tax planning

Areas of Focus for End-of-Year Tax Planning

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Many people have the idea that tax planning is only about paying less money right now, and that’s not the case. Tax planning is about paying less money over time.

There are many avenues to do that. As we’re nearing the end of 2021, it’s prime time to get your finances in order for the upcoming tax season, and hopefully this article can help you figure out how to pay less money over time.

In this article, we’ll focus on a few areas for your end-of-year tax planning: tax-loss harvesting and rebalancing, charitable giving, retirement plan contributions and Roth conversions.

Tax-Loss Harvesting and Rebalancing

Rebalancing your portfolio in the most tax-efficient way is key. You want to make sure you are pairing up gains and losses. In other words, if you have gains in your portfolio, you should pair them with losses to offset or minimize your tax exposure. 

I recently wrote about this strategy, tax-loss harvesting, which is essentially a method that helps you lower your taxable earnings after selling taxable investments and using those losses to offset the amount of gains you have to claim as income. Tax-loss harvesting can also let you push your capital gains further out, allowing you to save on your taxes in future years when your tax bill might be higher.

Charitable Giving

Giving directly to a charity is good for your soul, but maybe not for your tax bill, especially if you aren’t itemizing. You won’t get to deduct the full donation if you aren’t itemizing, but you’ll still get a $300 above-the-line deduction. 

Since the standard deduction for 2021 is so high – $25,100 for married filing jointly and $12,550 for single filers – more taxpayers have chosen to take it over itemizing deductions. CNBC reported that 16.7 million households claimed itemized deductions on their 2018 income tax returns, down from 46.2 million in the 2017 tax year. 

There are two avenues to explore charitable giving this time of year: establishing a donor-advised fund and making qualified charitable distributions from your IRA. 

A donor-advised fund allows you to bunch your charitable contributions this year so that you’ll be able to get a tax break. For example, you can bunch your charitable contributions for the next five years – say $10,000 a year – into a DAF and still be able to take the full tax deduction this year. This $50,000 donation will definitely get you over the standard deduction. 

If you want to get more in-depth on donor-advised funds, check out our blog post on DAFs and charitable remainder trusts. 

Qualified charitable distributions (QCDs), on the other hand, are good for people who have to take required minimum distributions (RMDs) but don’t need the money. QCDs allow you to donate $100,000 per taxpayer (so a married couple can donate $200,000) per year to a charity directly from your IRA if you’re over age 70½. The benefit here is you don’t have to pay income tax on that amount while also satisfying your RMD.

Establish and Contribute to Retirement Accounts

If you’ve taken a break from contributing to your retirement account, now is the time to catch up if you are able. The maximum amount you could donate this year is $19,500.

If you are a small business owner and have yet to set up a retirement account, doing so by the end of the year is a good idea.

First, you’ll want to explore which option is right for you. For example, if you don’t foresee yourself going over the $6,000 contribution limit for traditional IRAs, that would be a good option for you. But if you anticipate you’ll contribute more than that, the SEP IRA or solo 401(k) are also both viable vehicles.

These two options have different rules. For example, SEP IRAs are more cost-effective to set up and you can contribute 25% of your qualified business income or $58,000, whichever is less for 2021. So for example, if you’re self-employed and your qualified business income is $100,000, you can donate $25,000.

With a solo 401(k), the contribution limit is $58,000 plus a $6,500 catch-up contribution or 100% of earned income, whichever is less for 2021. So long as you establish your solo 401(k) by year end (December 31, 2021), you have until your company’s tax return deadlines (including extensions) to make contributions.

Roth Conversions

Roth conversions are when you transfer money from a traditional IRA and convert it to a Roth IRA, which is a taxable event. Essentially, you would pay taxes on that conversion as it becomes part of your taxable income now, versus paying taxes on that money in the future.

Let’s look at an example: Say you have $50,000 in an IRA and you want to transfer it into a Roth IRA. Your taxable income will now be $50,000 more than it would have been before. You and your financial professional need to evaluate whether this would be a good idea for your situation.

There are many benefits to doing the Roth conversion. First, we don’t know what is going to happen with taxes in the future, so if you anticipate you’ll be in a higher tax bracket next year, you can do your Roth conversion now and take advantage of this low-tax-rate environment. Second, Roth IRAs don’t have RMDs, so you won’t be required to take from this bucket in retirement. 

Also, you don’t have to pay taxes on the earnings from the Roth IRA if you meet certain IRS criteria. And since you’re contributing after-tax dollars, you can withdraw your contributions tax- and penalty-free. 

Lastly, Roth IRAs are a tax-efficient asset to leave to heirs. While they still must draw down the account in 10 years, when they do inherit the funds and draw down, it’s not a taxable event. 

One more thing to keep in mind when doing a Roth conversion: pay the taxes on it with cash, your taxable investment account or a trust account, instead of paying with the conversion.

In Conclusion 

Planning what you’re going to serve for the holidays might be top of mind right now, but you want to make some space for your tax planning so you can maximize your savings.

Taxes are inevitable, and good tax planning will help you pay less over time. It’s imperative that you connect with your trusted financial professionals to make the best tax plan for your unique situation.

Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

Re-balancing may be a taxable event. Before you take any specific action be sure to consult with your tax professional.

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