Note: A new tax law signed into law on December 22, 2017 will create several changes for individuals. Many of these changes affect itemized deductions such as those for state taxes, mortgage interest, and miscellaneous itemized deductions. These changes will generally take effect for tax year 2018. They will last until tax year 2025 unless Congress acts to extend them. See How Will The New Tax Law Impact Individual Taxpayers for more information.
As the year comes to a close, many of us start thinking about the income tax we will potentially owe upon filing our tax returns. But there are several year-end money saving tax planning ideas which may help in this regard.
For these strategies to work for the current tax year, they must be implemented by December 31st. There are also last minute tax planning strategies which may be implemented after year end. However, here we will focus on the former.
Use Tax Withholding to Catch Up on any Estimated Tax Shortfall
The U.S. tax code operates under a “pay-as-you-go” tax collection system. The IRS generally assumes that you earn your income evenly throughout the year. As such, taxpayers are required to have the related tax paid in at each quarterly deadline (4/15, 6/15, 9/15, 1/15).
Alternatively, if your income fluctuates or is skewed towards the latter part of the year, you can pay the related tax by the deadline for the quarter in which it is actually earned. In such a case you’ll have to use IRS Form 2210 to tell the IRS in which quarters you earned your income.
As an employee, you would typically meet these requirements through tax withholdings by your employer. If you receive distributions from an IRA or collect Social Security benefits, you can also have taxes withheld from such sources of income.
But you may also have other income not subject to withholding such as from rental properties or a small business. In such a case, you may have to make quarterly estimated tax payments in addition to any withholding. Use form 1040-ES for payment vouchers.
You May Be Subject To An Estimated Tax Penalty If You Don’t Pay on Time
Failure to pay at least 90% of your current year tax or 100% (110% if income was over $150,000) of your prior year tax by January 15 may result in an underpayment penalty. You may also be hit with the penalty if you have a shortfall in any particular quarter.
The underpayment of estimated tax penalty applied to any shortfall may vary from quarter to quarter. It is based on an annual interest rate derived by adding 3% to the federal short-term rate.
You may be subject to the penalty for different reasons. Often it results from income generated in the early part of the year for which there is no withholding and for which you did not make a quarterly estimated payment. Underpayment can also result from having claimed too many withholding allowances on the form W-4 you submitted to your employer.
Extra Withholding Tax Can Help Because It Is Deemed Paid Evenly Throughout the Year
But if you withhold extra tax from your last couple of paychecks, for example, you may be able to reduce or eliminate any potential penalty. This is so because withholding tax is deemed to have been paid evenly each quarter throughout the year. Even if it is withheld in December.
Besides reducing the underpayment penalty, extra withholding can minimize the amount of money you will owe upon filing your income tax return.
To determine if you are underpaid, you can do a projection manually, using tax software, or you can ask your accountant to do it for you.
See Withholding Tax Planning to Reduce Your Tax Bill for more information.
Give to Charity
As the holidays approach, the inevitable shopping frenzy is usually right around the corner. New clothes, toys, electronics, and other gadgets are bound to make their way into your home. As such, it may be productive to take an inventory of items in your house.
Take a look at clothing which you may not have worn for many years. Or which may be out of style or below your new fashion standards. Maybe take a close look at electronics or other household items which may be somewhat outdated or which you expect to replace with new purchases.
Donating such items to a charity can help you reduce your tax bill. Not to mention that it can help you declutter your home.
Of course you can also donate cash to the charity of your choice. If you make the donation using a credit card, it is deemed paid on the date it was charged. So it is irrelevant for tax purposes when the credit card balance is subsequently paid.
You can also donate appreciated stock, for example. Let’s say you want to donate $5,000 to a charity. Instead of donating cash, you may wish to donate an appreciated stock or fund from your portfolio. This way, you can still give the same amount while also avoiding tax on the capital gain if you were to sell the investment.
Make Gifts to Family or Friends
You can shift income to relatives or others via gifting. This is especially useful if the donee is in a lower income tax bracket.
Let’s say you own a mutual fund or company common stock which will be paying a dividend late in the year. Or you have an unrealized gain on such an investment, and you may be thinking of selling it. You can instead gift it to an adult child, for example, and avoid paying tax on any related dividend or capital gain.
Remember to watch out for the Kiddie Tax Rules if the child is under 24 at the end of the tax year.
If the donee child is in a lower tax bracket than you, they may pay less tax or possibly no tax at all on a dividend or capital gain (if they sell the stock). Of course this only makes sense if you intend to otherwise make a gift in the first place. And also if you are willing to part with the particular investment and its income.
In 2017, you can gift up to $14,000 to an individual without worrying about filing a gift tax return.
See Tax Planning With Donations and Gifts for more information.
Make a Required Minimum Distribution (RMD) if Required
Individual retirement plans such as IRAs, and small business retirement plans such as the SEP or SIMPLE require you to start taking money out for the year you reach age 701/2. You are considered to reach this age six months from the date of your 70th birthday.
Your first RMD must be taken out by April 1 of the year after the year in which you turn 701/2. RMDs for subsequent years must be taken by December 31 of each year. However, you may wish to take your first RMD by year end as well. This way you don’t take two in one year, and potentially bump yourself into a higher tax bracket.
Of course, if you expect to have lower income the following year, deferring the initial RMD until April 1 may be more beneficial for you.
If you do not take the required minimum distribution from your retirement account, you will be subject to an additional tax of 50% on any shortfall.
Any RMD may be withdrawn in installments, and it can be taken from multiple retirement accounts. Also, you can withdraw more than the RMD if you wish.
Note that with ROTH IRAs, withdrawals are not required until after the owner’s death. Also, for non-IRA retirement plans (i.e., 401k) which are sponsored by businesses of which you are not a 5% or greater owner, the rules are a bit different.
With such plans, the first RMD is required to be made by April 1 of the year following the later of the year you turn 701/2 or the year you retire.
The IRS provides Required Minimum Distribution Worksheets on its website.
Prepay Certain Expenses
It may be beneficial to prepay certain expenses you would otherwise pay. Doing so before year end can potentially lower your tax bill
State Income Taxes and Property Taxes
You may live in or otherwise earn income from a state which levies a state income tax. As such, you may have an estimated tax payment obligation. Fourth quarter estimated tax payments are typically due January 15 after the year end.
But if you are not subject to the Alternative Minimum Tax (AMT), it may make sense to make the estimated tax payment by December 31. This way, you can deduct the state tax paid in the current year. However, if you are subject to the AMT, prepaying the tax will not result in a tax benefit.
You can use software to perform a tax projection to see if you will be in the AMT. Or your accountant can do if for you. If you were in the AMT last year (line 45 of form 1040) and you have similar income and deductions this year, you will probably be subject to it again this year.
If you own a home, you can also prepay property taxes in order to lower your tax for the current year. But the payment must be made to the tax collector (not just to a bank escrow account) by year end.
You Generally Cannot Deduct Prepaid Interest Expense
Note that you cannot prepay interest expense. You can only deduct interest for the year to which it applies. So you will not get a benefit by prepaying mortgage interest. However, points (which represent prepaid interest) paid on a loan to buy or build your main home may be deductible in the year paid.
Note that taxes and interest paid will only benefit you if you are itemizing your deductions on IRS Schedule A.
Qualifying Education Expenses
You may also be able to get a deduction or tax credit by prepaying qualifying education expenses. This only works for expenses paid for an academic period beginning the first three months of the following year. See Tips to Help You Save and Pay for College for more information on education related credits and deductions.
Tax Loss Harvesting
As the year comes to a close it is wise to take a look at your portfolio for potential tax loss harvesting. This strategy only applies to taxable (non-tax deferred/retirement) accounts. Income and losses within tax deferred retirement accounts do not have a bearing on your current year income tax return.
So look at your taxable accounts for any investments which have unrealized capital losses. You can sell any losing investments by December 31 to harvest the losses for the current tax year. These capital losses can then be used to offset any gains realized during the year. However, they can even offset up to $3,000 of ordinary (non-capital gain income).
Just watch out for the wash sale rules. If you want to be able to use any realized capital loss, you cannot purchase the investment sold (or another which is “substantially identical”) within 30 days before or after the sale. A purchase, even if it’s in your IRA or other retirement account may trigger the wash sale rules and your loss will be disallowed.
Max Out or Increase Employer 401k Retirement Contributions
With IRAs, you generally have until April 15 to make contributions for the previous year. But with employer 401k plans, you generally must act by December 31. Your share of contributions for 401k plans comes out of your paycheck.
So if you haven’t reached the maximum contribution amount by December, you may be able to set aside more. You can increase the contribution deducted from your last couple of paychecks. Maxing out is an option but it’s not necessary.
Any increase in your contributions will lower your taxable W-2 wages. Not to mention that you will be putting aside more money for the all-important goal of retirement.
The maximum amount you can contribute for 2017 is $18,000. If you are age 50 or older, you can make an additional $6,000 contribution for a total maximum of $24,000.
Bunch Expenses Subject to Thresholds
Two common types of itemized deductions are subject to thresholds. These are medical expenses and miscellaneous deductions subject to the 2% of adjusted gross income (AGI) threshold. This makes it difficult to benefit from such expenses, especially if you make more income.
But if you bunch such expenses together, you may be able to get a benefit. The benefit may be greater if you do so in a year where your income is lower since the thresholds will also be lower.
For example, let’s say that you have adjusted gross income of $50,000 this tax year, and out of pocket medical expenses thus far amount to $5,000. As it stands now, you will not receive any tax benefit from your out of pocket expenses. This is so because you are only allowed to deduct anything over 10% ($5,000). So in this case, you are right at the threshold. If you have the same income and expenses next year, the same will hold true.
But what if you can move at least some of next year’s expenses to the current year? To the extent you can do so and exceed the 10% threshold, such expenses will be deductible this year. This may make it tougher to get a deduction next year. But something is better than nothing. A good strategy is to bunch expenses every other year if possible.
The same concept applies with miscellaneous itemized deductions subject to the 2% floor. This includes items such as unreimbursed employee business expenses, investment fees, union dues, and tax preparation fees.
For this strategy to work, you must itemize your deductions using IRS Schedule A. Also, if you are subject to the alternative minimum tax (AMT), you will not get a benefit from miscellaneous deductions subject to the 2% threshold.
Use Health Flexible Spending Account (FSA) Balances By Year End if There is No Grace Period or Carryover Feature
Because it is so difficult to get a deduction for medical expenses due to the 10% threshold, many turn to health FSA plans provided by their employers. These are plans which allow you to put pretax dollars aside for copays, prescriptions, and other qualifying out of pocket medical expenses. Certain dental and vision care also qualify. But insurance premiums and cosmetic types of procedures generally do not.
FSA plans essentially allow you to get a deduction for these medical expenses by reducing your taxable W-2 wages by the amount contributed to the plan. But these plans generally have a “use-it-or-lose-it” feature. So any funds in the plan not utilized by December 31 may be lost. Sometimes the employer provides a grace period or carryover feature. These features give you until early in the following year to use the money in the plan, or allow you to carry over a specified balance into the next year.
If such features are not included in your plan, or if you have more than the amount allowed to be carried over, you must act by December 31st. Use up the money by scheduling a visit before year end to your doctor or dentist, optometrist, etc.
Every one of the strategies discussed above may not apply to you. But even one of the above tax saving ideas can help you save some money.