Federal taxes get a lot of attention, but what you pay in state taxes is a big part of your tax bill, too. For Pennsylvania residents, there are some strategies that can both reduce this bill and help you meet other financial goals.
This article covers Roth conversions, capital losses, and the PA 529 plan, which are three areas of the Pennsylvania tax code that can save you a lot of money if you understand them, or cost you a lot more if you don’t. While I’m not a tax expert, and this is not an exhaustive list of money-saving opportunities, I often run into these three less-known situations when helping my clients avoid unnecessary taxes.
Disclaimer: These tax strategies are complex and contain many nuances. Please check with your tax advisor before implementing any of the strategies presented to see if they apply to your specific situation.
Does Pennsylvania Tax Roth IRA Conversions?
Roth IRA conversions are one of the most attractive opportunities available to save on federal taxes if you have significant assets in tax-deferred retirement plans.
Why is a Roth conversion so attractive? It allows you to pay taxes when you’re in a lower tax bracket.
There is often a significant drop in income for retirees between their retirement date and when they start taking social security or are forced to take required minimum distributions (RMDs) from their retirement accounts. If you retire at age 55 and wait to take social security until age 70, you could have 15 years of depressed income. This period is the sweet spot for Roth conversions.
The conversion process involves taking money from tax-deferred retirement accounts, paying taxes at the federal income tax rate, and putting the money into a Roth IRA account. Your money will then grow tax-free, can be withdrawn tax-free, and there will be no estate tax at the federal level for these accounts. In addition, Roth IRAs are not subject to required minimum distributions, which gives you more control over your income levels. Unfortunately, PA has an inheritance tax that can be as high as 15% depending on your relationship to the deceased, but that’s a topic for another day and doesn’t change the attractiveness of a conversion. Refer to the 5-year rule for exceptions and limitations involving conversions.
Unlike the federal government, Pennsylvania does not allow you to put money into a retirement account tax-free. You will pay a 3.07% tax when you first contribute to any retirement account. The state will also tax you on any IRA gains if withdrawn before their official retirement age of 59 ½.
The critical distinction to remember is:
A Roth conversion performed before age 59 ½ will be subject to the 3.07% Pennsylvania tax.
A Roth conversion performed after age 59 ½ will not be subject to the 3.07% Pennsylvania tax.
This difference can cost you thousands of dollars. When completing a Roth conversion, there are many factors to consider, including the timing of income, your current federal tax bracket, and your expectations of future tax rates. However, don’t forget to include the Pennsylvania 3.07% tax into any decision you make if converting to a Roth IRA before 59 ½.
Can I Carry Forward Capital Losses in Pennsylvania?
The federal government allows you to carry forward capital losses. A $100,000 loss generated by selling a stock can be carried forward into future years. If you have a $100,000 capital gain the following year, it washes out, and you pay nothing in federal taxes.
Pennsylvania, however, does not allow residents to carry forward a loss into future years to offset gains. Instead, you lose it if it’s not used in the year it is generated. In this example, you will owe state tax on the $100,000 in capital gains in year two. That’s a $3,070 check.
How do you avoid losing this potential deduction and pay less state tax? As long as it doesn’t adversely affect your federal state taxes, such as generating a short-term gain now or in the future, it often makes sense to sell a stock with capital gains in the same year. Also, there is no 60-day wash rule when it comes to generating capital gains. You can immediately buy back your investment. However, keep in mind your one-year holding period to achieve long-term capital gains will reset.
- You don’t want to convert long-term capital gains into short-term capital gains and pay more in federal taxes
- Consider the impact this might have on dividend-paying stocks and the taxation of dividends
- You can apply $3,000 in capital losses to earned income at the federal level, so you may not want to offset capital losses completely
- Always weigh the tax implications on both a federal and state level before making any decisions
- Capital gains and losses do not offset for spouses at the state level
Of all the topics discussed in this article, capital gains and losses may be the most intricate. Please do your homework and check with your tax advisor before making any decisions.
How Does the PA 529 Plan Tax Deduction Work?
The following discussion only applies to PA 529 plans. You can read about the difference between this plan and out-of-state plans here. Like the other topics in this article, I recommend you talk to an expert to determine the best alternatives for your specific situation.
There are many ways to save money for your child’s education, and a 529 plan is one of the most popular alternatives. Benefits include no Pennsylvania state tax on contributions, the growth of assets, or withdrawals. Because of this triple-tax-free treatment, it usually makes sense to run all applicable education expenses through your 529 plan.
The money you contribute can be withdrawn in approximately ten days, so even if your student is near the end of their college experience and your 529 plan has run low on funds, or has been completely drained, it can benefit you to make payments through the plan. You’ll avoid the 3.07% Pennsylvania tax and have more money to pay college tuition.
Planning for retirement is a process often filled with compromises and sacrifices. So it’s especially sweet when you can save thousands of dollars by deftly navigating tax laws. While federal tax laws get most of the attention, understanding Pennsylvania tax laws is just as important. Sometimes no compromises or sacrifices are necessary to save thousands of dollars, just some well-applied knowledge.
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David Tuzzolino, CFA, CFP®, is the Founder and CEO of PathBridge Financial, a firm that specializes in providing comprehensive financial planning and investment management services for clients that are nearing retirement and love to travel.