Some tax strategies do not work as planned. Some tax strategies don’t work because they are flat out wrong. That happens when non-tax professionals try their hand at tax strategies and misunderstand or misinterpret tax law.
Today we will review eight well known tax strategies that do not always work as planned. In some cases you can actually lock in higher taxes for several years. Understanding the details helps you avoid these pitfalls.
We will start with the most common tax strategy known that can cause harm when poorly executed.
What Is the Downside Of Retirement Accounts?
First, a few ground rules. A traditional retirement account gives you a tax deduction on contributions in most cases and distributions are taxed.
If your income is too high to make a deductible IRA contribution you may still be able to make a non-deductible contribution. Distributions in these instances will be treated as coming from the gains and basis (your original investments) on a pro rata basis. This means if you have an IRA balance of $100,000 with $10,000 of the balance from your non-deductible contributions, 90% of your distributions will come from gains and 10% from basis. Your non-deductible contributions do not get taxed since they have already been taxed.
Roth retirement account contributions are not deductible, but grow tax-free.
An unfortunate feature of traditional retirement accounts rarely discussed is that all gains, including long-term capital gains (LTCGs), are taxed at ordinary tax rates. In non-qualified accounts (a fancy way of saying your money is not in a retirement account) LTCGs are taxed at a maximum rate of 20%.
To be fair, there are some additional taxes that come into play which we will not discuss in this article. Still, LTCGs will never reach 24% on your federal tax return, even if all the other side taxes are maximized. Compare that to ordinary tax rates which peak at 37% on your federal tax return. And some of those nasty extra taxes can still come into play.
In the images below I used a future value calculator to give us a value when placing $5,000 in a Roth IRA each year for 20 years and $6,500 in a traditional IRA for 20 years. (I used round numbers for an easy illustration. There is no 23% tax rate. The goal is to understand the concept so you can apply it to your personal facts and circumstances.)
I use a higher contribution amount for the traditional IRA because you get a tax deduction. With the Roth you send $1,500 to the IRS every year in our example, leaving only $5,000 for the Roth contribution.
If your tax rate remains exactly the same between contribution and distribution, no harm, no foul; the cash you have at the end is the same as a Roth, after tax. If your tax rate declines in retirement you gain an additional tax benefit with the traditional IRA. And if your tax rate climbs in retirement you face a higher tax rate over the Roth IRA.
Now we deal with the real problem. Traditional retirement account distributions are added into income on your federal tax return. That means that in addition to paying tax on those distribution, you also may increase how much of your Social Security benefits are added to income. Taxpayers with lower income in retirement need to consider this. As your income climbs, most of your Social Security benefits will already be added to income.
Worse, Medicare premiums are based on income. Most taxpayers will pay the lowest Medicare premium rate of $185 per month in 2025 for Medicare Part B full coverage. That can climb to $628.90 per month in 2025. The higher your income, the higher the rate. Part D has similar rate increases as your income climbs. Use the link in this paragraph for current rates.
From bottom to top, the amount you pay in Medicare premiums can increase $443.90 per month. If you are married, double that. That is a $5,326.80 increase in 2025, $10,653.60 for joint returns. The Medicare premium is technically not a tax. But if you are sending an additional $10,000 to the government each year, call it what you want. It will feel like a tax.
Facts and circumstances rule. Your personal situation will differ from a neighbor, me, or anyone else. Apply the information about your personal details to built the best plan for you.
Remember, these rules apply to your 401(k) or other work retirement plans too. The information above will help you best determine the breakdown between Roth and traditional in your workplace plan contributions. These rules are not limited to IRAs.
A quick recap before we move to the next tax strategy
What is a disadvantage of a traditional IRA? If your tax rate is higher in retirement you will pay more in tax over your lifetime; Social Security benefits may be taxed; and Medicare premiums could be higher.
What are the tax drawbacks of a 401(k)? The traditional 401(k) faces the same drawbacks as the traditional IRA. Taxes upon distribution may be higher than taxes saved, Social Security benefits may become taxed, and Medicare premiums could be higher.
What is the downside of a Roth IRA? While gains are tax-free upon distribution, contributions are not deductible. If you have a lower tax rate in retirement you could have overpaid your taxes in the contribution years.
Caution! I focused on tax rates in this section. For taxpayers eligible for the Premium Tax Credit (discussed below) a traditional retirement plan may provide extra benefits in the form of the Premium Tax Credit.
Is the EV Tax Credit Worth It?
Remember the First-Time Homebuyer Credit? There were several versions during the housing crisis, but the end result is informative in our study of the electric vehicle (EV) tax credit.
How much did the First-Time Homebuyer Credit raise housing prices? About the amount of the credit in many markets. Of course, market forces still played a role. And when the credit ended demand slowed. Housing prices in many markets declined for a short period. The lesson is clear. Tax incentives affect the price of products.
The current EV credit is no different. EV prices are higher to reflect the tax credit. In some cases EV prices declined just enough to meet the new credit limits. But that begs the question: If EV manufacturers could easily lower their prices to meet the EV tax credit limits, how much more are prices elevated due to the EV tax credit? The number cannot be zero. Nothing happens in a vacuum.
The worst part is that you always pay the elevated price for the EV, but if for some reason you can’t take the EV tax credit, you lose twice.
As with housing over a decade ago, when EV credits are reduced or eliminated there is a strong likelihood used EV prices will decline hard. It is something to consider before buying.
I know many of you love the idea of owning an EV. So do I. But the math is hard to make work. The tax strategy might end up costing you more, not less, when all factors are considered. In the end, you are interested in keeping money in your pocket. If the EV manufacturer replaces the IRS for a portion of your money it still is a form of taxation.
Are there better alternatives to an EV? Maybe. Compare hybrid vehicles to EVs. When all factors are considered, the hybrid might be the better deal. In my own local analysis, the hybrid vehicle usually wins the race. However, your area may be different. Don’t just buy an EV for a tax credit. Consider all factors so you have the most money remaining in your pocket after the purchase.
Is Tax-Loss Harvesting Even Worth It?
As with most tax strategies, the answer is in the details.
Tax-loss harvesting is where you sell securities that are down from the purchase price, capturing the loss for tax purposes, and immediately buying something similar, but not identical, to the security sold to avoid the wash sale rules.
Companies like Betterment (I am NOT an affiliate) offer tax-loss harvesting for a fee. On paper this can sound like a great idea. By automating the process you can really maximize the losses captured. But it isn’t for most people!
Capital losses are limited to capital gains, plus $3,000 on your federal tax return. Therefore, any losses in excess of $3,000 (assuming you don’t have loss carryforwards from prior years) get carried to future years and are not used currently. Yet you still pay the fees for the service.
For most taxpayers, tax-loss harvesting is a waste of time and often wastes your money due to fees. Of course, you can manually manage your tax-loss harvesting. Since there are few, or no, fees for this it might be worth it. For most, however, tax-loss harvesting is killing your nest egg.
Can you write-off 100% of stock losses? No. Losses from the sale of stocks is limited to gains, plus $3,000.
So, who benefits from tax-loss harvesting? If you have a large capital gain tax-loss harvesting is a powerful tax reducing strategy. When consulting with clients I often explore the tax-loss harvesting potential for offsetting large capital gains from a stock sale or income property sale. Even with the additional fees from the automated tax-loss harvesting firms, time value of money is often worth the short-term tax-loss harvesting fees when selling another asset at a large gain.
Are Annuities Actually a Good Idea?
A few years ago I pointed out the problems with infinite banking, sometimes called bank with yourself. Infinite banking uses whole life insurance and is not an annuity. But is does illustrate the framework of a really bad idea that at first blush looks appealing, especially when presented by a slick insurance sales person.
First, I need to outline the taxes surrounding annuities.
If the annuity is bought inside a retirement account, the retirement account rules apply.
If the annuity is purchased outside a retirement account, the contributions are not deductible and the gains are taxable upon distribution. If you do not annuitize the annuity (turn the annuity into an income stream), distributions are from gains first and therefore taxed. The return of your money that has already been taxed, and does not get taxed again, comes out last. If you annuitize the gains are paid out pro rata.
Here is the selling point for annuities. They are guaranteed. But from what? Well, fixed annuities have a fixed rate of return. Index annuities allow you to share in some of the stock market gains, tied to an index. Variable annuities are like they sound. They can go up and down, depending on how the investments perform. Understand, there is a large number annuity products out there. Each policy is different. Research is required before investing!
What is the biggest disadvantage of an annuity? The biggest disadvantage is fees. But that is not the only disadvantage.
Non-qualified annuities look a lot like a non-deductible IRA. All the negatives discussed under retirement plans above apply. There is a tax penalty for early withdrawal before age 59½ in addition to any fees the annuity levies for distributions.
Annuities have a place. Most annuities are sold to the wrong people for the wrong reasons. The tax-deferred benefit is not what it seems. LTCGs inside the annuity can be treated like ordinary income upon distribution. That is a higher tax rate out of the gate.
Plus, taking distributions without annuitizing forces gains to come out first. Very nice for the IRS, not so much for you.
And, again, it could affect the taxable amount of your Social Security benefits and Medicare premiums.
The Downside Of Health Savings Plans
I love the health savings account (HSA). Contributions are tax deductible and gains are tax-free if used for qualified medical expenses or for Medicare premiums once you turn 65. What is not to like?
Actually, there are some issues with HSA qualified health plans.
First, HSA qualified health plans come with high deductibles. The HSA can have high fees. I personally use the Fidelity HSA, which has low fees.
Next, withdrawals for non-qualified expenses are subject to a 20% penalty by the IRS. Your state may add insult to injury with more tax penalties.
What is the biggest disadvantage of an HSA? The worst thing about HSA plans is that the insurance company knows you are getting a tax break. They price their policies accordingly. Often, HSA qualified health plans are more expensive than traditional health plans, plus the deductibles are often higher.
Can my HSA lose money? Yes! If the investments you make inside your HSA declines in value and you sell, you will lose money. HSAs are not a guaranteed investment. Of course, you could put a bank CD or other safe investment in the HSA to avoid this risk.
What Are the Negatives Of the Affordable Care Act (ACA)?
The ACA is an opportunity for taxpayers to have the government cover all or some of their health insurance premium. Unfortunately, ACA plans may contain some coverage you don’t need. It is still built into the premium.
The biggest advantage of the ACA is the Premium Tax Credit. However, if you claim more credit than you qualify for the IRS will want its money back. This can become a significant amount, so plan carefully.
ACA health policies can have a higher premium than other health insurance choices outside the healthcare marketplace. If you qualify for the Premium Tax Credit the marketplace will almost always be the superior choice. As your income climbs you will want to review health plans outside the marketplace to verify you are getting the best option.
There are a lot of rules with the ACA that can cause negative tax consequences, especially penalties. More than ever, it is vital to compare options. The marketplace is not an automatic yes or no. Research is required.
The Augusta Rule
What is the Augusta Rule? The Augusta Rule allows you to rent out your primary residence, including second homes and vacation homes, for 14 or fewer days in a calendar year without reporting the income.
Anyone near a sporting event can really rake in good money tax-free. Where I live in NE Wisconsin, people rent out parking spaces in their driveway and yard during home games for the Green Bay Packers. Since there are less than 14 home games for the Packers, and the rent rate is high at these times, people living near the stadium can get serious amounts of tax-free money.
But then somebody throws water on the whole tax strategy.
Can I use the Augusta Rule to rent my home to my business? As with so much in taxes, the answer is a firm maybe. If you have an office in the home the answer is no. If you don’t have an office in the home the answer is probably yes. If you have an office in your primary residence you can rent your second home or vacation property to your business using the Augusta Rule.
Can you use the Augusta Rule on multiple homes? Yes. You can rent your primary residence, second home, and vacation property using the Augusta Rule. Each property must be rented 14 or fewer days during the year to qualify.
How much rent can I charge my business using the Augusta Rule? And here is where tax professionals start pounding their head on their desk. You can only charge a reasonable rent rate when renting to your business using the Augusta Rule. I suggest you have documentation ready in case the IRS asks for it. Check what local rent rates are for what you are renting to determine an appropriate amount of rent to charge your business.
Remember, if you have a Schedule C business (sole proprietorship) with an office in the home you cannot use the Augusta Rule to rent your home to your business.
Itemized Deductions
Many taxpayers no longer itemize due to the higher standard deduction and state and local tax (SALT) limits.
The big items on Schedule A for itemizing deductions include: SALT, mortgage interest, and charitable contributions.
SALT is currently limited to $10,000 on joint or individual tax returns. Since the standard deduction is approaching $15,000 for singles and $30,000 for joint returns, the limit on SALT forces mortgage interest and charitable contributions to carry the rest of the weight.
I do not encourage paying more mortgage interest just to itemize. If you have ample mortgage interest, you are one step closer to itemizing. Still, better to live mortgage free.
That leaves us with charitable contributions.
First we need to understand the true value of itemizing. If you max out the SALT limit you still need nearly $20,000 more of itemized deductions before it starts to help on joint returns. Example: Your standard deduction is $30,000. SALT maxed out at $10,000. Adding $25,000 to charitable contributions does not reduce your income by $25,000, but by only $5,000, the amount over the standard deduction.
If you contribute to charitable causes the following tax strategy might work for you.
Instead of sending money to your favorite charity each year, deposit several years of donations to a donor advised fund so you can itemize at least once every few years. The donor advised fund can make the distribution to your charities of choice as you dictate, meaning each year each charity gets a contribution from you via the donor advised fund.
Whenever dealing with a tax strategy you have to ask: What can go wrong? Not just: Will the IRS audit me? But worse: Am I jumping from the frying pan to the fire?
Tax strategies are powerful tools for wealth building, as long as they are used correctly. Your facts and circumstances always rule.
And never forget the future consequences of today’s actions.
