This article, written by Lisa Hay, originally appeared on Betterment.
Year-end planning is about finding the right year in which to earn additional income or to spend money on more tax deductions. Now is the right time to think about this year and next.
To the extent that income and expenses can be moved from 2014 to 2015, these strategies can be utilized to optimize your tax liabilities between two years.
- Accelerating or deferring income.
- Accelerating or deferring expenses that can be used for tax deductions or tax credits.
- Taking advantage of any tax provisions that are scheduled to expire at the end of the year.
One of the tax breaks that remains an open-ended question is a tax deduction for contributions to charitable organizations directly from an individual retirement account, or IRA. Some retirees are holding off on taking their required minimum distributions to find out what happens with this law. Right now, some lawmakers say this, and other tax breaks, will be renewed. However, it's not a sure thing.
If your income is lower this year than you expect for next year, you might want to...
- Accelerating income and/or deferring deductions increases the amount of income that's taxed in the current year. This may be a useful strategy if your income falls in a lower tax bracket this year compared to the next.
- Ask your employer to pay out bonuses this year instead of next year.
- Sell off stocks and other investments with taxable gains this year to lock in gains at the 0% or 15% rates.
- Accelerate IRA distributions this year if your tax rate would be higher next year.
- Consider funding a Roth IRA instead of a tax-deductible traditional IRA. By paying taxes on the income now, rather than upon withdrawal in retirement, you'll be locking in a known tax rate on your contribution in return for tax-free investment returns.
- Similarly, convert pre-tax retirement savings to a post-tax Roth account to lock in a known tax liability.
- Defer paying medical bills, charity donations, property tax (if possible), and other deductions until the next year.
If your income is higher this year than you expect for next year, you might want to...
- Deferring income and/or accelerating deductions functions as a way to decrease the amount of income that's taxed this year. This may be a useful strategy if your income this year falls in a higher tax bracket compared to next.
- Ask your employer to pay out any bonuses in January instead of in December.
- Hold off on selling stocks and other investments with taxable gains until next year (especially if the gains would be short-term this year, but long-term next year. That is likely valuable even if you don't expect your income to be higher this year)
- Hold off on taking non-required distributions from an IRA or other retirement account until January.
- Pay tax-deductible expenses this year instead of next year, such as charity donations and property tax.
- Increase your 401(k) or IRA contributions. Strictly speaking, this is not an acceleration--annual deductions are "use it or lose it"--but taking full advantage of available deductions will reduce this year's taxable income.
- Paying college tuition. The IRS permits tuition expenses to be accelerated under certain circumstances. This could be a good strategy if taxpayers need additional tuition expenses to reach the maximum $4,000 limit for the American Opportunity Credit or Tuition and Fees Deduction, or to reach the $10,000 limit for the Lifetime Learning Credit.
- Pay medical expenses. This may be a good strategy for taxpayers who are close to reaching or have already reached the 10% of adjusted gross income threshold for deducting medical expenses.
- If applicable, pay your fourth state estimated tax payment in December, rather than in January. This works well for taxpayers who will itemize their deductions and who aren't subject to the alternative minimum tax.
- This strategy accelerates losses into the current year. Capital losses offset total capital gains, and if you have a net capital loss for the year, up to $3,000 of capital losses can be applied to offset your other income. Any capital loss in excess of this annual limit carries over to the following year. Be aware that if you repurchase the same investment within 30 days (before or after) realizing the loss, your loss will be disallowed under the wash sale rules. Of course you would typically want to reinvest the proceeds somehow. Betterment automates this process with Tax Loss Harvesting+. (Note: Tax loss harvesting can be valuable in a number of scenarios, even if you expect to earn more next year. Learn more here.)
So before you starting your holiday shopping, consider year-end tax planning. With proper tax planning, you can maximize your potential tax savings and minimize your tax liability.
Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect, and grow their wealth through smarter technology. The service offers a globally diversified portfolio of ETFs, designed to help provide you with the best possible expected returns for retirement planning, building wealth, and other savings goals. Betterment is a CNBC Disruptor 50 and Webby award winner and has been featured in the New York Times, Forbes, and the Wall Street Journal. Betterment helps people to achieve a smarter financial future with minimal effort and at a fraction of the cost of traditional financial services. Learn more here.
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