For most taxpayers, there isn’t a magic bullet to reduce taxable income to the extent many Americans might prefer. However, there are several ways to incrementally add layers of tax-efficiency and savings. When combined into one strategic tax plan, taxpayers can work to reduce their taxable income as much as possible, which helps prevent climbing into a higher marginal tax bracket for regular income and capital gains.
Reducing taxable income is important, as either your adjusted gross income or modified adjusted gross income is used to determine Roth IRA eligibility, Medicare part B and D premiums, various tax credits, financial subsidies and aid, and the deductibility of IRA contributions, medical expenses, student loan interest, and so on.
Not every strategy will apply to your situation or yield benefits that justify the time, risk, or cost. To avoid any unintended consequences, develop your tax planning strategy with your tax and financial advisor. By keeping the focus on your entire situation and goals, you can work to prevent the tax-tail from wagging the dog.
Reduce your taxable income by donating appreciated securities
If you have significantly appreciated long-term assets in a taxable account and are charitably inclined, consider the benefits of donating the securities to charity using a donor-advised fund. When you donate securities to your donor-advised fund, you receive an immediate charitable deduction for the fair market value of the asset as an itemized deduction, up to 30% of your adjusted gross income (AGI). Donations exceeding this limit can be carried forward for up to five years. By donating the security, you won’t have to pay capital gains tax on the appreciation.
Donor-advised funds can be set up relatively easily at a few the big financial institutions or with the help of your financial advisor. Though you can receive a tax deduction the year you make an irrevocable gift to your donor-advised fund, you don’t need to donate the proceeds to charity right away because you control the timing and recipient of the proceeds, provided it is IRS-qualified public charity.
When a security is donated to your donor-advised fund it is liquidated. The fund receives cash which can be invested in the market at your direction. Many different types of assets can be donated: from publicly traded stocks, bonds, and mutual funds, to real estate, vested stock options, or even shares in a closely-held business.
From a tax planning standpoint, you’ll want to work with your CPA or tax advisor to determine whether you’ll benefit more from the standard deduction or itemizing in order to maximize the value of donating appreciated long-term securities.
Think about harvesting losses
If you’ve realized large taxable gains this year from stock options, selling a company, or other appreciated assets, consider the pros and cons of tax-loss harvesting, or selling a security to ‘realize’ the loss for tax purposes.
Investors can use losses to offset taxable capital gains and potentially even reduce ordinary income by up to $3,000 in the current year. The remaining loss (if any) can be carried forward and used in future years.
Before tax-loss harvesting can be evaluated as a potential strategy, you’ll need to calculate your estimated capital gains and losses for the year. To do this, start by netting capital gains and losses of the same holding period: long-term gains are offset with losses and short-term losses reduce short-term gains. In general, long-term assets are held for over one year and short-term assets are owned for a year or less. There are exceptions though, so consult your CPA or tax advisor.
If the netted short and long-term totals include both a gain and a loss, they are netted once more. For example, if a taxpayer has $50,000 in net short-term capital gains and ($20,000) in net long-term losses, the result is a net short-term capital gain of $30,000.
After the netting process, if investors still have significant realized capital gains, they can consider tax-loss harvesting to offset their taxable gain by selling assets with unrealized capital losses.
Generally, tax-loss harvesting is most advantageous in specific situations, such as when an investor is looking to make changes to their asset allocation, rebalance, or diversify out of a concentrated stock position. Also, because short-term capital gains are taxed at higher regular income rates, this strategy is typically most effective when focused on minimizing this type of gain.
For investors who are satisfied with their holdings, tax-loss harvesting may not fit in. Wash-sale rules prevent investors from taking a loss if an identical or substantially identical asset is purchased within 30 days before or after the asset was sold for a loss. A month may not seem like a long time to be off of your target allocation or in cash but recall that after losing over -9% in December 2018, the S&P 500 was up 8% by the end of January 2019.
Check your tax withholding
If you’re self-employed, receive substantial bonus or commission income, or experienced a taxable windfall in 2019, you could be hit with an underpayment penalty and big tax bill in April.
You may be able to catch up before the end of the year if you have tax payments withheld through a payroll deduction, as those tax payments are always deemed to be timely paid. This enables some individuals to catch up on any previous under-withholding once they have more concrete income estimates near year end. Consider recalculating your withholding using the IRS withholding calculator to see how your tax payments compare to your projected tax due.
Be aware that quarterly tax payments may not help you avoid penalties or a surprise bill, even if you increase estimated tax payments during the year. To avoid an underpayment penalty, taxpayers can make quarterly payments of at least 110% of last year’s tax liability (if their adjusted gross income is over $150,000). Keep in mind that this doesn’t mean you won’t be surprised with what you’ll owe, it just means you won’t incur a penalty.
If you received a windfall this year, such as from the sale of stock options or a business, consult your CPA or tax advisor before spending or investing the proceeds to get a better sense of your overall tax liability for the year.
Max out your 401(k), 403(b), SIMPLE IRA, or other tax-deferred retirement plan
If you’re not already on track to meet the IRS contribution limit for 2019, consider increasing your election while there’s still time.
For employees with 401(k), 403(b), most 457 plans, or the federal government’s Thrift Savings Plan, the contribution limit for 2019 is $19,000. Workers age 50 or older have an additional $6,000 catch-up contribution for these defined contribution plans, and some 403(b) plan participants with at least 15 years of service may also be able to make a special catch-up contribution.
The maximum contribution to a SIMPLE IRA or SIMPLE 401(k) plan is $13,000 this year with a $3,000 catch-up contribution for those over age 50.
Pre-tax contributions to employer-sponsored retirement plans reduce your taxable income for the year. For many taxpayers with only regular W-2 income, making annual contributions to a retirement plan is the most meaningful way to lower your tax bill for the year.
Business owners: consider giving yourself a bonus
If you’re running your own business, you may want to consider giving yourself a bonus before the end of the year to increase your employer-side retirement funding. Depending on whether you have a SEP IRA or Individual 401(k), contributions may be permitted as employee and/or employer: SEP IRA funding is only at the employer level, but the Solo 401(k) can be a combination of the two.
Although your SEP contribution or employer 401(k) profit-sharing or matching contribution can be made as late as the tax filing deadline, if your company is taxed as a corporation, your annual contribution will likely be based on your W-2 wages paid during the calendar year. In this situation, your annual funding limit will typically be limited to 25% of your W-2 wages (up to $280,000 in annual compensation in 2019) with a maximum overall funding of $56,000. For 401(k) plans, the maximum funding includes individual contributions but excludes the catch-up contribution for taxpayers age 50 and older.
The funding limits are different for sole proprietors, partnerships, and unincorporated ‘disregarded entities’ for tax purposes. As is standard, eligible income must be considered ‘earned income’ and subject to the limits above. For pass-through entities, employer contributions are limited to 20% of net self-employment income. Before making any changes, consult your CPA to find out how your contribution will be calculated and discuss payroll tax implications.
The clock is ticking—most of the tax-saving strategies available to taxpayers are only available before December 31st.