Tax Planning

State and Local Taxes Affect Your Wallet There are other types of taxes besides income tax. We’ll walk you through common types of state and local taxes, and provide tips on how you can minimize your tax liability so that you can keep more money in your wallet. Long before I started working in the tax profession, I had my first experience with state and local taxes as a young child. While at the grocery store with my mother, I wanted a pack of gum. It was advertised as $1.00 and I felt pretty energized about persuading my mother to give me a one dollar bill to pay for it. Once at the register, I found out that with the 7% state sales tax in New Jersey at the time, the actual price came to $1.07—and I came up short. Smart investing can help you minimize your tax liability. First, let’s define some of the various types of state and local taxes that you will face. Income tax: Tax that is paid to the state or local authority based on income such as wages, business profits, interest, dividends, capital gains, etc. Wage income is typically subject to tax withholding at the time it is received (and reconciled through annual filing). In contrast, taxes on investment income are typically paid through quarterly estimated payments or at the time of annual filing. Sales tax: Tax that is paid to a local authority on goods and services, typically at the time of the sale. In some states, there may be an exemption for basic necessities such as medicine, food, or clothes. New York City has a sales tax rate of 8.875%, which  is one of the highest in the nation. Sales tax can be funny sometimes. For example, New York does not tax unprepared food like a whole bagel, but one that is sliced for you is taxed. Real estate tax: A tax on the value of owned real estate and property, based on the appraised value. It’s typically paid either on a quarterly basis to the local authority, or through an escrow account as part of a monthly mortgage payment. Excise tax: A tax typically paid at the time of sale on a variety of goods and services such as alcohol, tobacco, gasoline, and gambling. Sometimes these taxes are referred to in the context of “double taxation” because sales tax may also be imposed in addition to the excise tax. The good news is that you can minimize or even avoid certain state and local taxes. Investing in specific types of funds, or in specific types of accounts, can help reduce what you owe. You can even reduce or avoid certain taxes by living in a state with tax laws that help you keep more in your wallet. Treasury bond interest is not taxable at the state level. Most states and localities with income tax requirements look at your federal tax return as a starting point, and then they make adjustments. This means that your taxable income at the federal level might be higher or lower than your taxable income at the state level. One reason your state income might be lower is due to U.S. government interest, because it’s taxed at the federal level but not at the state level. Most of our portfolios here at Betterment contain at least some income from U.S. Treasury bonds, unless your allocation is set to 100% stocks. Municipal bond interest provides double, or even triple, tax benefits. Municipal bonds are another component of tax-smart investing, particularly because the interest they earn is generally not taxed at the federal level. The highest income tax rate at the federal level is 37% plus an additional 3.8% tax on investment income. Reducing what’s taxed helps you keep more in your wallet. Not having to pay any % of income tax on your municipal bond interest can help you keep more of what you earn. But, why settle for one tax exclusion when you can get two...or even three? States generally don’t tax interest on municipal bonds issued within their borders (but they do tax interest from out-of-state municipal bonds), so residents who buy them can typically collect interest without having to pay state taxes. Residents of cities that assess their own income tax, like New York City, could exclude income from municipal bonds issued within their state on their city tax forms, too, resulting in a tax-break trifecta of federal, state, and city tax breaks. New York and California Residents State municipal bonds are most advantageous for those in high-income tax brackets. Our standard portfolio for taxable accounts utilizes MUB, a bond ETF providing exposure to municipal bonds from all states. We offer ETFs that invest solely in either New York or California municipal bonds, for New York and California residents with a minimum balance, or an intent to fund, of at least $100,000. If you want to switch out MUB in your portfolio to CMF or NYF, please email us. We generally recommend making this switch before you fund your account. The state you live in affects how much you’ll owe in taxes. State and local income taxes can significantly reduce the amount of cash you have left after paying taxes—and this varies based on the state you live in. California, New York State, and New York City typically have the highest personal income tax rates in the U.S. California’s highest income tax rate is 13.3% and New York City residents pay up to 12.696%. Note that only New York City residents pay New York City income tax. New Yorkers who live outside of New York City do not pay any New York City income tax, instead, they’ll pay the state up to 8.82%. These rates apply to all types of income unless there is a special exclusion or exemption. The state and local income tax burden has recently increased due to tax reform. The federal tax deduction for all state and local taxes paid by a taxpayer is now limited to $10,000 per year. Distributions From Retirement Accounts Certain states provide a full or partial exemption from state and local taxes for distributions from your retirement accounts. Each state has its own rules and limitations. There are a few states with income tax rules that are generous to retirees. Illinois has a blanket retirement income exemption for withdrawals from 401(k)s, IRAs, pensions, and even for Social Security payments. Pennsylvania has similar income tax exemptions to Illinois but may impose taxes for early retirees. New York allows for each spouse to exclude up to $20,000 from 401(k)s, IRAs, and corporate pension income per year, and also excludes Social Security payments from income tax. California taxes all retirement income at the same rate as the federal government with the exception of Social Security payments, which are automatically exempt. If you move states in retirement, your former state of residence cannot tax your retirement income. Only the new state can, which means you can avoid taxes by moving to a state that generally doesn’t have any taxes on retirement income, like Florida or Pennsylvania. Please note that Betterment is not a tax advisor—please consult a tax professional for further guidance.

3 Time-Sensitive Tax Moves to Consider this December Tax planning can help you make the most of your hard-earned money, and December is a great time to do it. December is a great time to plan your taxes. Why? Because most of your 2018 numbers are now known, and you still have time to take actions that can reduce your tax bill come April. What’s different about 2018 is that it’s the first year after the tax reform bill, the Tax Cuts and Jobs Act of 2017. That means the experience of filing your taxes may feel different than past years. The good news is there’s no better time to plan your taxes than December, and most strategies still apply even after the reform. Here are three tax moves to consider this December. 1. Finish up your contributions to your IRA, HSA, 401(k), or 529 plans—better yet, max them out. For many taxpayers, the most straightforward way to lower your current year tax bill can be to contribute to a tax-deferred savings account such as a Health Savings Account (HSA), traditional IRA, 401k, or 403(b). If you aren’t sure whether or not you’ve hit the 2018 limits (up from 2017), however, check the rules twice. Did you reach the age 50 at any time during 2018? If you have, you get extra catch-up contributions to your retirement plan. For HSAs, you’ll have to wait until age 55. With 529 plan contributions, there’s no federal tax deduction, but you might get a break on state taxes. Either way, last year’s tax reform bill offers new incentives to consider a 529. Specifically, you can take a tax-free withdrawal of up to $10,000 annually for qualified elementary and secondary school costs. 2. Sell, convert, or gift your investment gains and losses, time shifting your taxable income. Time shifting taxable gains and losses on the sale of investments is another tax planning method to consider. When settling up your bill with Uncle Sam, it’s often a question of “pay me now or pay me later.” This strategy has you explicitly choosing now versus later depending on tax implications. Based off of your income this year, you might benefit from tax loss harvesting.  This is the practice of deliberately selling losing investments in order to use the loss on that sale to help offset other income, thereby reducing taxes. Some services are even doing this automatically for you throughout the year.  If you don’t use automatic tax loss harvesting, you have until year end to do it manually. If your taxable income is $38,600 or less ($77,200 for married couples), you might consider harvesting gains instead of losses. That’s because a portion of your profit may be subject to 0% long term capital gains tax rate. If you don’t qualify for the 0% rate and you have appreciated assets, your tax-planning options could involve transferring these investments to others. If you hold the assets for life, you could enable heirs to receive a step-up in basis. When they sell, they can avoid taxes on the gain the investments saw during your lifetime. Alternatively, you could donate the appreciated assets to a qualified charity or donor-advised fund, which may net you an immediate tax deduction. Since the charitable contribution is not subject to capital gains taxes, more of the value is preserved for the cause when the investments are sold. You may also want to consider doing a Roth conversion for time shifting taxes due on investment gains. Let’s say that over the years you’ve been contributing to tax-deferred retirement accounts. The usual course of action is to let these investments grow tax-free, and withdraw them in retirement when you expect to be in a lower tax bracket.  But suppose your 2018 income is unusually low (e.g. you took unpaid leave). That—plus the generally lower rates of the tax reform bill—may mean you are subject to a low tax rate. This means that it may be to your advantage to convert some or all of your traditional retirement savings to Roth. It’s worth noting that in the past, investors had the option to change their minds and undo Roth conversions. With the new tax reform bill, however, Roth recharacterization is no longer permitted. 3. Shift your expenses to bunch your deductions. Investment gains and losses are not the only elements of the tax planning equation that can be time shifted. Delaying or accelerating other income and expenses is also a popular strategy. Examples include pushing bonuses to January, prepaying education expenses, and “bunching” itemized deductions. “Bunching” is the practice by which taxpayers consolidate as many deductible expenses as possible into a given year. The goal? To make the most of itemizing rather than taking the standard deduction. Historically, this meant controlling the timing of things like medical expenses, state and local taxes, mortgage interest, property taxes, and charitable giving. The new tax law is expected to change all of that since it nearly doubled the standard deduction. As a result, few will qualify to itemize going forward.  Tax preparation may be simpler, but some taxpayers may end up owing more, including: Homeowners subject to new limitations on home mortgage interest deductions Residents with higher state and local tax rates, because the federal tax deduction for state and local taxes is now capped. Similarly, many miscellaneous itemized deductions have been disallowed. Bottom line: the benefit of bunching deductions has been severely curtailed.  The exception, appropriately enough during this season of giving, is charitable contributions. Here, careful planning still has the potential to help ensure a happier holiday and tax time for you and the lucky recipient. Move quickly before the end of the year, but talk with a professional. It’s the most wonderful time of the year for income tax planning. But as we’ve seen, tax law changes, limitations, and interdependencies between provisions make it something of a tricky business. It’s crucial that you (or your tax advisor) run projections to help you see the intended benefits and quickly—like holiday sales, the window on this opportunity closes fast. Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.

What Is a Tax Advisor? Attributes to Look For Since Betterment isn't a tax advisor, we often suggest that customers see a tax advisor regarding certain issues or decisions. Who exactly is a tax advisor and how should you think about picking one? Tax season is now upon us. Now that you’ve probably received all of your tax forms, you may be facing a choice for how to proceed with filing: do it yourself with tax software or hire a professional tax advisor? Although it certainly will be more expensive than using tax software, hiring a tax advisor makes sense for certain individuals, depending on their financial circumstances. Here are two important factors to consider when deciding if a tax advisor is right for you: Time: Even with tax software guiding you, filing your taxes yourself can be time consuming. You’ll need to make sure that you’ve entered or imported the data from your tax forms correctly, which often takes at least several hours. We’ve written before about valuing your time here. Complexity: The more complicated your financial situation, the more a tax advisor may be able to help you. Have partnership income, or income from an S corporation? Been subject to alternative minimum tax in past years? Received or exercised stock options this year? Tax software can handle these issues, but it will take time, and the risk of mistakes (and even an audit) increases. If you decide that your situation warrants professional assistance, some further questions are worth exploring: what exactly is a tax advisor and how should you think about picking one? Who counts as a tax advisor? Anyone with an IRS Prepare Tax Identification number (a “PTIN” for short) can be paid to file tax returns on behalf of others. But merely having a PTIN doesn’t tell you much about the tax preparer; tax preparers have different experience, skills, and expertise. What you really want is a tax advisor, a professional with a certification and experience level that qualifies her not only to prepare your return, but to use her knowledge of the tax code to provide advice on your financial situation. There are three different professional certifications to consider, each of which qualifies a tax advisor to practice with unlimited representation rights before the IRS. This means that in addition to preparing returns, they also are licensed to represent their clients on audits, payments and collection issues, and appeals. Certified Public Accountants (CPAs) CPAs have completed coursework in accounting, passed the Uniform CPA Examination, and are licensed by state boards of accountancy (which require that they meet experience and good character standards). Some, but not all, CPAs specialize in tax preparation and planning. You can find complaints about CPAs either by searching records with state boards of accountancy and at Better Business Bureaus. Enrolled Agents Enrolled agents are licensed by the Internal Revenue Service after they have passed a three-part examination and a background check. The IRS maintains complaints about enrolled agents on the website of its office for enrollment, and you can also find complaints on the National Association of Enrolled Agents website. Licensed Tax Attorneys Licensed attorneys have graduated from law school, passed a state bar exam, and are admitted to the bar in at least one state. Some, but not all, attorneys specialize in tax preparation and planning. Many tax attorneys have completed an additional year of law school study in a master’s program in tax (called a Tax LL.M. degree). Disciplinary actions against attorneys can be found by searching the state bar associations with which the attorney is registered. How to Select a Tax Advisor or Tax Consultant No tax advisor with one of the certifications described above is necessarily better than any of the others in all situations. Rather, what matters most is: How the advisor approaches the tax preparation process, including the specific experience the tax advisor has with issues relevant to your particular financial situation. Whether you feel comfortable with the tax advisor. How the advisor structures her fees. You may be able to screen potential advisors along several of these dimensions based on information you can find about them online; for others, an initial meeting will be critical to determine if the advisor is right for you. 1. Here is a general approach for evaluating tax advisors. You should feel comfortable with and confident in a tax advisor’s approach to providing tax advice. Here are a few specific factors to consider carefully. First, you should try to identify a tax advisor who will act ethically and with integrity. Before scheduling a meeting with a potential tax advisor, check to see if the advisor has been subject to any complaints, disciplinary actions, or other ethical infractions. When meeting with the advisor, be on the lookout for outlandish promises: if an advisor guarantees you a certain refund without having first looked at your returns, you should be wary (any promise that sounds too good to be true probably is). If the advisor suggests taking a position on a tax return that strikes you as overly aggressive (because it is not grounded in your actual financial situation) or if you simply do not understand something the advisor is saying, make sure to ask, and keep asking until you are satisfied with the answer. Having a tax advisor prepare your returns does not take away your responsibility for the accuracy of your tax return. Of course, an advisor who knowingly takes an improper position on a tax return will face consequences, but it is your return, and you can too. A good tax advisor also should provide more value than simply filling out your returns. She should help you to structure your finances in an optimal way from a tax perspective. Not every tax advisor has expertise with every nuance of the tax code, and so you’ll want to make sure that the advisor you select has significant experience with the particular issues for which you’re seeking expert advice. Of course, there are certain common issues that every good advisor should know: for example, how to maximize the value and efficacy of your charitable contributions, how to weigh the tax tradeoffs between renting and owning a home, or how to save money for or gift money to family members. For other less common situations, however, you’ll want an advisor with specific experience. If you own a business or are self-employed, if you work for a startup and own a significant number of stock options, or if some portion of your income is reported on a K-1 (because you are a partner in a business or own shares in an S corporation), you likely will be best served by finding an advisor who has worked with a significant number of clients with these tax issues. Finally, maintaining the security of your personal information is more important than ever these days, and the inputs for your taxes is some of the most sensitive information you have. There will always be some risk of data breaches, but a good tax advisor will take steps to safeguard your information. Make sure that you ask about how the tax advisor stores your personal information and what methods she uses to communicate with you regarding sensitive topics. You also should ask about whether the advisor has ever been subject to a data breach and what steps the advisor is taking to protect against future ones. 2. Assess your comfort level with the consultant. You want to make sure you have a good rapport with your tax advisor, and that you feel like you understand each other. At your first meeting, make sure to bring three years’ worth of old tax returns for your advisor to review. Ask if you missed any deductions, and if your old returns raise any audit flags. Consider the advisor’s responses. Does the advisor seem willing to spend time with you to ask thorough questions to fully understand your situation? Or does she rush through in a way that makes you feel like she might be missing certain issues or nuances? Does the advisor explain herself in a way that is understandable to you, even though you don’t have a tax background? Or does the advisor leave you confused? A tax advisor may work by herself or be a member of a larger organization or practice. Each approach has its benefits and drawbacks. You can be sure that a solo practitioner will be the one who actually prepares your returns, but it may be harder to reach the advisor during the height of tax season, and the advisor may find it difficult to get a second opinion on tricky issues or issues outside her core areas of expertise. On the other hand, although the collective expertise of a larger practice may exceed that of even a very talented advisor practicing on her own, it may be more difficult to ensure that your return is prepared personally by your advisor. Finally, think about whether you want to work with a tax advisor who is already part of your social network, or who has been referred by a trusted family member or friend. On the one hand, having the seal of approval of someone you know and trust may help to assure you that the advisor is right for you. On the other hand, consider whether it will be harder to part ways with the advisor down the road if she fails to meet your standards. 3. Evaluate the cost of the tax advice. The final issue you’ll want to think about is cost. Tax preparation services are a low margin business (particularly with the competition that tax preparers face from low cost software), but you can expect to pay more for tax planning services or advice. The best cost structure is one where the tax advisor charges for her time or for the specific forms that the advisor completes and files. By paying for the advice itself and not a particular outcome, this cost arrangement properly aligns the incentives between your tax advisor and you. Be wary of compensation structures that create the potential for conflicts of interest between you and and your tax advisor. For example, some tax advisors may try to earn additional revenue from you by selling other services or financial products along with tax preparation. Ultimately, when it comes to cost, your goal should not be solely to minimize your combined out of pocket cost to the IRS and your advisor for this year’s tax return. Rather, you should take a longer term view, recognizing that good, personalized tax advice can help you to structure your financial life in a tax-efficient way that can pay dividends for years to come.