It’s that time, again. Time to take stock of your overall situation and implement a few tax saving strategies before the end of the year. With the following reminders and tips, our goal is to help you lower your tax bill and get a head start on next year’s planning.
Fund Retirement Plans
If you have not done so already, maximize contributions to your 401(k) or other retirement plan. If your company plan allows in-plan Roth conversions, and your cash flow can handle it, take full advantage of this strategy. For 2022, the maximum 401(k) pre-tax contribution is $20,500, and the defined contribution plan limit including pre-tax, after-tax, and employer contributions is $61,000; if you’re age 50 or older, you can contribute an additional $6,500 pre-tax.
Harvest Tax Losses
Due to declines in both the stock and bond markets this year, you may have unrealized capital losses. To make the best of this situation, you can “harvest” these losses by selling positions at a loss and then immediately buying replacement securities to maintain your asset allocation. Learn about this technique in our Tax Loss Harvesting blog post.
Give to Charity
If you are charitably inclined, consider one of these strategies:
- A Donor Advised Fund (DAF) contribution allows you an up-front deduction, and you’ll have years to make grants from the fund to your favorite charities. A great time to make a large DAF contribution is in high tax years or in conjunction with an itemized deduction bunching strategy. Review our handy table comparing gifts of stock versus cash in our Donor Advised Funds blog post.
- Donating Appreciated Securities held for more than one year allows you to avoid capital gain and get a deduction for the full fair market value of the property. You can donate appreciated securities to a charity directly, or to a donor advised fund.
- A Qualified Charitable Distribution (QCD) allows you to donate to a charity directly from an IRA, satisfying a portion of your required minimum distribution (RMD) while avoiding ordinary income tax on the distribution. You won’t get a tax deduction for your charitable contribution, but avoiding income tax on the RMD can be a better strategy for some than a direct charitable gift. In general, QCDs benefit those who take an RMD and who either don’t itemize deductions or do not have appreciated securities; an advisor can prepare an analysis to determine if a QCD or DAF would be more beneficial for your situation. QCDs are limited to a total of $100,000 per year.
Some charitable planning strategies require several weeks to implement, as asset transfers are involved. So, start planning early. Schwab Charitable recommends allowing 14 business days to open a new donor advised fund. If assets are held at Schwab, contributions can be completed as late as December 31. But the transfer of assets held outside of Schwab can take two to six weeks, and Schwab must receive the securities by December 30 to count toward the 2022 tax year.
Bunch Itemized Deductions
This strategy involves paying attention to two years at once: this year and next year. If your itemized deductions from items like state and property taxes (capped at $10k for the year), mortgage interest, and charitable contributions exceed the standard deduction, then you’ll want to itemize. If your itemized deductions are close but don’t exceed the standard deduction and you plan to make additional charitable contributions next year, consider bunching those deductions in one year to take the larger deduction, and taking the standard deduction in the year you’re not itemizing.
The 2022 standard deduction is $12,950 for singles and $25,900 for married couples. If you’re at least 65, you get another $1,750 if you’re single or $1,400 for each married spouse.
Convert to a Roth IRA
A Roth IRA allows your principal and earnings to grow completely tax-free, because contributions are made on an after-tax basis. Key benefits of a Roth IRA are that distributions are not mandatory during your lifetime, and distributions made after age 59 1/2 and in certain other circumstances (such as a first-time home purchase) are not taxable.
The amount you convert will be taxed in the conversion year, but then the Roth IRA balance will grow tax-free and can be withdrawn tax-free in the future. A great time to consider a Roth conversion is after retirement but before you begin receiving Social Security and required minimum distributions from your IRA.
If you meet all of the following criteria, you may be a good candidate for a Roth IRA conversion:
- You have a long time horizon
- You expect to be in the same or a higher income tax bracket in retirement than you are in the year of the conversion
- You have non-IRA assets from which to pay the conversion taxes (allowing the tax amount to grow tax-free inside the Roth)
Alternatively, you may be a good candidate for a Roth IRA conversion if either of the following applies:
- You have high tax deductions relative to your income (perhaps because of retirement or temporary unemployment), and you are losing the full benefit of your deductions
- Your traditional IRA required minimum distribution (RMD) exceeds your expenses in retirement, and your heirs are not a charity (since a charity pays no income tax on an inherited IRA)
Read our 2014 blog post Converting a Traditional IRA to a Roth IRA to learn about other factors to consider before converting to a Roth IRA. Please note that the funding limits and RMD ages mentioned in this article have increased since it was published.
Make Gifts, Especially to 529 Accounts
The gift limit per person is $16,000 this year. Making gifts over this amount requires filing a gift tax return. If you are married, you and your spouse may give $32,000 to any one person without filing this return. Those helping kids or grandkids with education expenses may give up to 5 years of gifts at once if you contribute to a 529 plan—that’s $160,000 if you’re married, $80,000 if you are single.
Most people know that withdrawals from 529 accounts are tax-free, if used to pay for college; they can go toward private K-12 tuition, as long as the annual withdrawal for non-college expenses is no more than $10,000. (Note that the California Franchise Tax Board does not recognize this withdrawal as tax-free on your state return.) Even if you are required to file a gift tax return, no tax will be due unless you’ve already made $12.06 million in gifts during your lifetime. Read our blog post about 529 College Savings Plans.
The 2022 estate and gift tax exemption is $12.06 million per person, increasing to $12.92 million in 2023. In 2026, the exemption is due to revert to the pre-2018 level of $5 million (with an adjustment for inflation). If you’re concerned about estate taxes, an annual gifting strategy during your lifetime is a smart option to reduce your taxable estate. Just make sure that any gifts you are considering do not affect your ability to continue in your lifestyle.
If this type of giving is your goal, be sure to make your gifts well before year’s end, since gifts only count in a specific tax year if the check is cashed by December 31.
Contribute to a Child’s Roth IRA
If your child has earned income, consider making Roth IRA contributions on their behalf. While you can contribute up until the tax filing deadline, be sure you coordinate this strategy with your gifting strategy, as contributing to your child’s Roth IRA will count toward the annual gift limit. If your child is at least 18, no longer a dependent or a full-time student, and their AGI falls below the thresholds, they may even qualify for the retirement savings contribution credit, or savers credit, worth up to $1,000 per person.
Contribute to a Health Savings Account (HSA)
If you are enrolled in a high-deductible health insurance plan and have access to a Health Savings Account (HSA), consider maximizing your contributions prior to year-end. Contributions to an HSA are tax deductible, the money grows tax-free, and is tax-free when withdrawn to pay for eligible medical expenses. You can either spend the money in the HSA on current medical expenses or invest the funds within the HSA (if allowed by your plan) as a tax-free savings vehicle for future medical expenses.
Spend your Flexible Spending Account (FSA)
If you have a Flexible Spending Account (FSA), ensure you are spending your balance on qualified medical expenses by year-end. Unlike an HSA, FSA balances do not roll forward year to year.
While 2022 has been tough for many investors, we have created wealth for our clients by tax loss harvesting and guiding cash reserves to high-yield money market funds. Remember to take action on the strategies above by December 31.