by Jason Vitucci, CFP®
When it comes to year-end tax planning, many of us think in terms of the April filing deadline. But planning can begin much sooner, and some tax strategies require that you act before the end of the year. Here are a few tax-planning strategies to consider before the end of the year to help you potentially reduce your tax burden for 2020.
Increase 401(k) Contributions
Contributions you make to employer-sponsored retirement plans and other tax-deferred retirement accounts are taken out of your paycheck before taxes, which helps lower your taxable income. If your employer matches your contributions, increasing your 401(k) contributions can help you avoid leaving free money on the table.
For 2020, the maximum 401(k) salary contribution for an employee is $19,500 for those under 50 and $26,000 for those 50 and older. You should make any 2020 contributions by December 31. Other types of compensation may have different deadlines.
Consider Converting Your IRA to a Roth IRA
With traditional IRAs, contributions are typically made with pretax dollars and grow tax-free. However, withdrawals are usually fully taxable. With a Roth IRA, the money is contributed with after-tax dollars and you can take “qualified distributions” that are tax-free. In general, a qualified distribution is one made after you turn 59 1/2, or under certain exemptions such as to buy a first home, or if you were to become disabled. Roth contributions are subject to a five-year holding period before they’re considered “qualified” for tax-free distribution, this is something to consider before converting to a ROTH, when were you planning on taking distributions?
The tax savings from an immediate reduction in taxable income should be compared to the alternative. Take a moment to calculate how much tax you would pay on the funds you would convert to ROTH versus the tax you may face on the gains when you withdraw the money in future years. Depending on your financial situation, you may find that a Roth could offer significant savings, so it might be worth converting your IRA to a Roth IRA now. The deadline for a conversion is December 31.
You have until April 15, 2021 to make IRA contributions for 2020, you can contribute a maximum of $6,000 to an IRA for 2020, plus an extra $1,000 if you’re 50 or older.
Flexible Spending Account (FSA) Funds
Be diligent about submitting your FSA expenses before the end of the year, unless your FSA allows you to roll funds to the next year (be sure to check with your employer). An FSA allows you to set aside tax-free money to pay for certain out-of-pocket health care costs. Typically, the funds are a “use it or lose it” within the calendar year with a deadline of December 31.
Spending these funds doesn’t directly lower your taxes, but the purpose of the FSA is to provide tax savings when you contribute the funds. If you don’t spend the funds, you lose not only the tax benefit, but the funds set aside as well.
Tax-Loss Harvesting
Because any losses from selling stocks, bonds, or mutual funds can be used to offset any taxable capital gains, another year-end tax strategy is tax-loss harvesting. Any potential benefit from tax-loss harvesting will depend on your income level and the amount of your short- and long-term capital gains (minus any current losses that you may have already realized, or any losses carried forward from other years).
Charitable Contributions
If you make a charitable donation to a recognized non-profit before December 31, you may benefit from a deduction on your 2020 taxes. This will depend on if you take an itemized deduction, you can check with your tax preparer to see if you took an itemized tax deduction in the prior year.
