One of the basic goals of year-end tax planning is to look at the tax impact on two years at once – the current year, compared to the next tax year. It’s all about the timing of the use of your remaining income and deductions to your tax advantage.
Typically, it makes sense to push taxable income into the next year in order to defer payment of tax for at least one more year, if possible. But, if you expect to be in a higher tax bracket next year, you may want to do the opposite!
Similarly, you might want to accelerate deductions in the current year to reduce the income tax bill you must pay by April 15th.
In the meantime, review the following Financial To-Do List for several year-end ways to take advantage of tax breaks, financial strategies and opportunities to boost your savings.
1. Add more money to your Employer Sponsored Retirement Plan (ESRP)… You can only contribute a limited amount to your ESRP each year, and you can’t just add extra money into the account yourself; the pre-tax contributions must be made through payroll deduction. You have until your last payroll prior to December 31st to reach the annual limit. Ask your employer’s payroll department what steps you need to take to increase your contributions. Some employers also let you contribute a lump sum directly from a year-end bonus.
The beginning of the New Year, or when you get your next pay raise, is an excellent time to increase your payroll deducted contribution amount by 1 or 2 percentage points.
2. Fund your IRAs… You have until the April 2017 tax deadline to maximize your IRA contributions. A year-end bonus is a great way to fund such contributions. If you are under 50 years of age, your contribution limit is $5,500. For age 50 and over, the limit is $6,500.
3. Open an individual retirement plan for self-employment income… Whether it is a SIMPLE IRA, SEP IRA, or solo 401(k), this is one of the best ways for self-employed people to save for retirement. You have until April 15th of the next year to make contributions for the last (possibly longer depending on the plan selected or the date you file your tax return). But, you have to open the account by December 31st of this year. Self-employed people should also time their equipment purchases and other expenses carefully over the next few weeks to make the most of the deductions for this calendar year.
4. Consider a ROTH conversion… You have until December 31st of this year to convert money from a traditional IRA to a ROTH for this year. You’ll pay taxes on the conversion, but you’ll be able to withdraw the money tax-free from the ROTH in retirement. Making a ROTH conversion is a particularly good idea if your income was lower this year than in previous years. It is suggested that you look at your income each year and calculate how much you can convert without bumping any of the money into the next tax bracket. Spreading your conversions over several years, especially after you retire, can help you avoid having to take big required minimum distributions (RMD) after age 70 ½. That could trigger additional taxes on your Social Security benefits. If you convert and later change your mind because your tax situation changes, say you lose your job before the tax bill is due next year, or your investments do poorly, you have up to October 15th of the next year, or the date you file your tax return, whichever comes first, to undo the conversion (called “recharacterization”). If you do decide to recharacterize, you’ll get the money back that you paid in taxes and you can reconvert later, ideally with a lower tax bill.
5. Take your required minimum distributions… If you’re older than 70 1/2, you generally need to take required minimum distributions (RMD) from traditional IRAs, 401(k)s and other retirement savings plans by December 31st (except for the year you turn 70 1/2, when you’re given an extension until the following April 1st to make your first withdrawal). If you miss the RMD deadline, the penalties can be big. If you’re still working, you don’t need to take RMDs from your current employer’s 401(k). If you haven’t taken your RMD yet, contact your administrator soon so you have plenty of time to meet the December 31st deadline. Also, keep in mind that people older than age 70 1/2 can contribute up to $100,000 from their IRAs to charity, which counts as their RMD, but does not boost their adjusted gross income (AGI).
6. Make the most tax-effective charitable gifts… Giving money to charity before the end of the year is a great way to boost your deductions if you itemize. Be sure to research the charity to make sure you know how your donations will be used. You can deduct all kinds of charitable contributions, including cash, stock and non-cash donations, such as the cost of coats you buy for a local shelter. Some giving strategies can stretch the tax benefits even further. For example, if you have highly appreciated stock you were planning on selling, consider giving the stock to the charity instead of cash. That way, you get a deduction for the full amount, but you avoid paying capital-gains taxes on the increase in value since you’ve owned it. Remember that your contributions must be charged or postmarked by December 31st.
7. Remember this number when you give away your money… If you are planning to give money away to someone special, the current year annual gift exclusion is $14,000.
8. Contribute to a 529 college-savings plan… This strategy is a win-win. The beneficiary of the account (your child, grandchild or the child of a friend) can use the money tax-free for college tuition, room and board, and fees. Plus, in many states, you get a state income tax deduction for your contribution. Illinois residents can get a 3.75% tax credit on contributions up to $20,000, which can save you as much as $750 on state taxes. Many 529 plans require you to make your contributions by December 31st to count for that tax year (although some give you until April 15th of the following year). Check the details of your plan.
9. Check the deadline for cleaning out your flexible spending account (FSA)… Traditionally, people have to deplete their FSAs by December 31st or lose whatever money is left. That means December is a frantic time as people race to spend money at, say, the eye doctor or dentist. However, the U.S. Treasury Department and IRS have changed the FSA rules to allow employees to carry over $500 in their FSAs from one year to the next. Some employers already offer a grace period until March 15th, but a few employers still require you to use the money by December 31st or lose it. In that case, now is a good time to order contact lenses, visit the eye doctor or dentist, buy new glasses or prescription sunglasses, or pay for other eligible medical expenses.
10. Maximize Your Contributions to A Health Savings Account (HSA)… Those who have a high deductible health insurance plan, and qualify to contribute to an HSA, should double check the amount contributed year to date. For 2016 the annual limit for a HSA is $ 6,650 for a family and $3,350 for singles. This limit amount is 100% tax deductible from gross income.
11. Buy health insurance on the exchanges… Most who purchase insurance on an exchange will qualify for tax subsidies. A credit will be available for folks with household incomes ranging from 100% to 400% of the 2017 federal poverty level, meaning $11,880 to $47,550 for singles and $24,300 to $97,200 for a family of four. Critical deadlines include: December 15, 2016 (the last day to obtain coverage that starts on January 1, 2017); January 15, 2017 (the last day to buy coverage that starts on February 1, 2017); and January 31, 2017, (the last day of open enrollment for coverage in 2017).
12. Consider your Medical costs… If your qualified medical costs have topped 10% of your AGI or Adjusted Gross Income threshold (7.5% for filers over 65) or, if you are close to the AGI threshold, think about getting and paying for elective procedures this year. Total amounts that surpass these levels will realize a tax benefit. Seniors especially should seriously consider this tax tip because beginning in 2017 (for tax returns due in 2018), the threshold for deducting medical cost increases to 10% of AGI for people age 65 and over.
Medicare Parts B & D premiums are based on your AGI. You will pay higher premiums if you are married with income exceeding $170,000, or single with income over $85,000. Your 2018 premiums will be based on your 2016 income (the aforementioned two-year impact). Consider carefully whether a tax move you make now will push up your premiums in 2018.
13. Don’t wait to make your January mortgage or state estimated tax payments… If you make the January mortgage payment on your residence before the end of this year, you can deduct the interest portion this year. However, unless you do the same thing next year, you’ll deduct only 11 months of interest then.
The state deadline for fourth quarter estimated payments is January 15th. However, mailing your January payment in late December lets you claim the deduction as an itemization on your current year federal return. If you wait those additional two weeks past December 31st you will need to wait an additional 16 months until next year’s federal tax filling to claim this deduction.
14. Consider your year-end investment transaction timing… Before buying or selling any taxable investment in your portfolio, first consider any unrealized gain, deferred interest, or scheduled distribution. Stocks pay out 4th quarter dividends, mutual funds pay out year-end capital gain distributions, and selling something that has a gain before December 31st will add to your taxable income. Bad timing may cause tax liability surprises when you file your state and federal tax returns later. Talk to your Vermillion Advisor to gain a better understanding about timing your capital gains and losses and other tax moves to make before New Year’s Eve.
15. Make Sure You Know Your “Safe Harbor” Amount of Taxes… For individuals and families who pay quarterly estimated taxes, knowing your “safe harbor” number can save you possible tax penalties. If you don’t pay the IRS enough estimated taxes for the current year, they will charge you interest and payment penalties. However, as long as the amount you pay the IRS this year is as much as you paid last year, you’ve reached your “safe harbor”, and the IRS can’t charge you any penalties or interest.
The minimum “safe harbor” amount you must pay in state and federal taxes to avoid under-payment penalties, is a calculation. The calculation varies if your adjusted gross income was above or below $150,000. Check the amount you paid in taxes last year, and ask your Vermillion Advisor to calculate the amount of taxes you should have paid in for the current year. If there is an under-payment, be sure to make up the shortfall before December 31st.
If you are facing a penalty for underpayment of federal estimated tax, increasing your withholding from your paycheck, social security benefits, pension check, or required minimum distribution may reduce or eliminate the penalty. If you expect to owe state and local income taxes when you file your return next year, you can increase the tax withholding. Consider asking your employer to increase withholding, or making estimated tax payments of state and local taxes before year-end to pull the deduction of those taxes into 2016.
16. Harvest Tax Losses… Did you lose money on any investments this year? Significant tax benefits can be derived from realizing losses when they occur. If you sell a losing asset, and take the capital loss, the losses can then be used to offset capital gains incurred during the current tax year on a dollar-for-dollar basis. Commonly referred to as tax loss harvesting, losses that exceed gains are capped at $3,000, but you can carry them forward into future tax years. For those in the 10% or 15% tax bracket, you can pay 0% long term capital gains. If you fall in this tax bracket and you are planning to sell assets, do it before year’s end.
17. Defer your income… Income is taxed in the year it is received. It’s tough for employees to postpone wage and salary income, but you may be able to defer a year-end bonus into next year; as long as it is standard practice in your company to pay year-end bonuses the following year. If you are self-employed or do freelance or consulting work, you have more leeway. Delaying billings until late December, for example, can ensure that you won’t receive payment until the next year.
Of course, it only makes sense to defer income if you think you will be in the same or a lower tax bracket next year. You don’t want to be hit with a bigger tax bill next year if additional income can push you into a higher tax bracket. If that’s likely, you may want to accelerate income into the current year so you can pay tax on it in a lower bracket sooner, rather than in a higher bracket later.
18. Make best use of your standard deduction… If your itemizations just top the standard deduction amount, try shifting some of them to the current year and take the standard deduction next year. If you don’t have enough this year to itemize, delay some and itemize next year.
The standard deduction for the 2016 filing season is $12,600 for couples or $13,850 if one is 65, and $15,100 if both are 65 or older. For singles it’s $6,300 or $7,850 if they’re age 65. The standard deduction for head of household is $9,300 or $10,850 if age 65.
19. Think about Energy as a tax break too… If you are considering installing energy efficient windows, doors, insulation, or a new roof, this can earn you a 10% credit up to $500, even if installed in December
20. Run a tax preview… Before the end of the year, ask your Vermillion Financial Advisor to prepare a tax projection for a final estimate of your 2016 tax liability. If you wait until the New Year, it’s often too late to go back and make changes.
It seems like every year when we do our taxes, there are a few things we wish we would have done back in December to reduce our tax bill just a little more. So here’s a final tip… Don’t wait. Start making your new year’s Tax Saving Plans right now!
Note: The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendation for any individual. Please remember that past performance of investments may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this post serves as the receipt of, or as a substitute for, personalized investment advice from Vermillion Financial Advisors, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed within this newsletter to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.
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