5 Smart Year-End Tax-Planning Moves

Dana Anspach

December 12, 2020

Why is it, every year as fall approaches, we are shocked to find that we are hurtling towards December 31?

As busy as it may get at year-end, make a promise to yourself. Find a way to steal two hours from your day to focus on something that will help you save money before heading into 2021. Sit down and estimate your 2020 taxes.

Once December 31 passes, there is almost nothing you can do about your tax bill. A little planning now goes a long way.

When you project what your tax return will look like BEFORE the year ends, you can identify ways to do the items we discuss below. (Note – we covered these items in our recorded October 17, 2019 webinar on year-end tax planning moves which is on YouTube.)

1. Realize losses that reduce your tax bill

December 31, 2020, is the deadline to realize tax losses if you want to use them to reduce your 2020 tax bill. Investment professionals call this process “tax-loss harvesting.” Harvesting a loss means you will sell investments that have decreased in value and the same day exchange them into a similar investment. By doing this, you capture those losses on paper so they are reported on your tax return, and thus help decrease your income tax bill. This strategy does not work for investments owned inside of a retirement account – only for investments that you own in a brokerage account or other account that is not an IRA, 401(k) or other tax-deferred retirement account.

The equity market has been quite volatile this past year. Stocks, ETFs and mutual funds be worth less than what you paid for them. Go through your investment holdings and look for things you own that are worth less than what you paid for them. This is called an “unrealized capital loss.” Once you sell the investment, you realize the loss and it will be used to offset any capital gains. (Technically the way it works is short-term losses are first deducted against short-term gains, and long-term losses against long-term gains. Net losses of either type can then be deducted against the other kind of gain.)

That means in general if you have $5,000 of loss and $5,000 of gains they cancel each other out and no taxes are owed on the gains. What if you have $10,000 of losses and $5,000 of gains? Then up to $3,000  of the capital loss can be used to offset ordinary income. A $3,000 capital loss, if used against ordinary income, is worth anywhere from $300 to $588 in reduced taxes. Any additional losses can be carried forward to future tax years, so in this example, $2,000 of losses would shift to next year’s tax return.

If you already collect Social Security, a capital loss could be worth even more because lowering taxable income may also lower the amount of taxed Social Security benefits. For one low-income client, the $3,000 capital loss we generated lowered her federal tax bill by $720.

If you have gains that are going to be taxed at the 0% capital gains rate anyway, then using losses to offset those gains doesn’t make sense. It’ll be a wash. If you’re not sure what the “0% capital gains rate” is, read on. I explain in item 2 below.

2. Harvest gains that will be taxed at zero

With tax-gain harvesting, in contrast to tax-loss harvesting, you sell investments after they have appreciated. For some taxpayers, gain harvesting can deliver an outstanding return. The deadline for tax-gain harvesting is also December 31.

In 2020 married tax filers with taxable income up to $80,000 (singles up to $40,000) have a zero percent tax rate on long-term capital gains and qualified dividends. If you are at the 0% capital gains rate now, or even the 15% capital gains rate but expect your income to be higher later, you’ll want to realize gains now at the lower rate. If you wait until a later tax year when your taxable income is higher, you’ll pay a higher tax rate on those gains.

Your taxable income includes the gain, so when you are checking to see if this strategy works, calculate your taxable income first without the gain, then you can see how much room you have to realize gains at the lower rate.

3. Convert IRA savings to a Roth IRA at a low tax rate

I’m a big fan of Roth IRAs because the balance grows tax-free and distributions are also not taxed (when you follow the rules). In addition, once you reach age 70 ½, you will be required to take distributions from Traditional IRA accounts. Those distributions bump up your taxable income and could mean your capital gains and Social Security will be taxed at a higher rate. This distribution requirement does not apply to Roth IRAs – unless you inherit one – distributions are required from inherited Roth accounts.

Depending on your income, it could be wise to convert money into a Roth IRA. While you must pay taxes on this money when you convert it, from that point on the funds grow tax-free, no future taxable distributions are required, and you may be able to permanently remain in the 0% capital gains and qualified dividend tax bracket. If you have a lot of assets in non-retirement brokerage accounts, this is just one of many ways converting to a Roth now could pay off later.

Here’s a free online Roth calculator that can help you determine if a Roth IRA conversion is smart for you. This calculator (nor any online calculators that I can find) does not accurately illustrate the full value of Roth conversions as it doesn’t factor in the impact later on in retirement. Roth conversion planning is often far more beneficial to you than a free online calculator will indicate.

Traditional IRA to Roth IRA conversion must be completed by December 31st to count for the current tax year. Under old tax laws you could convert, and early in the new year if you decided you converted too much you could “recharacterize” or “unconvert.” However, since a 2018 change in tax law, this option is not available. Once you convert, you can’t undo it.

4. Give it away

For those over 70½, donating all or a portion of your Required Minimum Distribution (RMD) from retirement accounts to charity could be a smart move. The Qualified Charitable Distribution (QCD) provision allows you to give up to $100,000 directly from a Traditional IRA to a charity without having to include the distribution in your taxable income. This also means the IRA withdrawal doesn’t count towards other tax formulas such as the one that determines how much of your Social Security is taxable or if you will pay higher Medicare Part B premiums. If you’re going to gift or tithe anyway, why not do it from your IRA?

You can also give away appreciated stock of funds in lieu of a cash donation. For example, by using a donor-advised fund, you can transfer in shares of appreciated investments (thus you avoid the capital gains tax you would incur by selling those investments). Then the fund can sell the investments. And you can choose which charities to contribute to from the fund. Donors receive an immediate tax deduction of the full market value of the donated securities as long as it is isn’t great than 30% of adjusted gross income (AGI). (Note you must itemize deductions to receive the tax deduction and your itemized deductions must exceed your standard deduction for this charitable contribution to result in a benefit to you.)

5. Increase your 401(k) contribution or fund your HSA

You can defer all of your last paycheck of the year (or last few paychecks) into your 401(k) or other employer-sponsored plan such as a 403(b), or SIMPLE IRA. Here are the parameters to determine if this makes sense.

Let’s say you’re single and making a decent amount of money. You’ve put $15,000 into your 401(k) plan so far. You do your year-end tax planning and realize your income is such that you are right on the edge of the 24% tax bracket, with some income that will fall into the 32% tax bracket. That means any additional deductible contributions you make will save you taxes at the 32% federal rate. If you could get another $5,000 into your plan, it would save you $1,600 in federal taxes. In such a case it may be worth sacrificing the December paycheck (for now) and using other funds to get by for the month.

You can also see if you’re eligible to make an IRA contribution. And if financially feasible, fund your Health Savings Account (HSA) to the maximum allowable amount. You get a deduction for money you put into an HSA and this money is never taxed if used for qualified health care expenses. And, the good news about HSA contributions is they do NOT have to be made before year-end. You have until April 15th to get those in for the prior year.

And… Tactics: how to estimate taxes

To see if the items above apply to you, you must estimate your taxes before year-end. Start by gathering all the same information you would need to fill out your tax return. One way to make this easy is to take last year’s tax return and write what you think this year’s numbers will be in the margins. Then, to project current year results, try one of the following three items:

  1. Use an online 1040 tax calculator
  2. Put a sample scenario into tax preparation software
  3. Fill out a paper tax return

Once you have your estimated tax return prepared, here are the key line items to look at:

  • Adjusted Gross Income (AGI), line 11 on a 1040 Form.
  • Taxable Income, line 15 on a 1040 Form.

The only way you can identify tax planning opportunities and uncover all the tax savings ideas listed above is to do this work before year-end. Don’t procrastinate. Call your tax professional or adviser, or get out the tax forms and check out the online tools.

And, if you’re looking for a financial planner that does this kind of work for you, you can learn more about what we do on our WHY US page.