Voluntary and taxpayer are two words that usually are not found residing next to each other.
Corporations and individuals spend millions of dollars every year to hire tax professionals whose primary job is to legally minimize the amount of income taxes they are required to pay. They would rather pay people to find ways to avoid taxes than actually pay the taxes.
I am quite sure if the federal government made filing tax returns voluntary the Internal Revenue Service could be downsized relatively quickly.
Yet, in some circumstances, it could potentially benefit your family if you volunteer to pay more in income taxes this year than you normally would.
I understand this sounds like a sure-fire way to permanently part with your hard-earned money by donating to an organization that has a less-than-stellar reputation for its financial stewardship. But hear me out.
If you happen to be in one of the lower federal income tax brackets this year, the federal government will tax you at a rate of 10%, 12%, or 22% of your taxable income. This remains true for 2024 and 2025.
However, if Congress does nothing, the tax rates for these tax brackets automatically increase starting in 2026. The new tax rates are scheduled to be 10%, 15%, and 25%.
Knowing that your future income may be taxed at a higher rate than your current income presents an opportunity to become a voluntary taxpayer. Voluntarily paying 12% now could be better than involuntarily paying 15% or more in a few years.
The primary strategy for taking advantage of this temporary tax discount is to evaluate a Roth conversion with the help of your tax professional. This strategy gives you the opportunity to pay taxes on a portion of your tax-deferred retirement accounts today while benefiting from tax-free growth in the future (assuming you follow all of the rules).
A Roth conversion could be used to maximize the amount of your income that is taxed in the lower income tax brackets in 2023, 2024, and 2025.
Thinking beyond the next few years, you may wish to consider being a voluntary taxpayer if you have significant assets in tax-deferred retirement accounts that your children will inherit.
Most non-spousal beneficiaries of tax-deferred retirement accounts are now required to pay taxes on those accounts within 10 years of inheriting them. Congress enacted this rule for the sole purpose of boosting your children into higher tax brackets, and it works.
If you prefer that your children inherit more of your assets and the federal government inherit less, you should work with your tax professional to evaluate becoming a voluntary taxpayer – even if you are not in the lowest tax brackets. The income tax rates you pay now may still be lower than your children’s income tax rates after they inherit your tax-deferred accounts.
Volunteering to pay more in taxes right now goes against all of your instincts, but it potentially could save you and your family significant taxes in the future.
Quote of the week: Thomas Sowell: “I have never understood why it is ‘greed’ to want to keep the money you have earned but not greed to want to take somebody else’s money.”