At the end of the year, your thoughts are likely on the holidays, spending time with friends and family, and the promise of a new year. The last thing you want to think about is the possible tax bill that may be lurking just around the corner.
However, December is actually an excellent time to start thinking about your taxes because there are many things you can do before the year’s end to lower your taxes and perhaps keep more money in your pocket in the coming year. Here are five moves you can make before December 31st that might just reduce your tax bill and make for an easier tax filing season.
1. Max Out Your 401(k) Contributions
For the 2019 tax year (returns filed in 2020), the maximum contribution to a 401(k) retirement plan is $19,000 for individuals under age 50. People ages 50 and above can make a “catch-up” contribution of an extra $6,000, for a total of $25,000.
By making voluntary contributions to a 401(k) plan, you’re reducing your taxable income, so the more you contribute, the more you lower your tax bill.
These rules also apply to 403(b) plans (the 401(k) equivalent for nonprofits, religious groups, school districts, and governmental organizations), most 457 plans (for state and local government employees), and the government’s Thrift Savings Plan. If you need to adjust your contributions, contact your company’s HR representative and tell them you want to increase your contribution. If you haven’t already maxed out your contributions, one strategy for year-end — if it won’t create a financial hardship for you — is to ask if you can deposit your entire final paycheck into your 401(k).
Since 401(k) contributions are made with pretax dollars, you don’t need to file any additional IRS forms. Your employer will report your contributions in Box 12 (code D) of your W-2. You are only taxed on the distributions once you begin taking withdrawals.
A bonus of voluntary contributions to a retirement plan is that you may qualify for the Retirement Savings Contribution Credit, commonly called the Saver’s Credit. The credit is worth 10%, 20%, or 50% of your contribution, depending on your income, with a maximum credit amount of $2,000 ($4,000 if married filing jointly). The credit phases out completely if your income is over the following amounts in 2019:
- $64,000 if married filing jointly
- $48,000 if head of household
- $32,000 for all other filing statuses
2. Max Out Your IRA Contributions
The maximum contribution to a Roth or Traditional IRA for 2019 is $6,000 for those under age 50. People ages 50 and above can make an additional “catch-up” contribution of $1,000, for a maximum contribution of $7,000. If you’re able to, contribute as much as you can to your IRA before the tax deadline.
With a Traditional IRA, you may be eligible to get a tax deduction for the year you make the contribution, but you’ll pay taxes on withdrawals in retirement. With a Roth IRA, you don’t get a tax break now, but withdrawals in retirement are tax-free.
Whether you contribute to a Traditional or Roth IRA, you have until the filing deadline in April 2020 to make deductions for the 2019 tax year.
Roth IRA Limitations
Unfortunately, not everyone qualifies to contribute the maximum to a Roth IRA, and some high earners aren’t eligible to contribute at all. There are phase-out ranges that depend on your filing status and income. For 2019, these ranges are as follows:
- Single: $122,000 to $137,000
- Married Filing Jointly: $193,000 to $203,000
- Married Filing Separately: $0 to $10,000
What this means is that if you’re single and have a modified adjusted gross income (MAGI) of less than $122,000 in 2019, you can contribute the full $6,000 if you’re under 50 (or $7,000 if you’re 50 or older). If your MAGI is more than $122,000 but less than or equal to $137,000, your contribution is limited. If your MAGI is greater than $137,000, you’re not eligible to contribute to a Roth IRA at all.
IRS Publication 590-A has worksheets for calculating your MAGI and determining your reduced Roth IRA contribution limit.
Traditional IRA Limitations
If you earn too much to contribute to a Roth IRA, you can contribute to a Traditional IRA instead. However, if you’re also covered by a retirement plan at work, your contribution might not be tax-deductible. The phase-out ranges applicable to Traditional IRA contributions in 2019 are as follows:
- Single: $64,000 to $74,000
- Married Filing Jointly: $103,000 to $123,000
- Married Filing Separately: $0 to $10,000
This means that if you’re married, file a joint return with your spouse, have a retirement plan at work, and have a MAGI above $123,000, you can contribute to a Traditional IRA but cannot take a deduction on your return. If your MAGI is between $103,000 and $123,000, your deduction is limited. If your MAGI is $103,000 or less, you can claim the full deduction.
These limitations only apply if you — and your spouse, if you’re married — are not covered by a retirement plan at work. What happens to contributions to a Traditional IRA when you don’t get a tax deduction now? They become “basis” in your IRA.
Basis in a Traditional IRA
When you make non-deductible contributions to an IRA, the non-deductible portion of your contribution is considered “basis” in your account and treated as though you made it with after-tax dollars. Simply put, when you begin withdrawing money in retirement, the basis portion of your withdrawals are not taxable.
Where it gets complicated is tracking your non-deductible contributions. The IRS doesn’t do it for you, and neither does your IRA custodian — the bank, credit union, trust company or other entity that holds your IRA. Tracking basis on Form 8606 is your responsibility.
In any year you make a non-deductible contribution, you must complete Form 8606 to report the basis portion of your IRA. In subsequent years, you should continue filing Form 8606 to keep a record of your basis, even if you don’t make non-deductible contributions every year. If you stay with the same tax preparer or use the same online tax preparation software year after year, the form should roll over automatically. But if you change tax preparers or software, double-check to make sure your basis carries over as well.
If you don’t keep track of your basis, all of your distributions in retirement will be taxable, and you’ll wind up paying taxes twice on that money. Being taxed once is bad enough, so make it a priority to track your basis.
Excess IRA Contributions
The contribution amount of $6,000 (or $7,000 if you’re age 50 or older) is the maximum you can contribute to all IRAs (Traditional and Roth) in a given year. If you contribute more than the maximum, the IRS will assess a 6% penalty on the contributions and any earnings.
You’ll calculate this penalty on Form 5329. The penalty applies for each year the excess contributions remain in your account. To avoid this penalty, withdraw the excess contributions before you file your return.
3. Cut Your Losses
Are you worried about capital gains taxes on your investments? Check your portfolio for investments that aren’t performing so well.
When the price of stocks and mutual funds in your portfolio declines below their basis, you can sell them before the end of the year. The losses you generate may offset the gains you realized from selling stocks that increased in value.
Keep in mind, however, that you want to use tax-loss harvesting strategically. While there’s no limit to the amount of capital gains you can offset using this method, if you have more losses than gains, only $3,000 in losses ($1,500 if married filing separately) can be used to offset other income, such as wages and interest. Any losses over $3,000 can be carried forward and applied in future years.
Generally speaking, the gain or loss is determined as of the sale date, not the settlement date, which may be several days later — and, if you sell on December 31st, may even be in the next year.
To generate eligible losses, you must sell on or before December 31st, but don’t sell too hastily. Set up an appointment with your investment advisor before year-end to discuss which investments are truly duds and which are worth keeping.
4. Make Charitable Contributions
If you contribute to a qualified charitable organization, you can generally claim 100% of your contribution as an itemized deduction on Schedule A. Just be sure to make your charitable contributions by December 31st as there’s no grace period if you make them after year-end.
Also, be sure to get receipts for any donations as you’ll need to itemize everything on your return. The documentation requirements are as follows:
- Donation of Less Than $250: A canceled check, credit card statement, receipt or bank statement
- Donation of $250 or More: A contemporaneous written acknowledgment from the charitable organization
- Donation of $75 or More, Plus You Received Something in Exchange (Such as Tickets to a Charity Event): A written receipt or acknowledgment; you can only deduct the difference between what you gave and what you received
- Non-Cash Donations Over $5,000: An appraisal prepared by a qualified appraiser
- Donation of a Vehicle: See IRS Publication 4303
Keep in mind that your contribution must be made to a qualified organization to be eligible for a deduction. So while helping out a family in need over the holidays is a wonderful thing, your generosity won’t generate a tax deduction.
However, if you opt to give to your church — assuming your church is a nonprofit — or donate goods to the Salvation Army, those donations are tax-deductible. If you have any questions about whether a particular organization qualifies, the IRS maintains a database of tax-exempt organizations. It’s a handy tool if you don’t already have a charity of choice.
Also, keep in mind that you’ll need to itemize deductions to take advantage of the deduction for charitable contributions. If your total itemized deductions aren’t greater than the standard deduction of $12,000 for individuals ($24,000 for married couples filing joint returns), then you won’t get any tax benefit from your donation.
You’ll report charitable contributions on Schedule A. If you make non-cash donations greater than $500, you’ll also need to complete Form 8283. Remember, most charitable organizations are 50% organizations, meaning you can deduct contributions up to 50% of your adjusted gross income (AGI). Any donations over that limit can be carried forward for up to five years.
5. Gather Your Tax Documents Now
Employers and other entities must send copies of 1099s and W-2s to recipients by January 31st, so you won’t have them by year-end, but that doesn’t mean you can’t start planning. Whenever you have time, start gathering your prior year’s tax payments and any documentation you have for tax credits and deductions. If you’re not certain what you may need, there’s no time like the present for a little research.
If you start gathering your tax-related documents now, you’ll have an easier time preparing your returns in February, March, or April when the deadline is looming. Plus, the earlier you finish your return, the more relaxed you’ll be. If you get organized and set up a routine, you might just start looking forward to preparing your return.
If you’re stressed and anxious every tax filing season, perhaps it’s because you’re not prepared. You’ve heard the saying that the only two guarantees in life are death and taxes. Since you know you have to file your tax return every April, why not get a head start on the inevitable?
Start early, organize and prepare. Set yourself up for a stress-free tax day when others are frantically scrambling to beat the deadline.
What steps are you taking to make tax time less stressful this year? Are there any particular areas that cause you the most trouble?