As we inch closer to the end of the year, it’s crucial to make the right moves to minimize your tax burden regardless of the financial success, or lack thereof, you found in the past months. With this in mind, here are some year-end tax planning tips to help you save on next year’s tax bill.
Postpone your income
The IRS taxes income on the year in which it is received. So, if you have a windfall of money coming your way, why pay taxes on it today if you can postpone the taxes until next year?
Although employees can’t delay their salary or wages, it’s possible to defer income from an end-of-year bonus if the company allows. For those who are self-employed or do contracting work such as freelancing, you could put some of your invoices on leeway to ensure you receive payment next year. No matter how you receive compensation, you may want to consider deferring income from capital gains until 2021.
Keep in mind; this strategy only makes sense for those who think they will fall into the same tax bracket or lower in 2021. You don’t want to postpone a bonus or capital gains if you think you’ll fall into a higher tax bracket next year. If that may be the case, you might want to accelerate your income in 2020, so you can pay taxes in a lower bracket.
Assess the impact of the stimulus check
Due to the CARES (Coronavirus Aid, Relief, and Economic Security) Act, the IRS issued a stimulus check to all taxpayers up to $1,200 and $500 for every qualifying dependent child. Either your 2018 or 2019 tax return determines your payment. However, the payments are structured as 2020 tax credits. Since the credits were phased out for higher earners, it’s essential to speak with a tax advisor who can help you understand these payments’ tax implications.
Those who received a credit less than the calculated amount for 2020 can claim an additional refund.
Seek additional tax deductions
Accelerating tax deductions may also aid you in lowering your tax bill this year. Contributing to a charity, for example, is an excellent way to get a deduction. You can increase the tax benefit by donating stock or other property instead of cash. As long as you have owned the assets for over a year, you can receive double the benefit of the donation. Essentially, you can deduct the gift’s market value and evade capital gains taxes on the appreciation of the asset.
However, you must have a receipt to prove your contributions, no matter what the amount is. In the past, you only needed a receipt for contributions that were $250 or more. Now, you must have receipts for all contributions. Other deductions you can accelerate include property tax bill for next year or hospital bills.
For those who use the standard deduction (which in 2020 is $12,400 if you are single or $24,800 if you’re married and filing jointly), you might be missing out on valuable tax deductions. Consult with a tax advisor who can help you discover valuable deductions and decide whether you should itemize to avoid possible losses.
On the other hand, tax deductions can cost money. If you’re already in an alternative minimum tax (AMT) or could unintentionally trigger it, you may end up paying more than anticipated. Since the AMT is the excess of tentative minimum tax over your regular tax, the IRS calculates each separately. A tax advisor can help you determine if you are subject to this tax.
Sell poor investments
Another year-end tax planning strategy is to sell investments such as stocks and mutual funds to realize the losses. This strategy is often called “loss harvesting.” You can use this tactic to offset your capital gains realized during the year – dollar for dollar.
If your losses exceed your capital gain, you can use up to $3,000 to offset other income during the year. If you have more than $3,000 worth of losses, you can use the excess losses to carry over to the next year. Essentially, you can continue to carry over losses for your life.
Max out your retirement contributions
One of the best investments you can make is with a tax-deferred retirement account. Because of compound interest, these accounts can grow significantly over time. Employer plans such as 401(k)s are often a great deal because they provide an employer match, which matches the contribution you put in up to a certain amount. So, if your employer offers a match program, it’s wise to contribute the most you can to capitalize on the excess contributions up to the limit ($19,500 for 2020, $26,000 if you are age 50 or over). Even if you cannot afford the entire amount, try to contribute as much as possible.
You may also want to max out your IRA contributions. Usually, taxpayers have until April 15th as the tax filing deadline to make contributions for the year. However, the sooner you contribute, the sooner your money may begin to grow (based on market conditions). The contribution limits for IRAs in 2020 is $6,000 and $7,000 for those over age 50. Also, when you contribute to your traditional IRA, it’s tax-deductible, reducing your tax liability at the end of the year.
For those who are self-employed, you can consider a Keogh plan. Taxpayers must establish a plan by December 31st for it to apply to 2020. However, contribution deadlines may depend on when you file your return. The contribution limits depend on the type of plan you select.
Check for RMD requirements
Speaking of IRAs, you’ll need to check to see if you need to take a required minimum distribution (RMD). Beginning when you reach age 72 (70 1/2 if you turned 70 1/2 before January 1, 2020), the IRS requires distributions from traditional IRAs and 401(k)s.
During 2020, the CARES Act is allowing retirees to suspend RMDs. However, if your RMDs were to begin this year, you want to make sure you prepare for the 2021 distributions. Failing to take out enough can yield some IRS penalties, such as a 50% excise tax on the total amount.
If you decide to take distributions this year, consider asking your custodian if they will withhold taxes from the payments. This will allow you to set the money aside and avoid the hassle of sending in quarterly tax estimates.
It’s important to note that if you have a Roth account, alternatively, the IRS doesn’t require RMD.
Monitor your flexible spending accounts
Flexible spending accounts, or FSAs, are benefits employers offer to employees to help pay for medical expenses. The advantage of these accounts is that FSA account holders can avoid income taxes and Social Security taxes on the contribution’s amount. However, the downside is that if you don’t use the money within the year of contribution, you lose it.
With the end of the year rapidly approaching, you may want to speak with your employer to see if they adopted the grace period, which allows the account holder to postpone distributions until March 2021. If they didn’t, you might need to schedule a last-minute appointment at the dentist or doctor.
The bottom line
With the year getting close to the end, it’s wise to take some time to focus on year-end tax planning. You may want to consult with your tax advisor to determine how you can minimize your tax liability this year. You may also want to speak with your financial advisor for guidance.