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How to be tax-smart throughout the year

Ernst & Young and Fidelity discuss tax planning strategies you may want to consider.

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Key takeaways

  • Decisions about where to live can be complex and taxes are only one part of the equation. If you are limited by the new cap on real estate tax deductions, you may want to research the impact of relocating, along with other factors.
  • It may make sense to contribute to both a traditional and a Roth IRA if you are eligible, so you have tax-free and taxable options when you withdraw the money in retirement.
  • 529 savings plans can be a tax-efficient way to save for qualified education expenses. Not only does the money grow tax-deferred, it may come out tax-free if it's used for qualified education expenses.

In October, Fidelity and Ernst & Young joined forces to deliver a webcast that focused on the benefits of being tax-smart throughout the year. The event featured Chris Williams, principal of Ernst & Young's private client services and Colleen Rolph, vice president of learning at Fidelity Investments.

A number of tax-savvy tips were shared throughout the webcast which help answer questions such as:

  1. What are some of the tax implications of relocating to a different state—now or in retirement?
  2. What are the differences between traditional and Roth IRAs—and should I consider contributing to both as I prepare for retirement?
  3. What are the key tax advantages of college savings plans, including 529 plans?

State tax rules and state residency planning

It used to be that if you paid high state taxes, you could itemize that as a deduction on your federal tax return. That tax benefit helped offset some of the cost of the high state taxes. The federal rules changed dramatically at the end of 2017. Now you can only deduct up to $10,000 of state and local taxes of all types on your federal income tax return.

That is a major limitation for many people, especially those who live in high-tax states on the map. No wonder more people are thinking seriously about relocating to a more tax-friendly state.

If you pay taxes in a high tax state and are limited by the new cap on deductions, you may want to research the impact of relocating. While decisions about where to live are complex, it makes sense to weigh taxes as one part of the equation.

There are also people who choose to live in one state and work in another state. Since tax laws are different in all 50 states, consider working with your tax advisor to determine how income is recorded and how state residency requirements are documented.

States generally tax the income of nonresidents who generate income in that state. Income subject to tax can include:

  • Rental income
  • Gain on the sale of real estate
  • Employment income

This map (see graphic below) of the United States highlights the wide variety of income tax rates across the country. Among the highest tax states—the red ones—are California, New York, Oregon, Minnesota, and Maine. The dark blue states—which have no income taxes—are Washington, Nevada, Texas, Tennessee, New Hampshire, Alaska, Wyoming, South Dakota, and Florida.

Make sure to keep sets of accurate records. For example, if you work or own real estate in multiple states, keep detailed income and expense records. Things like calendars, the electronic toll tags in your car, and even passports (assuming you work abroad) can document how you spent your time. Your cell phone records can show where you were when you made a phone call. Also helpful: credit card statements to show where you were having dinner, or when you went to a coffee shop. Hold on to all of these records so that if the state has a question about your tax return down the road, you have those records to document your activities.

Tip: Because states and the federal government can look back 6 years in many cases, hold on to at least 7 years’ worth of records. Document when you moved from one state to the other—things like when you changed your driver’s license, or the particular day that the moving truck arrived. These things detail the active steps you took to make that switch from one state to the other.

Read Viewpoints on Fidelity.com: Should you move in retirement?

Next, let's explore the tax advantages of the 2 kinds of IRAs (individual retirement accounts): a traditional IRA and a Roth IRA.

It may be appropriate to contribute to both a traditional and a Roth IRA—if you can. Doing so will give you taxable and tax-free withdrawal options in retirement. Financial planners call this tax diversification, and it's generally a smart strategy when you're unsure what your tax picture will look like in retirement.

Remember, though, you can contribute only up to the contribution limit in any one year—so $6,000 in 2019, plus $1,000 if you are age 50 or older—in total across all IRAs you own, whether traditional or Roth. With the traditional IRA, you have the ability to make pretax deductible contributions, and the potential benefit is that you can get a tax deduction to help reduce your taxes today. Once you put the money into the traditional IRA, it can grow tax-deferred. When you take the money out, that’s when you typically pay the taxes. So, with the traditional IRA, the tax benefit to you is up front.

A Roth IRA is a little different. With a Roth IRA, you make an after-tax contribution and pay taxes upfront. A Roth IRA contribution won’t reduce your taxable income the year you make it, but there are no taxes on your future earnings and no penalties when you take a distribution, provided you hold the account for 5 years and meet one of the following conditions:

  • You are age 59½ or older
  • You are disabled
  • You make a qualified first-time home purchase (lifetime limit $10,000)
  • You have died

Two more advantages of Roths: Contributions, as opposed to earnings and converted balances, are never subject to taxes or penalties—even when the contribution amount is taken as a non-qualified distribution. And lastly, required minimum distributions (RMDs) do not need to be taken from Roth IRAs.*

Read Viewpoints on Fidelity.com: Traditional or Roth IRA, or both?

2 potential IRA pitfalls to avoid

1. Early withdrawal penalties

If you are age 55 or older with a 401(k) plan, you may leave your job and take money out of the 401(k) plan without the 10% penalty. You will still pay tax, but no 10% penalty. However, if you take a 401(k) plan and roll it over to an IRA, you will lose that age 55 exception; you’ll have to wait until age 59½ before you can avoid the 10% penalty unless you meet one of the other exceptions.

2. Taking your first RMD

If you have a traditional IRA, you have to remember that you will be subject to those required minimum distributions (RMDs). These begin during the calendar year in which you become 70½ years old. RMDs do not apply to Roth IRAs.

College savings plans, including 529 plans

The cost of higher education for a child may be one of your biggest expenses. Family income and savings now account for 48% of all college funding (see chart). Like retirement, there are no shortcuts when it comes to saving, but there are some options that can help your money grow tax-efficiently.

There are a number of college savings options, including Coverdell education savings accounts, prepaid tuition programs, and other custodial accounts.

The most common vehicle for savings for college is the 529 savings plan, which continues to be popular for a several reasons:

  1. They can be tax-efficient. Not only does the money grow tax-deferred, it may come out tax-free if it's used for a qualified education expense. That includes tuition, room and board if they're in school at least half-time, books, and even some computer equipment.
  2. If you contribute to a state-run 529 plan in the state of your residence, you may be eligible for a state income tax deduction.
  3. Beneficiaries can be changed at any time.

Read Viewpoints on Fidelity.com: The ABCs of 529s

From developing tax-smart Roth IRA and college saving strategies to helping you sort through the pros and cons of relocating to a different state, the subjects covered in this webcast are just part of the year-round financial planning topics that you can discuss with your financial advisor.

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* Spouse and non-spouse beneficiaries will be required to take RMDs from the Roth IRA after your death.
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