Personal Finance Articles

Reducing taxable income is an important part of running a small business, and there are two key ways to do it.

1. Open a Retirement Plan

First, you can open a retirement plan, such as a SEP-IRA, SEP 401(k), SIMPLE IRA, or SIMPLE 401(k). Qualified retirement plans such as these benefit employees and employers alike.

Although each plan works differently, any contributions you make as an employee are excluded from your taxable income. The money you put into a plan grows tax-deferred until you retire. Then, distributions and earnings will be included in your taxable income.

If you’re an employer, your contributions to qualified retirement plans are generally deducted from your business’s income.

2. Use the New Tax Law

Additionally, thanks to the Tax Cuts and Jobs Act of 2017, which went into effect in January 2018, there’s another way to reduce your business’s taxable income.

The new law allows pass-through entities (business entities that are not taxed at the entity level) to take a deduction of 20% against their business income. This essentially reduces the effective top rate on pass-through entities’ income by roughly 10 percentage points over pre-2018 tax law.

Of course, nothing that involves taxes is ever easy. Claiming the new 20% deduction requires navigating a tangle of barely comprehensible requirements and limitations that make it far from accessible to small-business owners. For example, single filers who earn less than $157,500 and married filers who earn less than $315,000 may take the deduction regardless of their field of business. However, after taxable income passes those thresholds, individuals operating service businesses, such as doctors, lawyers, and financial advisors, may not be able to take the deduction.

A financial professional can help you determine which of these options is best for your business.

No one likes to pay taxes, especially on an appreciated investment.

With careful planning, you could avoid or minimize capital-gains taxes. Here are three tips.

Hold investments for at least 366 days

How long you keep investments in your portfolio before selling them determines the taxes you pay on your gains. Short-term capital gains are taxed as ordinary income. Long-term capital gains are taxed at rates of 0%, 15%, or 20%, depending on your tax bracket.

Invest in a low-turnover fund

Mutual funds realize capital gains just as individual investors do. Any time your fund sells a security at a gain, that gain is taxable. Since the law requires mutual funds to pass most of their net gains on to investors, you realize a capital gain. This is either long-term or short-term, depending on how long the mutual fund held the securities. You can avoid these types of gains by investing in a low-turnover mutual fund.

Use capital losses to offset capital gains

Do you have a losing investment in your portfolio? You might want to sell it and use the loss to offset gains. For example, if you have $4,000 in capital gains, and you take a $4,000 capital loss, the two will negate each other, and your tax liability on the gains will be eliminated.

Plus, if your investment losses for the year exceed your gains, you can use the balance to offset your ordinary income, up to a $3,000 limit.

In the day, grandparents might have given their grandchildren small cash gifts for birthdays and holidays.

But now, with the cost of education rising and concern over job opportunities for recent graduates, grandparents may wish to pass on major assets to their children and grandchildren.

If so, you may want to consider one of the following three strategies: give cash or stock, or make a 529 plan contribution.

First, you can just give cash. In 2018, under the IRS’s annual gift-tax exclusion, each person may give up to $15,000 per individual with no tax consequences. So you and your spouse could transfer $30,000 to each of your children and grandchildren.

Or you can give a gift of stock. Say you decide to give your grandchild $10,000 worth of stock that you purchased for $5,000 more than a year ago.

The transfer isn’t taxed, and the stock can continue to (hopefully) appreciate. But if your grandchild ever needs the cash, he or she will have to pay taxes on the capital gain – the difference between what you paid for the stock ($5,000) and its current value.

Is this a negative? Not necessarily. It’s likely that your grandchild will be in a lower tax bracket and have a lower capital gains tax than you would.

Finally, if your grandchild is saving for college, you could make a 529 plan contribution. This education savings plan helps families save funds for their children’s (increasingly expensive) college costs. You can contribute up to $15,000 per year to each child or grandchild’s 529 plan. However, the law allows you to “front load” five years’ worth of contributions at once, which means you can contribute up to $75,000 in 2018.

Therefore, you and your spouse together can contribute up to $150,000 to a grandchild’s 529 plan – a sea change from the old days.

Recent months have brought a number of personal finance changes, including a rise in interest rates that will affect some of the terms for borrowing money and accessing credit.

In December 2017, the U.S. Federal Reserve increased its key interest rate by 25 basis points, marking the fifth increase in the rate since December 2015. And more hikes are expected.

One of the best tips for handling rising interest rates is to move away from adjustable-interest-rate debt in the form of credit cards, home equity lines of credit, and mortgages.

Most credit cards, for example, have a rate directly tied to the federal funds rate, so the 25-basis-point increase will hurt those with credit-card debt. Those with this type of debt may want to consider transferring balances to a credit card with a low (or 0%) introductory rate, and work toward paying down the balance permanently.

You also may want to consider refinancing if you have an adjustable-rate mortgage. Adjustable mortgage rates may not rise as quickly as credit card rates, but fixed mortgage rates are still relatively low – around 4% – so it may make sense to switch.

Home equity lines of credit with adjustable rates often reset quickly to a higher rate, but they generally can be converted into a home equity loan with a fixed rate.

Situations differ, so discuss your personal financial circumstances and goals with your advisor before making these changes. He or she can offer you options for making the most of interest rate hikes.

Most retirees follow conventional wisdom when it comes to asset allocation, and try to balance their nest eggs between stocks and bonds. But how do you achieve the correct mix?

The old rule of thumb was to subtract your age from 100 to get the percentage of your portfolio you should keep in stocks. For example: If you are 40, you should keep 60% of your portfolio in stocks; if you are 60, you should keep 40% of your portfolio in stocks.

But with people living longer, many advisors now suggest using 110 or 120 minus your age to determine the percentage of stocks in your portfolio: if you are 60, you should keep 50% or 60% of your portfolio in stocks.

Allocating to bonds can be difficult in certain market environments. Today, thanks to a booming stock market, many investors have a higher percentage of equities in their portfolios than they originally intended. They know they should allocate more to bonds, but with equities performing well and interest rates on bonds at record lows, it’s a difficult choice to make.

Having bonds is important, however, to protect your portfolio in the event of an equity-market downturn. And there are many types of bonds to choose from, increasing the odds of finding the comfortable balance between return and safety. These include short-term, intermediate-term, and long-term bonds, as well as government, high-yield, global and municipal bonds.

Your advisor can help find the bond type and allocation that will work for your individual circumstances and goals.

Capital-loss deductions can take the sting out of investment losses and reduce your tax return – if you understand how to use them.

A capital loss occurs when a capital asset (such as an investment) drops in value and is subsequently sold.

To determine if you have a capital loss, you will need to determine your basis, which is what you paid for an asset plus any other costs you incurred to acquire it, including sales taxes and commissions.

If you sold it for less than its basis, you have a capital loss. If you sold it for more, you have a capital gain.

When you have a capital loss, you must first use it to reduce any capital gains you have. Any capital losses left over can be deducted from your income up to $3,000 per year.

If your losses exceed $3,000, you can carry them forward indefinitely. So, if you have $5,000 in capital losses in 2017, you can deduct $3,000 of those losses on your 2017 return and carry the remaining $2,000 forward to your 2018 return.

Capital Gains

If you have capital gains instead of capital losses, the situation changes. The way capital gains are taxed depends on whether it’s a long-term or a short-term gain.

If you hold the asset for more than one year, your capital gain or loss is long term. If you hold the asset for one year or less, it’s considered short term.

Short-term capital gains are taxed at the same rate as other income.

On the other hand, long-term capital gains are taxed at a much lower rate: 0% if you are in the 10% or 15% income-tax bracket; 15% if you are in the 25%, 28%, 33%, or 35% income-tax bracket; and 20% if you are in the 39.6% income-tax bracket.

To gauge the performance of their investments, investors often turn to the Standard & Poor’s 500 (S&P) Index. But the S&P isn’t the only benchmark of investment performance.

Widely used as a benchmark for the performance of equities, the S&P is designed to be a broad indicator of stock price movement. It consists of 500 leading companies in major industries chosen to represent the American economy.

S&P limitations

But the S&P has limitations. There are more than 5,000 stocks listed on the New York Stock Exchange, and the S&P only tracks a small percentage of them. In addition, the S&P comprises essentially one asset class: large-capitalization companies.

But what if your portfolio comprises primarily small-cap stocks and international stocks? In that case, the S&P may not be the best benchmark.

Other benchmarks

Fortunately, there are other benchmarks. If you invest in a mutual fund, your prospectus and quarterly reporting materials will likely indicate which your fund manager uses. An emerging-markets fund, for example, might use the MSCI Emerging Markets Index; a bond fund might use the Bloomberg Barclays U.S. Aggregate Index.

But even if you are looking at the appropriate index, there are nuances you may not be aware of. For example, some indices aren’t equally weighted. Often, the largest and most popular stocks are weighted several hundred times that of less popular stocks, and the performance of these larger stocks may skew the entire index. In a bull market year, for example, the strength of a few popular stocks can boost the S&P’s return significantly.

Gain perspective on indices

That doesn’t mean you should ignore the S&P and other widely used indices. But do ensure you find the right index for your portfolio, and understand that differences in performance may be explained by differences in your fund’s composition compared with the index. Your advisor can help clarify this for you.

Growth stocks and value stocks tend to take turns leading the market, and as a result investors often raise the question of which of these two types of stocks is really “better.”

While both share a similar long-term, disciplined approach to investing, they are different, and advocates of the two investment styles go about their business in fundamentally different ways.

Growth stocks are those of successful companies with the potential to sustain growth over the long term. In searching for these stocks, analysts look for firms with healthy profits, rising sales, and solid balance sheets.

Value stocks are those of financially solid companies that may be “on sale” due to temporary, non-fundamental reasons. In searching for these stocks, analysts look for situations in which all the good news is not yet reflected in the stock’s price.

Value and growth are typically countercyclical, outperforming during different phases of an economic cycle. In a struggling economy, and during the early stages of recovery, value stocks have historically outperformed growth stocks; late in the recovery cycle, growth stocks have typically dominated.

In the late 1990s, for example, growth stocks dominated the market and value stocks were overlooked. In March 2000, however, the bubble burst, and value stocks started outperforming. We saw a similar dynamic during the great financial crisis that occurred around 2008.

So it actually isn’t a question of which is “better” – you’ll likely want both in your portfolio. Just as diversification between stocks and bonds is important, it’s also important to diversify by type of stock.

What’s the worst that could happen when you’re planning your retirement? For many, it’s the prospect of working and saving hard in their 20s to 50s, only to have a major market decline hit just as they’re finally retiring.

An extreme market event is no fun for anyone, but its impact on a 62-year-old is completely different from its effect on a 30-year-old.

When you’re older, and the market declines dramatically, it can erode decades of your retirement savings and totally alter your lifestyle in retirement. It may even prevent you from retiring when you had planned.

Such an event is not hypothetical. Consider the 2008 financial crisis. According to a study by Pew Research Center, one-third of those age 62 and older delayed their retirement as a result of its impact.

Lasting effect

CNBC reports on one concept developed by Prudential Retirement Services called the “Retirement Red Zone.” In the article, Srinivas Reddy, senior vice president at Prudential Retirement, notes: “The 10 years leading up to retirement and the 10 years after are all risky…. But the five years when you retire are among the riskiest.” Bad investment performance in this “zone” can have a significant – and likely permanent – impact on a retired/retiring individual’s portfolio.

One option to protect your nest egg during the red zone years is called “de-risking”-reducing your exposure to stocks and allocating more to less volatile asset classes such as fixed income investments.

Bonds are typically less risky than stocks. (In fact, they have not declined by 10% or more during any calendar year since 1926.) In fact, bonds as a de-risking strategy during the 2008 stock-market correction would have preserved wealth for those in the red zone.

De-risking doesn’t mean removing all equity risk; equities play an important role by facilitating growth. Your advisor can help you determine the best allocation for you.

Baby boomers preparing to retire – many of whom lack the savings to do so – may want to review basic ways of “paying yourself first.” For many years, financial professionals have recommended that everyone increase their savings for retirement. And this is one of the best ways to do it.

The concept of paying yourself first makes sense: the idea is that your retirement comes first. Before paying your bills, set aside a portion of your income and move it to a savings account or retirement plan.

Automatic deductions

It’s especially easy if you arrange for money to be automatically deducted from your paycheck and moved into accounts set aside for emergency savings or retirement. Because you never “see” the money in your checking account, you won’t be tempted to spend it.

Maximize 401(k) contributions

You also can maximize contributions to your 401(k) plan. At first it may seem daunting to set aside 10% or 15% of your income. But look at it another way: Can’t you live on 85% or 90% of your income? Plus, that hit isn’t as big as it may seem: it’s coming from pretax money.

Shift gears

Finally, change your mind-set. Initially, it may seem as if you have less money at your disposal, so you’ll need to adapt your spending habits to match this somewhat lower income. However, after a while, it will feel less like a sacrifice – and you’ll have the peace of mind that comes from knowing you are preparing yourself and your loved ones for a comfortable lifestyle in retirement.