With year-end approaching, it is time to start thinking about moves that may help lower your tax bill for this year and next.
For information on strategies that may be helpful with your company’s taxes, see our article on year-end tax planning for businesses.
This year’s planning is more challenging than usual, due to the uncertainty surrounding pending legislation that could increase top rates on ordinary income and capital gains starting next year.
Whether or not tax increases become effective next year, the standard year-end approach of deferring income and accelerating deductions to minimize taxes will continue to produce the best results for all but the highest income taxpayers, as will the bunching of deductible expenses into this year or next to avoid restrictions and maximize deductions.
If proposed tax increases do pass, the opposite strategies may produce better results for the highest income taxpayers: pulling income into 2021 to be taxed at currently lower rates, and deferring deductible expenses until 2022, to offset what may be higher-taxed income.
Here are some steps that may help you save tax dollars if you act before year-end.
- Higher-income individuals must be wary of the 3.8% surtax on certain unearned income. The surtax is 3.8% of the lesser of: (1) net investment income (NII), or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).
As year-end nears, the approach taken to minimize or eliminate the 3.8% surtax will depend on the taxpayer’s estimated MAGI and NII for the year. Some taxpayers should consider ways to minimize (e.g., through deferral) additional NII for the balance of the year. Others should try to reduce MAGI other than NII. Some individuals will need to consider ways to minimize both NII and other types of MAGI. Note that NII does not include distributions from IRAs or most other retirement plans.
Pending changes to the 3.8% net investment income tax NIIT would subject high income (e.g., phased-in starting at $500,000 on a joint return; $400,000 for most others) S shareholders, limited partners, and LLC members to NIIT on their pass-through income and gain that is not subject to payroll tax. Accelerating some income into 2021 could help avoid NIIT on it under potential 2022 rules, but would also increase 2021 MAGI.
- The 0.9% additional Medicare tax may require higher-income earners to take year-end action. Employers must withhold the additional Medicare tax from wages in excess of $200,000. Self-employed persons must take it into account in figuring estimated tax.
- Postpone income until 2022 and accelerate deductions into 2021 if doing so will enable you to claim larger deductions, credits, and other tax breaks for 2021 that are phased out over varying levels of AGI. These include deductible IRA contributions, child tax credits, higher education tax credits, and deductions for student loan interest. Postpone income may be desirable if you anticipate being in a lower tax bracket next year.
- If you believe a Roth IRA is better for you than a traditional IRA, consider converting traditional-IRA money invested in any beaten-down stocks or mutual funds into a Roth IRA in 2021 if eligible to do so.
- It may be advantageous to arrange with your employer to defer, until early 2022, a bonus coming to you, to both cut and defer your tax.
- Many taxpayers won’t want to itemize because of the high basic standard deduction amounts that apply for 2021 ($25,100 for joint filers, $12,550 for singles and for marrieds filing separately, $18,800 for heads of household), and because many itemized deductions have been reduced or abolished. These include the $10,000 limit on state and local taxes; miscellaneous itemized deductions; and non-disaster related personal casualty losses.
You can still itemize medical expenses that exceed 7.5% of your AGI; state and local taxes up to $10,000; charitable contributions; and some mortgage interest. But these deductions won’t save taxes unless they total more than your standard deduction. In addition to the standard deduction, you can claim a $300 deduction ($600 on a joint return) for cash charitable contributions. - You may be able to work around these deduction restrictions by applying a bunching strategy to pull or push discretionary medical expenses and charitable contributions into the year where they will do some tax good.
- Consider using a credit card to pay deductible expenses before the end of the year. This will increase your 2021 deductions even if you don’t pay your credit card bill until after year-end.
- If you expect to owe state and local income taxes when you file your return next year and you will be itemizing in 2021, consider asking your employer to increase withholding of state and local taxes (or make estimated tax payments of state and local taxes) before year-end, to pull the deduction of those taxes into 2021.
- Required minimum distributions RMDs from an IRA or 401(k) plan, or other employer-sponsored retirement plan, have not been waived for 2021, as they were for 2020. If you were 72 or older in 2020 you must take an RMD during 2021. Those who turn 72 this year have until April 1 of 2022 to take their first RMD, but may want to take it by the end of 2021 to avoid having to double up on RMDs next year.
- If you are age 70 or older by the end of 2021, and especially if you are unable to itemize your deductions, consider making 2021 charitable donations via qualified charitable distributions from your traditional IRAs.
- Take an eligible rollover distribution from a qualified retirement plan before the end of 2021 if you are facing a penalty for underpayment of estimated tax and increasing your wage withholding won’t sufficiently address the problem.
- Consider increasing the amount you set aside for next year in your employer’s FSA if you set aside too little for this year and anticipate similar medical costs next year.
- If you become eligible in December of 2021 to make HSA contributions, you can make a full year’s worth of deductible HSA contributions for 2021.
- Make gifts sheltered by the annual gift tax exclusion before the end of the year if doing so may save gift and estate taxes.
- If you were in federally declared disaster area and you suffered uninsured or unreimbursed disaster related losses, you can claim them either on the return for the year the loss occurred (that is, the 2021 return you will file next year), or on the return for the prior year (2020), which may generate a quicker refund.
- If you had a loss in a federally declared disaster area, you may want to settle an insurance or damage claim in 2021 to maximize your casualty loss deduction this year.