Getting Your 6% (While You Still Can)

The following is for informational purposes only, and should not be relied upon for specific financial, tax, or legal advice. There’s always a fair amount of nuance to each of these areas, so please be sure to consult your own advisor and tax professionals for how these may apply to your specific circumstances.

As we transition to Fall, our focus as a firm begins to narrow in on year-end tax planning for our clients. For many, taxes will represent the single largest line-item expenditure of their lifetime. With that reality, it also represents one of the biggest areas of value add an advisor can bring to the table.

The primary focus is usually on managing Federal taxes due to marginal rates pushing as high as 40.8% for some individuals (and the potential for higher rates in the future). There will be a follow up post to this one in the coming weeks highlighting planning strategies we regularly use with regards the Federal side of things.

For this post, I thought I’d highlight some of the less talked about planning ideas and developments around managing your State taxes. While this will be Iowa-focused, there are some strategies within here that may be applicable to my out-of-State readers (again, see your local advisor/tax professional).

Let’s start with some background for us Iowa taxpayers. Recent legislation has passed that is taking the top tax rates from last year’s 8.53% to 6% for this year (2023), 5.7% in 2024, 4.83% in 2025, and a flat 3.9% in 2026 and beyond. While the tax rate reductions are certainly welcome news, it is important to know that Iowa has also has removed the ability to deduct Federal taxes paid on your Iowa tax return. This does serve as a bit of an offset to the overall rate reduction, but does not dilute the value of good State tax planning.

Starting this year, the State has also changed how retirement income is taxed. If you’re 55 or older, disabled, or meet certain criteria as you inherit retirement assets, that income is now excluded from Iowa taxation.

What counts towards retirement income? Things like pensions, social security, pre-tax IRA/401k distributions, Roth conversions, annuities, and certain deferred comp plans. (among others)

With that as background, let’s jump into a few things that we’re regularly focusing on with our clients to get the most out of this new/changing State tax environment. The overall theme of each of these items is to delay recognizing income that can be taxed today and accelerating deductions to the degree possible.

Increased Value of Pre-tax Retirement Plan Deferrals – When you contribute to the pre-tax (sometimes termed “Traditional”) side of a 401k, IRA, or other qualified retirement account, you get both a Federal and State tax deduction for your contributions. In addition to avoiding taxes while the dollars are growing inside the account, the goal is also to capture a higher tax deduction today, and pay a lower tax rate when distributing in retirement. This can lead to significant tax savings if done correctly. Now we know that deferring into the pre-tax side allows for a State tax deduction today (i.e. 6%) and if that balance is distributed/converted after age 55, you’ll pay a 0% State tax rate in the future. (assuming no tax law changes)

This has us doubling down our analysis, and regularly pushing additional pre-tax deferral into these retirement accounts to take advantage of this State tax dynamic. (FYI – 2023 401k limits allow up to $22.5k/yr/person; and an additional $7.5k for those 50 and older)

In extreme cases, we’re having some clients 59.5 or older increase deferrals to their workplace retirement plans and supplement their income with withdrawals from existing IRAs. This allows them to capture the 6% State deduction on the contributed funds, and avoid State taxes on distributions from their existing IRAs.

Retired Farmer Lease Income Exclusion – Closely related to the above retirement income exclusion for my farmers out there. Those aged 55+ and who have been active in farming for 10+ years will want to assess whether or not it makes sense for them to make this election and benefit from State income tax exclusion on the lease payments they receive on their farmland. A lot of specific requirements and nuances with this one, so make sure you’re visiting with your advisor and tax professional to assess the pros and cons of making this election.

Partial Roth Conversions – It’s important to note that the overall goal of tax planning is not to avoid taxes entirely. Instead, the focus should be on paying the lowest effective tax rate over your lifetime. We’re big fans of partial Roth conversions for our retirees in years of low income. This allows us to take funds out of a pre-tax balance at a relatively low tax rate and place them in a tax-free Roth account to grow in the future. This does involve us paying Federal taxes now on the distribution, but can translate to considerable taxes savings over the long term. With State taxes no longer a consideration for those 55+, this is a great time to re-assess if and how much this strategy may make sense for you.

Pass-Through Entity Tax – This is more for my business owner readers out there. As many of you are aware, the Tax Cuts and Jobs Act of 2017 capped your ability to only deduct a maximum of $10k of State taxes paid on your Federal returns. (many pay multiples of that every year) Earlier this year, Iowa became the 33rd state to implement a workaround to that limit. A lot of nuances to this, and most of the tax professionals I’ve visited with are still working through the pragmatics of exactly how it works. (I’ll provide greater detail in future posts) If you’re a business owner, make sure this is part of your year-end tax planning discussion. For many profitable business owners, this can be a significant Federal tax savings by being strategic on how you pay your State taxes.

Increasing/Maximizing Health Savings Account (HSA) Contributions – Frankly, this has always been a good idea, but more so now that the value of your State deduction will be declining over time. Savings into this account allows for a Federal and State tax deduction. (and Social Security/Medicare taxes if done properly through your employer) If funds are used for qualified medical expenses, distributions are exempt from both Federal and State taxes. You do need to be on a qualified high deductible health insurance plan, and contributions are limited to $3,850 for individuals, $7,750 for families. I’ll go deeper on other strategies with this type of account with my future Federal tax blog post.

Maximizing/Frontloading 529 Contributions – If you have desire to assist with some level of education costs for the people you care about, you’ll want to consider starting or increasing deferrals to these plans. Iowa has a great plan available (collegesavingsiowa.com), and you’re able to deduct contributions up to $3,785/account owner/beneficiary. Given the declining future tax rates, contributions made in these early years will mean a higher upfront State tax benefit than contributions made later.

A simple example of a married couple with two kids can contribute and deduct up to $30,280 off their State income if handled appropriately. (upfront potential tax savings of over $1,800) Not only can you get the benefit of higher upfront tax savings, but also get these accounts compounding tax-free earlier.

Lumping Charitable Giving – Another topic I’ll go deeper with on the Federal side, but it may be worthwhile for you to consider accelerating your giving now vs. future years. This can be accomplished through outright gifts to charities of cash or appreciated securities, or you can contribute to a specialized giving account known as a Donor Advised Fund. This donor advised fund allows you to make your contributions into an account for the tax deduction today, but complete the gifts to the charities you wish to support in future years.

Endow Iowa Tax Credit – Potentially a great compliment to the gifting strategy from above is to take a look at this tax credit. Gifts to certain qualified permanent endowments in Iowa may be eligible for a State tax credit of 25% of the gifted amount. (maximum $100k/individual; $200k/couple) Another area that comes with a few wrinkles that may not make this right for everyone, but certainly something to explore for those that are charitably inclined.

Continued Phase-Out of Inheritance Taxes – This often comes as a bit of a surprise to people that Iowa has an inheritance tax. This applies to inheritances being passed down to non-spouse/non-lineal ascendents or descendants. Fortunately with legislation passed in 2021, this tax is slowly being phased out. Depending on the relationship to the person who has passed, there is either a 4% or 6% tax in 2023, 2%/3% tax in 2024, and a full repeal (i.e. 0%) tax starting in 2025.

Property Tax Exemption for Those Aged 65+ – For those 65 and older, be sure you’re capturing the additional property tax exemption available to you. This reduces the taxable value of your property by $3,250 for 2023 and that amount doubles to $6,500 in future years. Check with your county assessor to ensure you’re getting this. (it is automatic for some)

Cash Management via Short-Term Treasuries – With the Federal Reserve continuing to raise rates throughout the year, we now find ourself in an environment where super-safe short-term treasuries are yielding around 5.5%. In addition to the nice yield and safety offered from these securities, the interest is also exempt from Iowa income taxes. A great alternative for your emergency fund of extra cash that is sitting around for shorter-term needs.