10 Tax-Smart Strategies With December Deadlines
This year marked the first time taxpayers filed their returns under the Tax Cuts and Jobs Act of 2017 (TCJA). Due to the sheer number of changes introduced, many taxpayers may not be aware of steps that need to be taken before year-end to help manage their tax exposure under the new law. That’s where year-end tax planning can play a critical role. Important decisions, such as whether you will itemize or take the standard deduction next April, depend on the actions you take before year-end 2019. That’s because December 31st is the deadline for implementing certain strategies that can help reduce your taxable income, increase your allowable deductions, and keep more of your money working for you.
Below we examine ten tax-smart strategies to consider before year end.
1. Determine if you will itemize or take the standard deduction
While the 2020 tax filing deadline may seem like a long way off, now is the time to determine if it makes sense for you to itemize on your 2019 return, or take the standard deduction, which nearly doubled under the new tax law. In 2019, the standard deduction is $12,200 for individuals and $24,400 for married couples filing joint returns. The TCJA eliminated many standard deductions, including miscellaneous deductions for tax preparation costs, investment expenses, home office expenses (unless you’re self-employed), and unreimbursed employee business expenses. It also capped the deduction for state and local income tax (SALT) at $10,000 and limited the home mortgage interest deduction to acquisition indebtedness up to $750,000 in mortgage loan interest (for new mortgages taken out since 2018; the limit remains $1,000,000 for all existing mortgages). The floor for unreimbursed medical expenses, which was temporarily lowered to 7.5% of adjusted gross income (AGI) for tax years 2017 and 2018 only, reverted to 10% of AGI in 2019.
These changes resulted in fewer taxpayers being able to itemize on their returns under the new law. However, for many taxpayers, the significant increase in the standard deduction made up for the loss of itemized deductions. However, taxpayers still need to tally up their allowable deductions in 2019, to determine if they add up to more than the standard deduction. If they do, it makes sense to itemize.
2. “Bunch” deductions
December 31 is the deadline for capturing medical expenses or making charitable donations for tax-year 2019. Some taxpayers may find themselves on the fence when it comes to itemizing, due to a significant amount of unreimbursed medical expenses, or a desire to take advantage of the higher floor for charitable deductions, which rose to 60% of AGI under the new law.
“Bunching” deductions into the current tax year is a strategy you may want to explore to increase your itemized deductions. For example, if you have a significant amount of unreimbursed medical expenses, it may make sense to accelerate elective treatments, procedures, or medical equipment costs into 2019 if your combined deductions will bring you over the standard deduction amount.
If bunching charitable deductions in years where you will be able to itemize makes sense in your situation, you may want to consider a donor advised fund to achieve that goal. Donor-advised funds are established with public charities. As the donor, you transfer money or appreciated stock and receive a deduction in the year the charitable donation is made. For example, let’s say you plan to give $3,000 a year to charity over the next five years, for a total of $15,000.
While your annual $3,000 donation may not be enough for you to itemize and thus realize a deduction for your charitable gift, “bunching” five years of charitable deductions into a single tax year, may enable you to deduct your charitable donations. If donating the full $15,000 in 2019 (5 X $3,0000) would enable you to itemize on your tax return, you would then take the standard deduction in the remaining years (2020 through 2023). The contributions within your donor-advised fund could still be disbursed to the charity on an annual basis, over the five-year period. However, keep in mind that contributions to a donor-advised fund are irrevocable.
3. Make a Qualified Charitable Contribution (QCD)
If you’re over age 70 ½ and have an individual retirement account (IRA), a qualified charitable contribution (QCD) may be a more beneficial way to satisfy your charitable giving goals, especially if you don’t have enough deductions to itemize. With a QCD, the custodian of your traditional IRA makes distributions directly to a charitable organization on your behalf. The advantage here is that distributions paid directly to a charity are not taxable and will count toward your required minimum distribution (RMD) for the year. You can direct all or a part of the RMD (up to $100,000 per tax year) to a qualified charitable organization and you will only be taxed on any remaining portion of the distribution that you received.
Keep in mind, you must be at least age 70 ½, and distributions must be transferred directly from your IRA to a qualified charity by your IRA custodian. If you take the RMD as a distribution first, then decide to donate all or a portion to charity, it won’t count as a QCD. To take advantage of the exclusion from income for IRA contributions to charity on your 2019 tax return, you’ll need to arrange a direct transfer by the IRA trustee to an eligible charity by December 31.
4. Time your income and expenses
In many cases, the timing of your income and expenses can help reduce your tax liability. If you don’t expect to be subject to the alternative minimum tax (AMT) in the current year or the next year, deferring income to 2020 and accelerating deductible expenses into 2019 can be an effective strategy for deferring taxes.
However, if you expect to be in a higher tax bracket next year, the opposite approach may be beneficial. That’s because accelerating income will allow more income to be taxed at this year’s lower rate, and deferring expenses will make the deductions more valuable when you’re subject to a higher tax rate. Common types of income where you may be able to control the timing, include:
- Consulting or self-employment income
- U.S. Treasury bill income
- Retirement plan distributions (to the extent they’re not subject to early-withdrawal penalties and aren’t required minimum distributions)
You’re generally not able to defer RMDs. However, there is one exception. If you’re over age 70 ½ and are still working, you may be able to defer RMDs by rolling the assets from an IRA or a former employer’s retirement plan into your current employer’s plan, if the plan allows. This would enable you to delay taking RMDs until you’re no longer working and in a lower income tax bracket.
5. Maximize pre-tax deductions
If you have access to a flexible spending account (FSA) through your employer, you can direct up to $2,700 in pre-tax income to the account in 2019 to cover qualified, unreimbursed medical expenses. However, what you don’t use by the plan year’s end, you generally lose. Some plans allow you to roll over up to $500 to the next year, or provide a 2½-month grace period to incur expenses to use up the previous year’s contribution. However, plans cannot allow both options and are not required to offer either. If it’s still open season for selecting 2020 benefits through your employer, you may want to consider contributing to an FSA. If open enrollment has closed, make a note to look into this option next fall.
If you’re covered by a qualified high deductible health plan, you can contribute pretax income to an employer-sponsored health savings account (HSA) or make deductible contributions to an HSA you set up yourself. You can contribute up to $3,500 for self-only coverage and $7,000 for family coverage for 2019 (plus an additional $1,000 if you’re age 55 or older) on a pre-tax basis. HSAs offer a number of advantages. Withdrawals for qualified medical expenses are tax-free, and unlike FSAs, an HSA balance can be carried over from year to year. In addition, contributions can be invested where they grow tax-deferred, similar to an IRA.
6. Maximize retirement plan contributions
Contributing the maximum allowed to an employer sponsored defined contribution plan, such as a 401(k) or 403(b), is one of the most effective ways to reduce taxable income. Traditional contributions are made on a pretax basis, reducing your modified adjusted gross income (MAGI). This can help you reduce or avoid exposure to the 3.8% NIIT (net investment income tax). Plan assets grow tax-deferred, so you pay no income tax until you take distributions. In addition, many employers match some or all of your contributions.
In 2019, you can contribute up to $19,000 to a 401(k) or 403(b) in the form of salary deferrals. And if you’re 50 or older in 2019, you can make an additional $6,000 catch-up contribution, for a total maximum contribution of $25,000. (In 2020, these limits will increase to $19,500, and $6,500 for catch-up contributions. If you’ll be 50 or older next year, that provides an opportunity to reduce your taxable income by $26,000 in 2020.) The contribution limits for individual retirement accounts (IRAs) have also increased in 2019, to $6,000 for those under age 50, and an additional $1,000 catch-up contributions for those age 50 or over, for a total annual contribution of $7,000. (IRA limits will remain the same in 2020.)
If you participate in an employer-sponsored retirement plan, you may be able to designate some or all of your contributions as Roth contributions. While Roth contributions are made on an after-tax basis, and don’t reduce your current MAGI, qualified distributions will be tax-free. Roth contributions may be especially beneficial for higher-income earners, who are ineligible to contribute to a Roth IRA.
Keep in mind, you only have until December 31st to maximize your 401(k), 403(b) or other employer-sponsored retirement plan contributions for tax-year 2019. Unlike individual retirement accounts, or IRAs, where you can make 2019 contributions up until the April 15, 2020.
7. If you’re self-employed, consider a profit-sharing plan or SEP IRA
Profit-sharing plans are defined contribution plans that allows discretionary employer contributions and flexibility in plan design. In 2019, you can generally make deductible contributions of up to 25% of your compensation, not to exceed $56,000. Contributions can be made as late as the due date of your 2019 income tax return, including extensions, as long as your plan exists on December 31, 2019.
A simplified employee pension plan, or SEP IRA, is another option for self-employed business owners. Annual contribution limits cannot exceed the lesser of 25% of compensation or $56,000 in 2019. The amount of compensation you can use to calculate the 25% limit is also capped at $280,000 in 2019. Catch-up contributions are not allowed for SEP IRAs.
8. Consider a Roth IRA conversion
If you have a traditional IRA, consider whether you might benefit from converting some or all of it to a Roth IRA. A conversion can allow you to turn tax-deferred future growth into tax-free growth (as long as you meet all qualified distribution requirements), while providing important estate planning advantages. Unlike traditional IRAs, Roth IRAs are not subject to RMDs, so you can let the entire balance grow tax-free over your lifetime for the benefit of your heirs.
While there’s no income-based limit governing who can convert assets to a Roth IRA, the amount converted to a Roth is taxable in the year of the conversion. Whether a conversion makes sense for you depends on a number of factors, such as your age; whether the conversion would push you into a higher income tax bracket; your current tax bracket now and expected tax bracket in retirement; and whether you can afford to pay the tax on the conversion, among other considerations.
Keep in mind, under the TCJA, you no longer have the option to undo a Roth IRA conversion by “recharacterizing” the account as a traditional IRA. However, you can still recharacterize new Roth IRA contributions as traditional contributions if you do it by the applicable deadline and meet all other rules.
9. Harvest tax losses
Time, not timing, is generally the key to long-term investment success. However, timing can have an impact on the tax consequences of your investments. That’s because your long-term capital gains rate can be as much as 20 percentage points lower than your ordinary-income tax rate. The long-term capital gains rate applies to investments held for more than 12 months. The applicable rate depends on your income level and the type of asset you’ve sold.
Remember, appreciation on investment assets isn’t taxed until the investments are sold. That can provide greater flexibility when it comes to deferring taxes and allowing you to time the sale of investment assets to your advantage from a tax perspective. For example, you may want to recognize gains in a year when you have capital losses to absorb the capital gain. If you’ve realized sizeable gains during the year and want to reduce your 2019 tax liability, look for unrealized losses in your portfolio and consider selling them before year end to offset your gains. Both long- and short-term gains and losses can offset one another. But beware of the wash sale rule. The wash sale rule prevents you from taking a loss on a security if you buy a substantially identical security (or an option to buy such a security) within 30 days before or after you sell the security that created the loss.
10. Don’t forget about annual gifts
While the TCJA kept the estate tax rate at 40%, it more than doubled the exemption base amount from $5 million to $11.4 million for individuals, and $22.8 million for married couples filing joint return in 2019 (adjusted for inflation). However, this provision is scheduled to sunset at year-end 2025, absent further Congressional action. Using up some of your exemption during your lifetime can be tax-smart, especially if your estate exceeds roughly $6 million (twice that if you’re married).
The annual gift tax exclusion amount, which is $15,000 per recipient in 2019 ($30,000 for married couples) allows you to gift to anyone you choose without cutting into your lifetime gift and estate tax exemption. However, gifts made under the annual gift tax exclusion must be made by December 31, since the exclusion doesn’t carry over from year to year.
Benefits of tax planning
Tax planning can be a smart way to not only move closer to realizing your goals, but identify gaps in your overall financial plan. Engaging in tax planning throughout the year can help lessen or shift your tax burden, free-up more money to save or spend, and help you avoid mistakes that can result in penalties or paying more than your fair share. However, you never want to make decisions based solely on the tax consequences. Tax planning is part of a comprehensive approach to planning driven by your financial and lifestyle goals.
Before putting any of these strategies in place, be sure to meet with your CPA or tax professional, and your financial advisor to coordinate and implement the strategies that are right for you.