitable gift fund can be invested in mutual funds so that they can benefit from stock market returns. You don’t receive any additional tax breaks, but you have more money to give away if the mutual fund appreciates. My favorite gift fund is the Fidelity Giving Account (www.fidelitycharitable.org,or 800-262-6039) that allows you to write checks to charities for as little as $50.

The new 2018 tax law did not change my very favorite tax-saving pension plan. Anyone who is self-employed may open a SEP-IRA where he or she can deposit up to 25 percent of his or her income.

The SEP-IRA not only bypasses federal and state taxes as 401(k)s do, but it also avoids FICA and Medicare taxes, too. (You may open a SEP-IRA and also contribute to a 401(k) and Roth-IRA if eligible.) The contributions to SEP plans may vary each year — from zero to 25 percent.

For middle-income taxpayers in the 22 percent bracket (taxable income: $38,701 to $82,500 single and $77,100 to $165,000 married), the SEP saves them almost 44 percent in taxes (22 percent IRS plus 15.3 percent FICA and Medicare plus 5.5 percent North Carolina equals 43.8 percent)!

The annual maximum for SEP-IRAs is $55,000 — that contribution amount would require an annual income of $220,000 or higher. (Small-business owners who have employees must contribute the same percentage amount for their employers as they do for themselves if the employees have worked for them two years or longer.)

There is one other little-known tax shelter for owners of small businesses that have only one owner or an owner and spouse. It is called an Individual 401(k) that allows sheltering up to 100 percent of income.

Twenty-five percent may come from the employer’s pocket — thus bypassing all taxes including FICA and Medicare. The remaining 75 percent comes from the employee pocket, after 15.3 percent for FICA and Medicare are deducted. The individual 401(k) limits are the same as for all other 401(k)s — $18,500 for under age 50 and $24,500 for age 50 or older.

I recommend opening an Individual 401(k) at T. Rowe Price (troweprice.com or 800-831-1344) because, overall, it has better performing stock mutual funds than either Fidelity or Vanguard and it offers either the traditional tax-deductible 401(k) or the tax-free-forever Roth 401(k). My favorite diversified fund there is Price Blue Chip Growth (TRBCX) that has a terrific two-decade record.

Finally, for very-high-income individuals, there is a terrific tax shelter available if your company’s 401(k) plan allows after-tax contributions. Even though the individual traditional or Roth IRA contributions are limited, depending on age, to $18,500 or $24,500, tax law permits sheltering as much as $55,000 yearly — the same amount as the SEP-IRA limits.

For example, suppose that an age 50-plus employee contributes the maximum of $24,500 to his or her traditional or Roth IRA. The employer match is $6,000 so the total is now $30,500. The employee can then put $24,500 ($55,000 minus $30,500 equals $24,500) into an after-tax 401(k).

The gains from that $24,500 are tax-deferred but because all the contributions were after-tax, they may be rolled over to a tax-free-forever Roth IRA when the employee quits or retires, or even annually if the 401(k) plan permits yearly rollovers.

Less than half of large companies offer an after-tax contribution option — often their pension-department employees are unaware that after-tax contributions to max out $55,000 annually are a viable option.

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