By Tom Rasmussen, CFP®
Year-end tax planning is a bit contradictory. It is difficult to plan when the end of the year has already arrived. To truly be effective, tax planning should look forward by starting at the beginning of the year. However, you have several levers to pull at the end of the year if you have not already. Taxes are a complicated topic. We can’t cover everything in this article, but below are some basic end-of-year tax planning strategies to consider.
Tax Items to Review at Year-End
Although these items ideally would have been taken care of throughout the year, you still have time to address them now:
1. Max out your 401(k) or other workplace-sponsored plans:
If you can afford to, contribute the maximum to your 401(k) plan. You may have already done so via payroll deductions throughout the year. Now is a good time to make sure you are on track to max out your contributions and adjust as needed.
For 2020, the maximum you can contribute to your 401(k) is $19,500 if you are under age 50. You are allowed an additional $6,500 in catchup contributions if you are 50 or older. By default, most employees contribute to the pre-tax side of their 401(k), which results in a deduction from their income.
2. Max out your IRA or Roth IRA:
If you are under the IRA phase-out limitation, consider maxing out your IRA if you need the additional deduction. If you do not need the additional deduction, then you can max out your Roth IRA—again, if your income is within the phase-out limitations.
The maximum you and your spouse can contribute to IRAs or Roth IRAs cumulatively is $6,000 each, with a $1,000 catchup contribution for those 50 or older in 2020.
3. Make charitable donations:
If you are on the path to itemizing your deductions rather than taking the standard deduction, consider charitable donations if you are philanthropically inclined. These, too, are a deduction from your income, lowering your taxable income.
There are many ways to give, from direct donations to charitable giving accounts and donor-advised funds. Giving to your favorite nonprofits can be a great way to help control your tax situation.
4. Max out your FSA or HSA:
Like a traditional IRA, you should consider maxing out your flexible spending account (FSA) or health savings account (HSA) if your employer offers one. The contributions to these accounts are tax-deductible, lowering your taxable income.
If your health plan qualifies for an HSA, the maximum 2020 contribution is $7,100 for a family plan and $3,550 for single coverage. Those 55 (not 50 like all the others) or older can also make a $1,000 catchup contribution. For FSAs, the 2020 contribution cap is $2,750.
What to Do in 2021
As I mentioned, your tax planning should ideally begin at the start of the year and continue all year long. The last thing you want in February, March, or April is a surprise tax bill. You want your tax bill or return to be an educated estimate rather than a pull of the slots. Year-long tax planning can help.
There are steps you can take in 2021 (or even start now!) that will help your planning and reduce the anxiety that often accompanies taxes:
Meet with your advisor to project your income for the year, including dividends, capital gains, interest, and real estate income. To the best of your ability, project your total income for the year. If you received a stimulus check, make sure to note that.
This step will help your advisor get a good idea of which tax bracket you will land in for the year. It will allow them to help guide you on tax withholdings. If you are employed and already have a good idea of your income, you shouldn’t find too many surprises. Just remember to monitor your tax situation as an ongoing process throughout the year.
For those who are retired, planning for your income and taxes becomes even more important. A big part of what our San Mateo- and Vancouver-based financial planning firm does in projecting a client’s income and tax bracket is determining if Roth conversions are right for their situation. We typically like to maximize their tax bracket through Roth conversions.
For example, if you are $20,000 away from creeping into the next bracket, we may do a Roth conversion close to that amount to maximize your tax bracket. This allows us to get as much into your Roth bucket as possible, which, in turn, makes tax planning easier down the road.
If you waited until year-end 2020 to start your tax planning, now is the time to act. Use this article as a starting point for some of the tax moves you can make to improve your situation. If you have questions about how a tax strategy applies to you, consider talking with a fee-only financial advisor who will advise you in light of your entire financial picture and objectives.
Once you’ve got your year-end strategies locked down, consider working with your financial advisor early in 2021 to start game-planning for the upcoming year. Many variables go into your tax plan and will affect how much you end up owing or how much is returned to you.
Effective, ongoing tax and financial planning allow you to have a good sense of where you stand throughout the year and when you go into your CPA’s office to file your tax return. Your taxes are one of the most important areas of your financial plan. You do not want to leave them to chance.
Schedule a complimentary meeting with a fee-only financial advisor to discuss your situation.