We’re getting close to the end of the year so now is the time to make sure you are prepared to minimize your income tax bill. Certain tasks can be completed early next year but most need to be done before the calendar year ends. So start thinking about these topics now.
Properly taking advantage of all of your tax-minimizing options can save thousands of dollars. That’s serious money that you want in your pocket rather than in the government!
Here are a few of the big items that you definitely want to look into if you haven’t already.
If you have had a particularly bad year with your taxable investments (not retirement accounts), then you might want to consider what is often called tax-loss harvesting.
When you sell taxable investments for a loss, you can use the loss to offset other gains, and sometimes even regular income. How this is generally handled is rotating from one fund to another.
Example: If you had an S&P 500 Index fund that was down for the year. Perhaps you believe that moving forward it will do well though, so you still want to own a similar fund. You can sell it to take the loss, then purchase a different fund that tracks the same index. Note that you cannot purchase the same investment, well, you can but then you can’t write off the loss. The goal though would be to purchase a similar investment that will perform the same.
Using this tactic gives you a tax advantage while still maintaining your balanced and diversified portfolio ratios. You need to think a bit about this first though. In many cases, there could be trading fees involved in rotating your stocks. Also, consider first if the amount of the loss is large enough to justify making the changes.
Track and report donations
When you donate money to a federally-organized non-profit company (501c3) you can write off that donation amount from your taxes. So when donating to places like (most) churches, the American Red Cross, or Samaritan’s Purse, and many others, track these donations to deduct them from your annual tax filing.
Just be sure that these are actual donations – meaning that you don’t get any direct benefit from it. For example, if you purchase materials from a non-profit, that isn’t a donation but rather just a purchase. It’s still a way to support them, and perfectly fine, but it won’t be a tax-deductible situation.
My wife and I keep a folder next to the computer where we place anything tax-related for the year. So whenever we make a donation, we put a receipt of the printed confirmation page into this folder. And of course, we record it on our budget tracking software. Many charitable organizations will send end-of-year statements, but this isn’t a requirement so not all of them do. It’s definitely best to make sure you are tracking this on your own so that nothing gets missed when tax time rolls around.
Also, pay attention to miles driven to and from places where you volunteer. If you are doing volunteer work for a non-profit, you can take a deduction for the miles driven. For 2020 this means $.57.5 per mile can be deducted from your taxes – which can really add up over a year. Karla volunteers at the homeless shelter in Charleston one day per week. That’s 14 miles each way, so 28 miles (or $16.10) per week that we need to track and report on your taxes. Tracking and reporting that means hundreds of dollars saved each year in taxes – and that’s just one of the events where we volunteer. If you volunteer a lot, this can be substantial. Even if you volunteer just a little, take advantage of this because those little things can add up to a lot over a year.
Hopefully, you are already taking advantage of your employer’s 401k plan if one is available. Having run a company for almost twenty years, and now coaching people on personal finances, I know firsthand that a lot of people aren’t taking advantage of this. Not only does it save you money on taxes – no money is paid on the contributions (taxes are only collected when the money is withdrawn in retirement) – but most employers also offer a company match. A common match is 50% up to the first 6% of your income. So if you contribute 6% of your income that means you will get an immediate 50% gain on that investment! Wow – don’t miss out on that benefit!
If you aren’t already in your company’s plan, but they do have one, reach out to your human resources or benefits person to find out when the next enrollment period is. There are limits on when you can join the program and it’s usually near the later part of each year. Figure out when you can join and then decide how much to contribute. Remember that this is a tax benefit plan so, for example, if you put in $500 per paycheck and are in a 25% tax bracket, your take-home pay is only lowered by $375. And your match could mean another potential $250 is added, so for $375 less in your paycheck, you get to potentially add $750 to your retirement savings!
Contribute to other retirement plans
You should consult your accountant to see if you qualify to contribute to an individual retirement account (IRA) or even a Roth IRA. (If you are self-employed you should look into whether a SEP-IRA, SIMPLE IRA or even a SOLO-401k might make sense for you.)
For many Americans, contributions to an IRA are generally tax-deductible – again, be sure to check with your accountant on specifics because there are definitely guidelines to follow. If you qualify this can save you a lot of money on your taxes, plus allow that money to grow tax-free until retirement. You will be taxed on the withdraws you make in retirement but many people are in lower tax brackets at that point so they save a lot of money by deferring the tax hit.
To Roth or Not
If you think your tax rate in retirement might actually be higher than your tax rate now, then it makes sense to consider a ROTH-IRA. For a ROTH IRA you pay taxes on the money today, so no tax savings this year, but when you withdraw the money in retirement no further taxes are owed – even on the gains in the account. This can be a huge saving for someone who has really low tax liabilities right now but is on track to have a huge retirement income down the road.
I’m not going to get into the details of the self-employed retirement account types – best to consult your accountant on that point to see what you may qualify for, the costs, the guidelines, and the contribution limits.
If you are self-employed – even if you have a full-time job and self-employment is just in your spare time – you have the ability to track and deduct certain expenses.
Do you drive with a ridesharing service? Maybe you bring in your extra money from your blog? Or perhaps you do freelancing? If there are expenses that are directly related to this work, and required for you to perform it, you should track them.
For example, if driving with a ridesharing service, you should track all of your miles driven to deduct those on your taxes (which should more than cover the cost of gas and general maintenance). If you are doing work online to bring in extra income then you, of course, require Internet access, so this can likely be tracked and deducted as a work expense. Even the computer you use might be deductible if it is legitimately required for you to perform your work.
That Expensive Health Insurance
Here’s a big one a lot of people don’t think about: Health insurance. If you are self-employed and have to pay your own health insurance, meaning you don’t have another job that offers coverage, then you can likely deduct those costs on your taxes too. Health insurance can be very expensive so having the ability to recoup some of that money through tax savings is huge for many people.
On any of these deductions be sure to consult with your accountant. There are definitely guidelines to follow to make sure you are tracking and reporting properly – and that the deductions fall within the IRS guidelines for the type of business you are running. A good accountant familiar with self-employment can often save you more in money each year than what it costs to hire them. They can also save a lot of headaches helping avoid audits or provide documentation in case of an audit. BTW I’ve been through audits and yes, they are a hassle, but if you have the proper documentation and are following the rules, they aren’t that big of a deal.
Speaking of health insurance: FSAs and HSAs
Many companies offer their employees the option of contributing to a flexible spending account (FSA). This is money that you can have held back from each paycheck, pre-tax, and stored in a special account for your specific use toward qualified medical expenses. A big note here: An FSA is a spend-it-or-lose-it type of account. So you really need to estimate your annual medical expenses fairly well, or under-estimate so you don’t lose any money. If you know you spend about $1,000 each year on medical expenses though, it makes sense to contribute to the FSA and pay those expenses from the FSA. That means $1,000 less you pay taxes on, so a savings of $250 for someone in a 25% tax bracket.
Do you have a high-deductible health insurance plan? If so, check with your provider to see if the plan qualifies you to use a health savings account (HSA). An HSA is very different in that the HSA account is held at a bank of your choice rather than with the employer, and it can also be carried over from year to year. We contribute the maximum amount ($6,750 in 2016) to an HSA each year so we can take the tax benefit but we don’t spend any of the money. That way the account can just continue to grow and we’ll use it in the future. I’m sure as we age we’ll have increasing amounts of expenses related to medical situations so we have no concern that the money won’t get used at some point. In the meantime, that money can grow tax-free.
HSAs are sometimes called triple-tax-advantaged. The reason is that you get to deduct the amount you contribute (so you save on taxes each year you add to the account), plus the balance grows tax-free, plus you don’t pay any taxes on the money when you withdraw it as long as it is used for qualified medical expenses – which is a very wide definition that covers most normal medical costs.
You definitely don’t want to pay any taxes that you don’t owe so be sure to take advantage of all of the tax tips above that may apply to you, and always look for other ways to lower your tax bill. It’s your money so don’t give it away.
While we aren’t tax-accountants, we can certainly help you understand your benefits, tax-saving options, and other ways to save money. Accountants are great at “doing the work” of accounting. But sometimes it is nice to have a person in your court to explain everything and help walk through the decisions with unbiased input. Also, understand that accountants generally are focused on helping you minimize your taxes in the current year. That might conflict with your bigger-picture goals though. One example is an accountant who suggests to not pay off the mortgage so you can get the tax deduction – bad advice that we’d love to discuss with you.