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Tax and financial planners generally recommend a four-part strategy for reducing clients’ income taxes: Deduct, Divert, Defer and Convert.
• Deduct: Taxpayers should strive to itemize their deductions (rather than use the standard deduction) and then maximize all deductible expenses, including charitable contributions.
• Divert: In some cases, investment income can be channeled to a family member (a parent or child, for example) who is in a low tax bracket.
• Defer: Postponing taxes to a future year can enable your investments to grow faster, which is possible through tax-deferred retirement accounts, deferred annuities, U.S. savings bonds and growth stocks.
• Convert: Investors in high tax brackets should consider investments that are taxed at low rates, such as tax-free bonds or stocks that produce long-term capital gains or dividends, which generally are taxed at a low 15% rate.
Here is an example that reflects all four tax strategies. In recent years, thousands of people have decided to convert their taxable IRAs to tax-free Roth IRAs. IRA amounts that had been deferred from taxation in past years were then treated as taxable income. It made sense for these people to deduct as much as possible in the conversion year to offset that extra income, which they could accomplish by maximizing charitable gifts. One plan might be a charitable gift annuity that provides a large deduction and also diverts payments to a parent or other person in a lower tax bracket than the donor. (Charitable remainder trusts offer good deduction opportunities, as well.)