Addressing end-of-year loose ends with taxes
As we near the end of the year, it’s a good time to reflect on the year you’ve had. What went well? What didn’t? What things might you change moving forward? The end of the year also represents an opportunity to think through any loose ends related to your income taxes. While some things can be handled early next year before the April tax deadline, other issues must be addressed before the end of the calendar year in order to maximize savings on your taxes.
Here are some tips to consider to maximize your tax savings before the year ends:
- Figure out if you’re going to be in a standard deduction or itemized deduction situation. Understanding how you might file, based on your income and expenses for the current year, is important to your end of year tax savings strategies. Although 90% of U.S. taxpayers take the standard deduction, there are still ways to itemize in certain years while taking the standard deduction in other years, maximizing your tax savings. There are some deduction ideas below that might put you into an “itemized” status.
- Stash more into retirement accounts. If you have a 401k and are not yet maxing out contributions (currently $19,500 for 2021; $26,000 for those 50 or over), consider increasing your contributions before the end of the year. The door for 401k contributions for the current tax year closes on December 31st. While IRA contributions can still be applied to the current tax year through the April tax deadline, if you have the funds available now, the sooner it gets into those accounts and earning gains, the better. Traditional IRAs allow you to take a tax deduction (if you meet income requirements), but you must pay income taxes when the money comes out later. Roth IRAs on the other hand are funded with after-tax money, so withdrawals (including all the money gained) are NOT subject to income taxes later. I wrote a recent article on the key differences between the two accounts. Note, tax deductions taken for traditional IRA contributions are on top of your standard deduction.
- Make charitable contributions. If you typically take a standard deduction, your maximum deduction for charitable donations is limited to $300 for single and $600 for married for 2021. If you tend to donate money annually (vs. in one big lump sum) and are on the cusp of a standard deduction or itemizing your deductions (based on the total of your deductible expenses), you may want to consider starting a donor advised fund. These can be opened with places like Fidelity and Schwab. They allow you to ‘front load’ your donation in the current tax year by making a lump sum deposit into the account, then spread out contributions through several years to various charities. Say you fund it with $10k in the current tax year. That is $10k you can immediately write off as a deduction. Then, you can choose how you want to disperse that over the next year or several years. You can also transfer appreciated assets, such as stock and bonds, into the fund without any tax implications for any gains you made. The money you put into the donor advised fund can also be invested so that you can provide even more to your charities over time.
- Make Health Savings Account (HSA) contributions. If you are enrolled in a qualified high-deductible health plan and already have an HSA that you’re not maxing out, or if you haven’t opened an HSA yet, but are eligible for one, you should consider putting more into this account. Doing so will not only reduce your tax bill this year, but the gains made inside the account will grow tax free and the withdrawals you make down the road will be free of tax if spent on qualified health expenses. I wrote about the power of HSAs in a recent blog. You have until April next year to make additional HSA contributions for the current tax year. Note, tax deductions taken for HSA are on top of the standard deduction and are also not subject to FICA/social security taxes if taken directly from your paycheck, which is an added bonus.
- Deposit more into your Flexible Spending Account (FSA) if you intend to use it, and make sure you spend funds before the deadline. If you are not eligible for an HSA, another option is a Flexible Spending Account or FSA. If you’re already enrolled in one and find that you’re running low on funds on medical expenses, consider making an additional deposit into the account before the end of the year if your employer allows it. Note, however, that FSAs are NOT HSAs. If you do not use the funds in your FSA by the end of the year, you lose it. The IRS does allow employers to provide up to 2.5 months of a grace period to spend the funds into the following year. Check with your employer on the exact ‘use it or lose it’ date, as it can vary. Note, FSA contributions are deductible on top of your standard deduction and like HSA, are not subject to FICA/social security taxes if taken directly from your paycheck.
- Make 529 college savings plan contributions. If you have children or you have an opportunity to gift a relative or friend money toward an educational savings account, doing so could save you money on your state income taxes. Additionally, funds grow tax free and can be withdrawn free of tax for qualified educational expenses. Contributions to a 529 savings account are not deductible on your federal return, but over 30 states allow you to deduct 529 contributions from your income for the purpose of state income taxes. In Michigan, for instance, if you are a single filer, you can deduct up to $5,000 of your income per year if you’re single; for married, $10,000. There are 20 states, including Michigan, that allow friends and family who are not parents to contribute to a 529 they do not own, and they can get the deduction on their taxes as well. The holidays are approaching, and this is a gift that will be well-received by loved ones while giving you a potential tax break if you live in one of the states that allows you to deduct the expense.
- Prepay expenses, including mortgage payments. If you are on the borderline of itemizing or taking a standard deduction, you can also ‘bunch’ or prepay some of your tax-deductible expenses from next year in the current year. Make that January mortgage payment before 12/31, and you can deduct the interest expenses in the current tax year. Pay ahead things like property taxes or state taxes that are due early the next calendar year as well. Then, the following year, you’ll likely just take the standard deduction vs. itemizing if you don’t have enough expenses to itemize. You can cycle through this approach in an attempt to lower your tax bill year after year.
- Harvest losses on investments. If you have money in investments that are held outside of your retirement accounts (e.g. in a brokerage account), you might want to consider selling some of your losing investments. This will enable you to take a loss for the current tax year. Some investors sell loser investments, then buy them back 30+ days later (you have to wait that long to qualify for the deduction) if they feel like the investments are going to rebound. This is called a wash sale. With a wash sale, you can benefit from the tax deduction ($1,500 max per year for single/$3,000 for married) while also potentially benefiting from a rebound on the investment in the following year. You can carry over losses each year until you have written off your total loss.
- Consider making Roth conversions. If it makes sense, and you’re expecting to be in a higher tax bracket next year vs. the current year, you might want to consider converting some of your 401k or traditional IRA funds to a Roth IRA. Or, if you’re retired already and are sitting in a lower tax bracket, you should consider converting traditional IRA or 401k funds into a Roth. Doing so while taxable income is lower will reduce your tax bill down the road and reduce the amount of required minimum distributions (RMDs) you need to take from your tax deferred accounts.
- Schedule your RMD for 2021. If you are 72 or older, you are required to take minimum withdrawals or distributions from your tax-deferred accounts, like traditional IRAs and 401ks. Your first RMD must be taken by 4/1 of the year after you turn 72 (if you turn 72 after Jan 1, 2020). Subsequent RMDs must be taken by 12/31 of each year. If this is you, make sure you schedule those distributions before year end, or you could face a steep fine (a 50% penalty!). The Required Minimum Distribution (RMD) amount depends on the amount of money you have saved in these accounts.
Get ready
We are weeks away from the end of the year. It is hard to believe. Use this time to figure out the things you might want to do before December 31st. Making the best decisions about your income taxes ahead of the deadlines is ‘Good for Your Wealth.’