10 Ways You Can Reduce Taxes Before the End of the Year
For many, 2020 has been a hard year. The pandemic has probably upended your life and maybe even your finances. We’ve summarized below some end-of-year tax strategies you can use to lighten your tax burden. Review this list to see if you can find some way to reduce your taxes at the end of this tough year.
1. Maximize retirement and health account contributions
For the tax year 2020, you can deduct contributions to IRA, SEP accounts, and Health Savings Accounts (HSAs) up until April, 15 2021. If you plan to contribute to these accounts, make sure you have sufficient money to fund them by April next year. This deadline is not the case for contributions to 401(k)s.
If you want to grow your 401(k), you have less time. You must contribute by December 31, 2020. For this year, you can contribute up to $19,500 if you are 50 years or younger. If you are 50+, you can add a catch-up contribution of $6,500 for a max of $26,000.
These deductions can greatly reduce your taxes. For example, if you are 49-years-old and in the 24% tax bracket, a max 401 (k) contribution will reduce your tax bill by $6,240.
2. Consider converting traditional IRA to Roth IRA
In the coming years, tax rates may increase. We currently have some of the lowest tax rates we have seen in years.
The IRS taxes withdrawals from IRAs when you take distributions in retirement. On the other hand, the IRS taxes your money when you put it into a Roth IRA but not when you withdrawal money. Furthermore, you will not incur a required minimum distribution (RMD) with a Roth IRA.
You will pay taxes at the current rate when you convert an IRA to a Roth IRA. Review your IRA accounts and your current tax rate. Here’s a list of the 2020 tax brackets. This strategy may be ideal for you if this conversion will not place you in a higher tax bracket.
If you have seen a lower income this year, now may be a great time to convert an IRA to a Roth IRA. This tactic can also work for you even if you are already in retirement.
3. Cancel your RMD
In legislation this year, Congress waived RMDs for the tax year 2020. You can read more about RMDs in this blog post.
If you are in retirement and you have accounts in a 401 (k) or an IRA you must take an RMD each year after you reach the age of 72. You pay taxes at your current rate on this withdrawal.
As mentioned above, with the CARES Act, Congress waived the RMD for this tax year. If you have not yet taken your RMD and you don’t need the money right now, you can cancel your automatic RMD.
4. Take hardship withdrawal
If you have less income this year due to a layoff, reduced hours, or lost business, you can tap into your retirement accounts.
The IRS usually charges a 10% penalty on money pulled early from IRAs or 401 (k) s. Congress authorized some relief from this penalty with the CARES Act. If COVID affected you financially this year, you will not pay this 10% penalty on early withdrawals.
You must make this withdrawal by December 31, 2020, and you have up to three years to pay off the income tax on this transaction.
5. Capture capital gains if you are in a low tax bracket
Even during the pandemic, the stock market continued to increase. If you have significant gains in your stocks, this could be a good time to sell. Of course, this tactic applies to stocks or mutual funds you hold outside your retirement accounts.
If you are in the lower tax brackets (10% or 12%), this could work for you. In these lower tax brackets, you may not owe capital gains. If you like these assets, you can repurchase them, which allows you to reset the basis. When you reset the bases, you reduce your gains on the assets in the future and the amount of the tax you will owe.
6. Hold-off on mutual fund purchases
Many mutual funds make year-end distributions. If you purchase mutual funds in December, you could incur taxes on a profit you did not realize.
Financial experts suggest that investors should be wary of purchasing mutual funds at the end of the year. This caution applies to purchasing mutual funds in a taxable account (not a tax-exempt account).
If you do want to purchase a mutual fund for your taxable portfolio, consult with your broker or financial advisor to see when the fund makes its distributions.
7. Make gifts to family
Right now interest rates are at historic lows and the amount of the lifetime gift exemption is at an all-time high. The IRS currently sets the gift and estate tax exemptions to expire in 2025. With the new administration, the IRS might accelerate this expiration.
The confluence of these two trends makes now a great time to give assets to family members as a tax-exempt gift.
With the tax overhaul a few years ago, Congress doubled the then $5 million per person base level exemption to $10 million (indexed for inflation) with a flat tax rate of 40%. In 2020, the IRS allows an individual gift and estate tax exemption of $11.58 million (due to the indexing).
President-elect Biden has proposed restoring estate and gift taxes to their 2009 level: $3.5 million per person for the estate tax, $1 million for the gift tax, and a top rate of 45%.
8. Donate cash to charities
In addition to giving gifts to family members, now is a great time to give cash to charities.
In the recent tax overhaul, Congress essentially eliminated personal deductions by greatly increasing the standard deduction. For the tax year 2020, the standard deduction for a single taxpayer is $12,400 and $24,800 for a married taxpayer filing jointly.
With this increase in standard deductions, many folks did not have a financial incentive to contribute to charities.
The CARES Act seeks to bring financial relief to the nation’s charities during the pandemic. Taxpayers who take the standard deduction can take an above-the-line deduction for up to $300 in cash donations to charity. If you donate more than $250, you will need a written receipt from the charity.
If you itemize your deductions on your tax return, you can deduct cash donations to public charities of up to 100% of your adjusted gross income. You cannot make this deductible donation of cash to your donor-advised fund.
The tax regulations only allow this tax-deductible cash donation for the 2020 tax year.
Consult your tax professional before you send a large cash donation to your favorite charity. In some cases, a better tax strategy may be to give away appreciated stock.
9. Take business deductions for your side gig
Did you start a side gig during the pandemic to boost lost income? If you did, make sure you deduct all allowable expenses for the small business. You can deduct only ordinary and necessary business expenses.
You can deduct many expenses related to operating a business from your home. Check out our post on deducting expenses for a home office
You can only deduct expenses related to operating an independent business. You cannot deduct expenses related to setting up a home office, which allows you to work from home for your employer.
10. Revisit your withholding amount
If you did start a side gig to boost your income and you receive a paycheck from an employer, make sure you are withholding enough in taxes. You can visit our post on calculating AGI to estimate the amount of tax you will owe for the year.
In general, the IRS requires taxpayers to pay at least 90% of the taxes they owe for a year by year-end. If your AGI is more than $150,000, you must pay at least 110% of the taxes you owed last year.
You can also speak to your personnel office and increase the amount of taxes your employer withholds from your paycheck.
If you have any questions on these strategies or want help with your taxes, please contact us.