TLDR; NOT TAX ADVICE! There are situations where paying more taxes can be beneficial, such as avoiding AMT when exercising ISOs, maximizing financial aid, investing in taxable accounts, Roth IRA conversions, and estate planning, etc. However, make sure to consult a financial advisor and CPA for your own unique circumstances.
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If the title alone didn't prompt you to click "unsubscribe", thank you! You’re a brave soul! I understand how controversial it sounds to pay more taxes when it's almost universally desired to pay less. However, there are circumstances where a higher tax payment might be the right choice. They mainly boil down to the following two categories:
When higher tax payment brings you more benefit in other areas
When higher current tax payment can help you save taxes during your life time
Category 1: Higher tax payment brings you net total benefits
Exercising Incentive Stock Options (ISOs) and Avoiding the Alternative Minimum Tax (AMT)
Incentive stock options (ISOs) are a popular form of employee compensation, offering potential tax benefits if managed correctly. When exercising ISOs, you may be subject to the Alternative Minimum Tax (AMT), which is a parallel tax system designed to ensure that high-income earners pay a minimum amount of tax.
To avoid triggering the AMT, you might choose to pay more taxes in the year you exercise your ISOs by selling some shares immediately and paying ordinary income tax on the gains. By doing this, you can reduce your exposure to the AMT and save on taxes in the long run.
Maximizing Financial Aid by Paying More Taxes in FAFSA Filing Years
The Free Application for Federal Student Aid (FAFSA) determines a student's eligibility for federal financial aid, including grants, loans, and work-study programs. One of the factors considered in the FAFSA is the family's income, which directly impacts the Expected Family Contribution (EFC).
In some cases, paying more taxes in the years leading up to filing the FAFSA can help increase financial aid eligibility. By strategically paying more taxes in those years—through reduced deductions, for example—you can report a lower adjusted gross income (AGI) on the FAFSA, which may lead to a higher financial aid award.
Investing in Taxable Brokerage Accounts
When it comes to investing, many individuals opt for tax-advantaged accounts like 401(k)s, IRAs, and HSAs. While these accounts offer significant tax benefits, they also come with withdrawal restrictions and limited investment options. In some cases, investing in a taxable account can provide greater flexibility and access to a wider range of investment opportunities, even if it means paying more taxes on your gains. After all, our life is not linear. Having flexibility can be a good tradeoff for some additional tax bills.
Category 2: When higher current tax payment to save taxes during your lifetime
Roth IRA Conversions
In last month's newsletter, we discussed Roth IRA Conversion in more depth. You can read it here if you're interested. Roth conversion can be a great tax planning strategy that takes advantage of the changing tax brackets throughout your lifetime. By converting funds from an IRA to a Roth IRA during your low-income years, you can save a significant amount of money in taxes and reduce your RMD amount.
Roth IRA Contribution
Similarly, contributing to a Roth IRA also triggers tax in the contribution year.
Estate and Inheritance Taxes
Estate and inheritance tax planning is another area where paying more taxes might be the best choice. In some situations, paying taxes on assets during your lifetime could be more advantageous than passing them on to your heirs, who could face a substantial tax burden. Proper estate planning can help you evaluate your options and determine the most effective strategy for transferring wealth to your loved ones.
However, it's essential to carefully weigh the potential benefits of increased financial aid against the additional tax burden. Consult with a financial advisor or tax professional to determine the best approach for your specific situation.
Cheers!
Lei Deng, CFA, CFP®
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