It might seem hard to believe, even after months of lockdown, but year-end is upon us. That means tax season is right around the corner. Even though April 15th may seem far away, it’s not too early to do some planning for it. Actually, ideally, tax planning should be done throughout the year.
If you’ve gotten behind on yours, taking action now can still pay off. Below are five steps you can still take to save on taxes.
#1. Max out your 401(k) or other pre-tax retirement savings plan
Each dollar you stash in a pre-tax retirement account reduces your taxes. That’s because the contributions you make lower your taxable income. For example, say you are in the 32% tax bracket, make $200,000 a year, and contribute $19,500 to your 401(k) account. Your contributions will reduce your taxes by $6,240.
For 2020, the maximum you can contribute to a plan is $19,500. But if you’re 50 and older, you can make additional contributions of up to $6,500. And if you’re contributing to a tax-deductible IRA, Solo 401(k), or SEP IRA, the latter two apply to business owners, you might be eligible to make a contribution for the 2020 tax year as late as April 15th, 2021.
Here’s the nitty gritty on potential deductions, maximum contribution limits, and deadlines for business owners:
- Solo 401(k). Business owners have until April 15, 2021 to contribute $57,000 (plus an additional $6,500 if they are age 50 or older, for a total of $63,000) to their account for the 2020 tax year so long as they opened the account by December 31, 2020.
- SEP IRA. The deadline to set up a SEP IRA and make a tax-deductible contribution (max: $57,000) for the current tax year is the date your business tax return is due, typically April 15, 2021, plus extensions.
- SIMPLE IRA. Provided your plan was in place by October 1, 2020, you have the same deadline SEP IRAs do, the date your business tax return is due, including any extensions, to make contributions to your account for the 2020 tax year. But your maximum tax-deductible contribution is limited to $13,500 plus $3,000 if you’re 50 or older.
SEP IRAs and SIMPLE accounts offer business owners an additional benefit in addition to tax-advantaged savings. The assets in these accounts are protected from creditors.
#2. Use up those FSA dollars
Flexible spending accounts are a great way to reduce your out-of-pocket healthcare costs. Similar to 401(k)s, amounts you set aside come from your pretax income. That means they reduce your taxable income. The catch is that in most cases, you have to spend all you’ve set aside by December 31st, or you lose those funds.
Some employers allow employees either a grace period of two and a half months after year-end to use their leftover funds or a carryover amount of $550 . If you still have funds in your account, now’s the time to check if your employer is one of them. (Additionally, as part of Congress' coronavirus relief legislation, the IRS permitted some employers to amend their plans to extend the grace period or relax carryover rules for some FSA and Dependent Care FSA plans.)
Also think about accelerating or prepaying if possible qualified medical expenses (for instance prescription drug co-pays) or scheduling doctor appointments before year-end to spend down your account.
#3. Sell money-losing investments
If you know you’d like to sell a losing position from a taxable investment account you own, like a self-directed brokerage account, consider doing it before year-end. You can use investment losses of up to $3,000 in a given year to reduce your taxable income.
If your losses will exceed $3,000, you can also consider tax-loss harvesting — using the losses from certain investments in your portfolio to offset the gains from selling your investment winners — to reduce your taxable income. Because of IRS rules, this can get complicated. For best results, you’ll want to work with your tax professional and your financial advisor.
One thing to keep in mind is that you always want to consider doing this in the context of your overall investment strategy and financial goals, not just to save money on taxes. In other words, don’t let the tax tail wag the dog.
#4. Make your charitable contributions
This year, Congress passed the Cares Act. It allows taxpayers to deduct charitable contributions of up to $300 even if they don’t itemize their taxes.
Beyond that, if you plan on making a large charitable donation and you typically itemize your deductions on your tax forms, doing it before year-end can reduce your taxable income. Just make sure you leave enough time for the funds to clear your account before year-end.
#5. Set up time to meet with your tax professional
Now’s the time to get on your tax professional’s calendar, before the tax season rush starts. If you wait too late, you may find the best ones are short on time or already booked. If you don’t have one and/or don’t know how to find a tax professional, get referrals from the other trusted advisors in your life. (As part of the comprehensive wealth planning we do for clients, GRID offers tax planning services.)
Every person’s situation is unique. And we know that tax planning is only one part of a comprehensive strategy to build and preserve wealth. But taking some basic steps, and being consistent about them, can mean not just saving on taxes, but holding onto more of your hard-earned cash over time. And that’s an important part of achieving your long-term wealth goals.
GRID 202 Partners is a holistic financial planning firm specializing in fee-based, comprehensive financial and investment planning for individuals, couples, businesses and institutions. We serve successful, ambitious professionals and business owners ready to take the next step in developing a budget, reducing debt, and creating wealth for themselves and future generations.