It’s the holiday season and 2016 is almost behind us. Mariah Carey is on every radio station, Home Alone is playing on repeat, and you’re bundled up by the fire with your computer thinking about taxes. Sure, April 15th is a long way out, but you know that the game is won or lost before year-end. Tax planning is about making conscious decisions, (e.g. to buy, sell, contribute, distribute) that will affect your tax bill. Eleven months’ worth of financial events have come and gone, and many of your cards are on the table. You know your income, tax rate, deductions, and filing status. With a few days remaining in the year, you’re looking for small actions that will have a big impact and save you money.
Trump and Your Taxes
Year-end tax planning takes on significant importance this year, given the impending change in administration. The talking heads and pundits are predicting that with Trump in the White House and the Republicans controlling both the House and Senate, tax reform is inevitable. If the administration is successful, actions taken before year-end could produce significantly higher savings than the same action next year, due to lower tax rates. So what should you consider?
The Year-End Tax Planning Tool Bag
Medical Savings Accounts
If you have a Health Savings Account (HSA) or Flexible Spending Account (FSA), take some time to review them before year-end. (If you want to learn more about medical savings accounts check out the post The Power of the HSA.)
Flexible Spending Account: If you have an FSA, simply put: You better spend that bad boy! FSAs are tax advantaged accounts owned by your employer and tied to a health insurance plan year. That makes them strictly use it, or lose it. Generally you have until year-end to submit receipts and make qualified purchases. (Although some employers allow a “grace period” up to March 15th.) The best way to spend your FSA at year-end is to accelerate purchases you’d be making anyway, like contact lenses. If you don’t wear contacts or glasses, revisit this list of qualified expenses. You may have to get creative and buy a crate of Band-Aids or a few sets of crutches to spend down your account. First aid kits make wonderful stocking stuffers!
Health Savings Account: If you have an HSA, you don’t have to worry about spending the account in full before year-end. That’s one of the great things about HSAs—the money is yours to roll over from year to year. Your year-end tax planning consideration here, is whether you want to make additional contributions to your account.
Contributions to HSAs can reduce your taxable income and thus the amount of taxes you owe. Using an HSA to save for a medical emergency or an elective procedure like Lasik or fertility treatments can create significant tax savings over the long-term. Consider making contribution before year-end if you’re saving for an emergency, large expense, or using the account for regular expenses and reduce your tax bill.
Individual Retirement Accounts (IRAs)
Saving for retirement is one of the main reasons we work hard each year, and IRAs are an excellent way to save for this goal. If you’re already maxing out your 401(k) or 403(b), putting additional savings into an IRA is the next logical step.
Traditional IRA Contributions: You can receive a tax deduction for Traditional IRA contributions if your Adjusted Gross Income (AGI) is below a certain threshold, making them a great year-end planning tool. Additionally, since the accounts are subject to annual contribution limits ($5,500 in 2016) if you are aggressively saving for retirement, you’ll want to sure you are contributing the maximum each year.
Roth IRA Contributions: There’s no current year tax deduction for Roth IRA contributions. They’re a tax advantaged way to save for retirement, but since distributions are not taxed when taken in retirement, there is no deduction for contributions. Generally speaking, making a Roth contribution is advantageous over Traditional contributions, if your current effective tax rate is lower than you’ll be paying in retirement. (The decision of whether a Traditional IRA or a Roth IRA is more beneficial for you is covered in detail in the post Traditional Versus Roth.)
Roth IRA Conversion: If you have an existing Traditional IRA, the IRS allows you to convert it to a Roth IRA. You take a distribution from the Traditional IRA, recognize it as income, pay taxes on it, and transfer the funds to a Roth IRA. When properly executed, Roth conversions can produce significant lifetime tax savings. Without going into the extensive detail that this topic warrants (future blog post!) I’ll highlight the main idea. With a Roth conversion, you have full control over the amount and timing of the distribution that will be subject to tax. Therefore, you want to do it in a year where your tax rate is zero or substantially below your average rate. This may occur because you’re a student, taking a sabbatical, or between jobs for a large part of the year. If you think you could benefit from a Roth conversion, speak to your CPA because it’s not something you want to do willy-nilly.
Charitable Donations
Making charitable donations is one of the most common forms of year-end tax planning. Listen to NPR or any other public radio station around this time of the year and you’ll be sure to hear about the tax deductibility of charitable donations. I encourage you to be as charitable as your heart and wallet can stand, but know that you’ll only get a tax benefit if you’re itemizing your deductions.
We don’t really have control over whether we’ll itemize—we either have more deductions than the standard deduction or we don’t. This creates an opportunity if we know that we’ll be able to itemize one year and not another. For example: maybe you paid a lot of mortgage interest, real estate taxes, and state income taxes this year. However, next year you’re selling your house and moving to a state with no income tax. You’re likely to itemize this year, but not next. This creates a tax planning opportunity! If you “prepay” your January tithe, or move scheduled donations for next year into the current year, you’ll be able to include those donations as an itemized deduction and receive a tax benefit where you otherwise wouldn’t have.
If you generally itemize every year, think about when it’s more advantageous to take the deductions. Ask yourself what may change, such as your income or federal tax policy. If your income is going to be the same, but Trump’s going to reduce your tax rate, it would be more beneficial to get the deductions in the current year. Deductions create higher tax savings when tax rates are higher.
Taxable Investment Accounts
The next place to look for year-end tax planning opportunities is your taxable (non-retirement) investment accounts. What you’re looking for is an investment loss, (where you paid more for an investment than it’s currently worth.) If you sell it before December 31st, you may be able to deduct the loss on your taxes and reduce your tax liability. This is called tax-loss harvesting.
IRS rules allow you to deduct up to $3,000 of investment losses to offset wages and other earned income each year. If your effective tax rate is 25% and you recognize $3,000 of loses, you could save $750 in taxes!
Wash Sale: We can’t talk about tax-loss harvesting without mentioning the wash sale rule. To combat taxpayers selling an investment for a loss then immediately purchasing it again, the IRS created the wash-sale rule. The rule says that if you purchase a “substantially identical” investment within 30 days of the sale, any loss will be disallowed for tax deduction purposes. To avoid this, be sure that you wait 30 days to repurchase any investments sold for a loss, so that you can receive the tax benefit.
529 Education Savings Accounts
There are two year-end tax planning considerations when it comes to 529 accounts, depending on whether you’re in the account accumulation or spending stage.
529 Account Distributions: If you’ve started using the account to pay for qualified educational expenses, make sure your timing is right. Qualified expenses and their corresponding account distributions must take place in the same year. That means if you have expenses from this year, make sure you submit for distribution before year-end. Additionally, don’t take that spring semester distribution too early or you could create tax issues.
529 Account Contributions: If you live in one of the 34 states or the District of Columbia that offer state income tax deductions for 529 account contributions, it could be advantageous to make your contributions before December 31st. Most states limit the contribution deduction allowed in a single year, so check the rules for your state.
Withholding and Estimated Tax Payments
If there was a big change to your family or financial life, you may benefit from adjusting your withholding or making an estimated tax payment.
Family: Did you get married, have a child, or have a child graduate from college? All of these situations could change the number of dependents or the filing status on your tax return, which will impact your tax liability. If you didn’t report the changes to your HR department on Form W-4, your tax withholding may be incorrect. Consider adjusting your withholding to avoid a large payment or penalty when filing.
Financial: If you’re self-employed, have a side hustle, or generate any income outside of a traditional job, you may need to make an estimated tax payment. Taxes are due when income is earned (which is the purpose of withholding). If you spent your summer evenings driving for Uber or running errands for Task Rabbit (which are not subject to withholding), the taxes due on that income should have been paid already. The IRS may charge you a late penalty, so it could be advantageous to make an estimated tax payment now instead of waiting to pay when you file your return.
Accelerate or Delay Income
Accelerating or delaying income is about choosing which year would be more advantageous to be taxed. A choice may arise if you are given an option to receive a bonus this year or next, or if you own a business and have some flexibility on collecting payments. It’s advantageous to receive income in the current year if you believe your effective tax rate will be higher next year. This may be because of a higher salary, business growth, or a move across state lines. It’s advantageous to delay your income, if you believe your effective tax rate will be lower next year. As discussed above, the current expectation is that the incoming administration will reduce income tax rates. If you believe they will be successful, delaying any income possible into the new year could be a smart move.
Be Proactive
Year-end tax planning considerations can quickly become very complex. You need to consider your filing status, dependents, deductions, exemptions, phase-outs, and tax rates. Some decisions can be made easily, like spending your FSA or contributing to a 529 account. However, others may require complex analysis, like Roth conversions. The incoming administration, and the expectation for a dramatic reduction in tax rates, is creating a once in a decade tax planning opportunity. Don’t miss out! Be proactive, talk to your CPA, and figure out if any of the actions in the year-end tax planning tool bag could save you money!
Are you interested in getting one-on-one personalized tax planning advice? Click here to schedule a FREE 30 minute call with David, a Certified Financial Planner (CFP®) professional and Certified Public Accountant (CPA), and get answers to all of your money questions.
