How Year-End Decisions Can Directly Impact Your Savings and Minimize the Amount of Taxes You Owe
2020 has been as unconventional a year as we can remember, and your tax situation may be different than in previous years. As an audit or consulting professional, you understand the importance of proactive tax planning. Now is a great time to implement certain tax strategies prior to December 31. Whether you’ve had a banner year or are looking forward to putting this one in the rear-view mirror, these year-end tips can directly impact your savings and minimize the amount of taxes you owe.
Tip #1 – Finalize charitable donations
Take some time to evaluate your charitable commitments for the rest of the year. While charitable donations by check or cash are the most common, you may also consider utilizing low-cost-basis stocks for larger charitable contributions. If you plan to itemize, you can receive a tax deduction based on the fair market value as of the date of the gift, and both you and the charity can avoid paying taxes on the gain. This is applicable to investments that have been held for at least 12 months.
If you do not itemize, it may make sense to combine two or three years of charitable contributions that you would normally make over multiple years into a single tax year. The strategy of consolidating your gifts into one tax year is called bunching. The bunching technique can benefit donors whose itemized deductions fall below the standard deduction ($24,800 for married filing jointly, $12,400 for single filers, in 2020) as long as there is sufficient taxable income to fully deduct. In a tax year during which combined gifts are made using the bunching strategy, you can use a charitable vehicle, such as a donor-advised fund (DAF), in order to receive an immediate tax deduction through itemizing federal deductions. You would then be able to recommend grands from the DAF to qualified charities using the standard deduction in subsequent years.
To receive credit for the 2020 tax year, these transactions would need to be completed by December 31, 2020.
Tip #2 – Actively harvest losses to offset gains
Tax-loss harvesting works by taking advantage of selling assets that have declined in value in the short term, a common occurrence in a heavily weighted equity portfolio, and replacing the investment with a highly correlated alternative investment. If done correctly, the result is that the risk profile and expected return of a portfolio remain unchanged, but the temporary tax losses are extracted in the transaction. By realizing the investment loss, a tax deduction is generated that can lower your taxes. These tax savings can then be reinvested to further grow the value of your portfolio.
This ongoing trading strategy allows the long-term investor to stay invested in the space, weather the short-term asset class pullback and transfer the loss to his or her tax return. Losses can be used to offset ordinary income taxes at $3,000 per year, current year capital gains (unlimited), or can be carried forward until utilized against future income or gains.
Given the tremendous market swings we saw in early 2020, it is an important year to keep an eye on any actively managed legacy mutual funds to see what their projected capital gains distributions will be. These are typically released in November. If investors sold mutual funds and realized capital gains when the markets were uncertain, those that held on may receive a higher capital gains distribution than normal before the end of the year. In this case, it may be wise to have tax harvested losses from this year or prior years to offset the unexpected gains. It may also be worth reviewing your projected capital gains versus your decision to diversify the position if you can make the move with neutral or minimal tax impact.
At Big 4 Financial Freedom, we take advantage of market volatility by actively tax harvesting client portfolios throughout the year, but it is a good planning checkpoint to clean up these losses prior to year-end as appropriate.
Tip #3 – Review withholdings for remaining paychecks
Companies’ open enrollment period for the next calendar year typically occurs in November. This is a great opportunity to review your remaining withholdings for the current calendar year, as well. Certain withholding requirements must be met in order to avoid underpayment. Consider running a tax projection to include all of your income, current 2020 withholdings and any projected income before the end of the year. You may also consider adjusting your W-4 for the remainder of the year.
When reviewing your withholdings, also take a look at your progress toward the funding of your retirement plan and consider maximizing those contributions. For example, 401(k)s have an annual contribution limit of $19,500, with additional catch-up contributions permitted for employees age 50 and older. At a minimum, if your company offers matching contributions, make sure you are contributing enough to receive the full match. If you are unable to maximize your contributions, even an incremental increase can impact your long-term savings with minimal impact to your monthly cash flow. Prior to adjusting your values, be sure to review the impact of any increased deferrals to profit sharing or any company match.
Now is also a great time to determine if your deferrals to other accounts, such as your health care savings account (HSA) remain in line with your objectives. If you are self-employed, it is also important to review your plan document and deferral deadlines.
Tip #4 – Finalize annual gifts to family members
The 2020 federal estate and gift exemption is $11.58 million per person. The federal annual gift amount remains consistent at $15,000 per person for 2020. This $15,000 per year is the maximum amount that can be transferred to another individual without being taxable to you. Any gifts must be made by the end of the calendar year. If no gift is made this calendar year, the annual amount is not rolled over.
Consider funding children’s 529 college savings plans prior to the end of the year. Named after Section 529 of the Internal Revenue Code, a 529 plan offers tax and financial aid benefits and, depending on the state, may also offer state tax deductions. Earnings in 529 plans accumulate on a tax-deferred basis and distributions are not taxed federally when used for qualified higher education expenses. Eligible expenses were expanded in 2017 to include up to $10,000 per year in K-12 tuition. In 2019, eligible expenses were expanded again to include student loan payments (both of these items are pending state-specific adoption, as a number of states still have not aligned with federal law in these areas). The funding deadline is December 31, 2020, for this calendar year.
When gifting, it may be advantageous to contribute up to $6,000 to Roth IRAs for family members/children (note that the recipient must have $6,000 of earned income). In addition to the tax-deferred growth of these accounts, distributions after age 59 ½ are tax free.
According to the IRS, as a general rule, any gift is a taxable gift. However, there are many exceptions to the rule, including gifts that are not more than the annual exclusion amount for the calendar year, tuition or medical expenses you pay for someone directly, gifts to your spouse and gifts to a political organization for its use.
In summary, by taking a proactive approach to verifying your deductions, tax projections, withholdings, charitable goals, gifts and year-end financial moves, you have the potential to add more money to your pocket after taxes. Keep in mind that each individual’s situation is unique and there are many variables that can impact which actions may be appropriate.
Big 4 Financial Freedom is a specialty practice of Creative Planning. Each of our dedicated teams specializes in working with audit and consulting professionals and includes an attorney, a CPA and a CERTIFIED FINANCIAL PLANNER™ practitioner. These experienced professionals will help you gain an understanding of your current situation and any opportunities for tax savings as we implement customized strategies to help you achieve your long-term financial goals. For tax planning guidance, or for any other financial matter, please schedule a call.