When winter melts away and springtime flowers start to bloom, your first thought is that tax filing season is around the corner, right?
If that’s just us, that’s ok, because we’re reminding our clients of a few things they can do to reduce their previous year’s tax bill. We prefer, however, to be more proactive with tax planning, so let’s talk about what you can do now and throughout the year to plan for your next tax bill.
Adjust Your Withholding
Did you unexpectedly owe taxes last year? You’re not alone. As with any tax law change, it’s a good idea to update your W-4 form but it is especially important since the IRS released a new form in 2020.
Thanks to the Tax Law and Jobs Act of 2017, those who did not have enough taxes withheld from their paychecks in 2018 were surprised by their tax bill. The new W-4 is quite a bit different from the old form and is designed to help taxpayers more closely align the amount their employer is withholding with their expected tax liability for the year. You can find more information about the differences here but, in general, it’s a good idea to update your W-4 if you have any major life changes (marriage, divorce, children, etc.) and you can do so with your employer at any time.
Contribute to a 401(k)
A major way to reduce your taxable income is by contributing to a pre-tax retirement account, such as a 401(k) or 403(b) plan. These plans are only available through your current employer and contributions are made via payroll deductions. Your income is reduced by the amount you contribute pretax, thus your overall income tax liability for the year is reduced.
The contribution limit for 2020 is a maximum of $19,500, with an additional contribution of $6,000 allowed for those age 50 or older. The higher maximum contribution for workers who are 50 or older is called a catch-up contribution and is intended to help older individuals save more as they approach retirement. You can also contribute up to $6,000 this year to a Traditional IRA, depending on your income, which you can also deduct when filing your taxes.
Most employers who offer retirement plans now offer a Roth, or after-tax, contribution option. Be sure to consult your tax or financial advisor when deciding whether or not to contribute pretax or Roth because even though the Roth contribution won’t reduce your current year taxes, it may be beneficial by lowering your future potential tax liability.
Donate to Nonprofit Organizations
If you’re someone who itemizes your deductions instead of claiming the standard deduction on your taxes, donations to nonprofit organizations can also help reduce your taxable income and lower your tax bill. Make sure you’re donating to a qualified tax-exempt organization, which is usually distinguished by having 501(c)(3) status or being a religious organization. If you don’t know, you can check with the nonprofit, speak with a tax professional, or use the search tool the IRS has on its website. Be sure to keep a record of your donation; many organizations will send you an acknowledgement letter indicating the date and amount of your donation. When donating in-kind property, you’ll need a receipt and potentially a written appraisal or picture of the property in case the IRS has any questions.
Double Up Itemized Deductions
This strategy involves doubling up your deductions and applying them in a single year so you reap the tax benefits by having a higher itemized deduction where you might have otherwise claimed a standard deduction. For example, you might pay your property taxes for the current year in January and then pre-pay next year’s property taxes in December. (Be aware that there is a $10,000 maximum deduction limit for property taxes.) If you’re making charitable donations, you might donate two years’ worth in one year.
If you have a non-retirement investment account, you might consider tax-loss harvesting throughout the year. This is when you sell investment assets at a loss and then apply those losses towards any capital gains you realize throughout the year. A loss offsets any realized gains, dollar for dollar, thus reducing your potential capital gains tax for the year. If you work with a financial advisor or online roboadviser, it’s possible that this is already being done for you behind the scenes. If you don’t have any realized gains, you can still offset up to $3,000 per year of taxable income. Remember, these asset sales only apply to taxable assets, such as those in an individual or trust investment account.
Retirement accounts such as IRAs and 401(k)s grow tax deferred, so they are not subject to capital gains and, therefore, are not eligible for tax-loss harvesting. Since there are various rules surrounding tax-loss harvesting that must be followed for your loss to be counted, be sure to discuss any asset sales and reinvestments with your financial adviser and CPA ahead of time. There are many different strategies you can use to manage your tax liability throughout the year. It’s always important to consult with your financial advisor and tax professional when making decisions that will affect your finances.