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Year End Tax Planning

As we approach the end of another tax year, it is beneficial to consider certain actions that can not only result in a lower tax bill this year, but also in the years to come. Below are a number of strategies you may wish to utilize prior to December 31:

  • Take advantage of preferential capital gains rates For those individuals whose income falls in the 15% marginal bracket, long-term capital gains are taxed at 0%. With this in mind, you may wish to consider realizing enough gains to fill up the 15% bracket and therefore pay no capital gains taxes on that income. However, be careful as an increase in Adjusted Gross Income (AGI) can affect taxability of Social Security, itemized deductions subject to thresholds, charitable deductions, credits, etc.
  • Harvest losses If you anticipate having large capital gains this year, they can be offset by selling other positions at a loss. This can be especially beneficial in situations where the gains will be subject to the higher rate (20%) and/or the 3.8% Medicare Surtax. In addition to mitigating capital gain income, you can also offset up to $3,000 in ordinary income and carry the remaining balance forward for future tax years. Finally, reducing net gains will also reduce AGI which can have a positive effect on certain deductions. An important reminder when utilizing this strategy is to avoid the wash sale rules this means that if you sell an investment at a loss, you must wait 30 days (either before or after) to purchase that same investment.
  • Convert your Traditional IRA If you think you might be entering a higher tax bracket in the future, will be in a lower than normal bracket this year, or think tax rates will rise, it might make sense to convert your Traditional IRA to a Roth IRA. This will allow tax-free growth of your money and future qualified distributions will be tax-free (assuming you meet the necessary qualifications). This strategy can also be beneficial in situations where your account has lost money but will likely recover; a conversion will result in less taxes payable than otherwise would be due to the diminished balance. Consider pairing this strategy with a charitable donation (below) to at least partially offset taxes due on the conversion. Remember you have until October 15 of the following year to recharacterize the conversion if your situation changes or you find yourself unable to pay the tax.
  • Donate to charity For those who itemize deductions (or plan to) and are charitably inclined, donating cash or property to a qualified organization can have a sizeable impact on your tax bill. In general, contributions to charity can be deducted by up to 50% of AGI, but a 30% limitation may apply to certain organizations. In addition, the IRS usually (retroactively) allows tax-free Qualified Charitable Distributions (QCDs) directly from your IRA to a charity of your choice in lieu of taking a traditional RMD. To utilize QCDs, taxpayers must be over 70 and up to $100,000 can be transferred.
  • Increase retirement plan contributions Even though it is the end of the year, there is still time to save! If you find yourself with extra income, make sure to contribute any excess to your retirement plan during the last few pay periods; if you receive a year-end bonus, you can also re-direct a portion of that to your retirement plan. Not to mention, you may qualify for a higher employer match.
  • Bunch itemized deductions Taxpayers who do not have enough itemized deductions in a given year may want to consider bunching items together in order to exceed the standard deduction threshold. This is especially useful in cases where an item must exceed a percentage of AGI in order to be deducted. For example, if you know that you (and your spouse, if applicable) might need certain medical procedures in the near future, it may make sense to schedule them within the same tax year so that you are able to meet the AGI threshold for deducting medical expenses.
  • Contribute to a 529 College Savings Plan If you would like to help someone save for college, a 529 College Savings Plan can be the perfect vehicle. These accounts let you contribute on a state tax-deductible basis (depending on where you reside) and distributions are tax-free if used for qualified higher education expenses.
  • Be careful of year-end mutual fund purchases Many mutual funds pay out dividends and large embedded capital gains at the end of the year, which will be reportable by the owner of the fund as of the ex-dividend date. While it may seem like a good idea to buy shares before this date in order to receive the extra income, it is important to be aware that the payout causes the share price to fall by that same amount. Not only that, but even if you automatically reinvest the dividends, you still have to pay tax on that income (assuming the shares are held in a non-qualified account). For some people, it may make sense to sell a mutual fund prior to a large capital gain distribution and reinvest that money in a low-cost ETF in the interim, then re-purchase the fund at a later date (again, be careful of the wash sale rules). Note that this situation usually only benefits people who are holding a fund without a large unrealized capital gain; otherwise, the sale of the fund will trigger its own capital gain on the net proceeds.
  • Make gifts to family Not only can you help your family financially, you can also receive a tax benefit by gifting certain property. For example, if you gift a stock or mutual fund prior to the ex-dividend date (as mentioned above), the new owner will be responsible for reporting the distributed income. This can make sense if you have a sizeable position with a large expected distribution and can shift the income to a beneficiary in a lower tax bracket than yourself. You can give $14,000 per year, per beneficiary free of gift tax. Giving property to family can also help you to reduce your estate.
  • Review your withholding To reduce the chances of owing money at tax time, make sure that your current tax withholding is as up-to-date and accurate as possible. You can use online tools to help calculate the correct amount; if you have been withholding too little, try to approximate the amount of additional withholding necessary to break even. To adjust the percentage for the final few pay periods of the year, all you need to do is file a revised W-4 with your employer.
  • Remember your RMDs If you are older than 70, make sure to take your Required Minimum Distribution from your retirement plans and inherited IRAs. While the IRS tends to be fairly lenient when it comes to missed RMDs, there is a chance that a potentially sizable penalty could be due (50% of shortfall) if the mistake is not forgiven.
  • Consider AMT preference items While the Alternative Minimum Tax only affects 4-5% of taxpayers1, it is important to be aware of so that you can limit it, or avoid triggering it in the first place. Certain deductions, like state and local income taxes and property taxes, are not deductible under AMT. Before accelerating certain payments, make sure to consider how these might affect the AMT calculation.

If you are considering utilizing one or more of the above strategies, you may wish to consider having a MASTERPLAN done first. This financial plan will take a comprehensive look at your financial situation and assist you with tax-related issues, as well as uncover potential opportunities. Finally, make sure to review any tax strategies with an accountant prior to implementation to ensure all aspects of your situation are being considered. Please contact Hefren-Tillotson for further details.

1Tax Policy Center, Quick Facts: Alternative Minimum Tax (AMT)

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