Surprise birthday parties may be fun, but a surprisingly large tax bill is not. Unfortunately, there are many situations that can trigger an unexpected tax hit.
“A change in your life such as a new job, moving to a different state, a change in your investment portfolio or a change in your IRA minimum distribution status can incur a tax liability,” says Dean Deutz, a private wealth consultant with RBC Wealth Management – U.S.
Tax codes are complicated, so it’s easy for even the most savvy business owner or high-net-worth household to make a mistake or misinterpret the laws.
“You should always talk to your financial and tax advisors before making a major financial decision,” Deutz says. “You don’t want to wait until you and your accountant do your taxes to find out that you’ve unknowingly triggered a capital gains tax.”
Financial preparation can help reduce surprises
Deutz recommends revisiting this discussion with your advisors every fall to run tax projections, so you have time to make changes before the year ends.
“As you and your tax advisor are preparing, you should start thinking about what might be different next year,” he says. “Will your W-2 be the same or different? Think about whether you’ll need to make estimated tax payments at a higher or lower rate.”
Deutz notes a few options to consider:
Manage your income stream: Tax-efficient income planning requires proactivity. For example, if you expect to be in a lower tax bracket in the future, you may want to see if you can defer income. Or, if you’re heading into a higher tax bracket next year, moving as much income as you can to the current tax year may be beneficial. Your advisors can recommend strategies for your specific situation.
Bunching your charitable contributions: To maximize the tax benefit of charitable giving, you may want to consider combining multiple years of donations into a single year, perhaps with biennial giving, a donor-advised fund or a private foundation.
Qualified charitable distribution (QCD): If you’re age 70 1/2 or older, you can donate up to $108,000 from an IRA directly to a charity to help make your required minimum
distributions more tax efficient. You won’t be able to take the charitable deduction for the donation, but you’ll reduce your taxable income for the year by the amount of the donation.
Strategies for paying your tax bill
If, despite your consistent planning efforts, you owe the IRS a substantial bill, there are several ways to pay, including:
Cash: If you have plenty of cash, that’s an easy way to pay your bill, Deutz says, but it’s risky if you’re digging into your emergency fund. “It’s best to have a back-up plan so you don’t have to pay cash if you don’t want to,” he adds.
Securities-based line of credit: Another option is to borrow from a securities-based line of credit, says Matt Franks, head of Wealth Management Lending at RBC Wealth Management – U.S. “An advantage of leveraging credit is that you’re not creating a new taxable event when you borrow from your account,” he explains.
But remember, the loan from your line of credit will need to be repaid.
“Borrowing can be smart if you know you have income coming in soon to pay off the debt,” Deutz says, “for example, if you’re paying your tax bill in April and know you’ll get a bonus in June. But if you don’t have a lot of cash coming in, it’s best to avoid using debt for a big bill.”
Sell securities: Occasionally, selling securities may be an effective way to cover your tax bill, but it’s not usually the best option, Deutz says.
“You could be selling at the wrong time in the market and losing out on the benefit of a more strategic sale,” he explains. “In addition, selling securities could cause a bigger tax bill the following year because you have to include the proceeds as income.”
When it comes to navigating complex tax situations and preventing surprises, professional advice is essential.
“If you have a big tax liability, it’s important to communicate with your financial and tax advisors and recognize that you have several arrows in your quiver,” Franks says. “So many people think they need to sell assets when they’re hit with a bill, but there are other options.”