Tax time can be a stressful event in the lives of many, especially if you may be one of the millions who owe money. However, there are ways to minimize tax-related stress and maximize the amount of money you keep in your pockets.
There are proven tips to ensure you’re in good financial shape when it comes time for year-end tax planning. We’ve made it easy by focusing on four main action items, as outlined below. Follow these steps to be sure you’re in control at tax time.
Tax Planning Tips for Maximizing Your Money
It may seem counterintuitive to spend money in an effort to save, but when it comes to taxes, this can sometimes be the case. Whether or not you plan to itemize can make a difference here, as some of the recommended action items affect those who do itemize (always check with a tax advisor on specifics). Let’s review a few scenarios where spending before the can actually reduce your year-end taxes.
Pay Bills Ahead of Time
Property payments provide you with several opportunities to pay ahead and reduce your taxable income.
The first opportunity is to pay your mortgage early. Mortgage interest payments are tax-deductible, so if you have the ability to pay ahead, you can do so and deduct the additional interest payment.
You can also do this with any rental properties you may own. Mortgage interest payments on rental properties qualify as tax-deductible business expenses.
The second opportunity is with property taxes. If you’re itemizing, you can deduct up to $10,000 in state and local taxes. If your municipality allows it, you can pay your January property tax bill in December and deduct it from the previous year’s taxes.
When it comes to property taxes, however, you should be aware of the Alternative Minimum Tax (AMT). When you’re accelerating deductions (i.e. paying them ahead), it can potentially cost you money. The AMT is calculated differently than your standard tax liability and does not allow for certain write-offs, such as property tax. Be sure to educate yourself on this before paying ahead on property tax.
Paying tuition payments in advance allows you to take advantage of another common tax write-off. While the aforementioned deductions are only available to those who itemize, you are not required to itemize to take advantage of this pay-ahead option.
The American Opportunity Tax Credit (AOTC) allows those pursuing their first four years of undergraduate education (or those paying for dependents to pursue) to receive up to $2,500 a year in credit on their taxes. You may be able to prepay your first quarter’s tuition bill in December to take advantage of the $2,500 cap. If you are able to do so, you can get the credit on the previous year’s taxes and then increase the amount you have available in the next year for future tuition expenses.
If you’re pursuing education outside of a standard 4-year undergraduate degree program, you won’t qualify for the AOTC. However, you can take advantage of the Lifetime Learning Credit (LLC) and use the same “pay-ahead” method to increase the credit you receive on your taxes for the prior year.
Spend Your FSA Dollars
If you work for a company that offers a Flexible Spending Account (FSA), you may be able to leverage it to avoid taxed income, while simultaneously increasing the state of your financial health. FSAs are accounts you pay into for out-of-pocket healthcare costs your plan may not cover.
The beauty of flexible spending accounts is that the money you put in avoids income and Social Security tax. However, there is a catch to these accounts; they are “use it or lose it.” If you don’t use the total balance by the end of the year, it doesn’t rollover into the next year and you will have missed a valuable opportunity to take advantage of all the tax-free money you had saved. Be sure to stay on top of these accounts and appropriately spend the money before the end of the year.
Maximize Charitable Donations
For those who itemize their taxes, donations can offer a charitable way to lessen your taxable income. If you have items you’d like to give away or items you no longer need, you can increase your deductions by giving to charity. If you pursue this option and donate more than $250 worth of items, make sure you obtain a written acknowledgment from the organization to which you’re donating. (It may also be worthwhile to snap a picture). Your donation amount, and the deduction you claim, are based on fair market value.
Transfer from an IRA to a Charity
Another giving option is to transfer money from an IRA to charity. For those who are 70 ½ years and older, up to $100,000 can be donated from a traditional IRA to a charity. This donation would be tax-free as long as it is made directly to the charity.
If you choose this option and are 72 and older, this donation has multiple benefits. The transfer will count as a required minimum distribution, which would reduce the number of future withdrawals and also decrease the size of your IRA. This reduction in the size of your IRA would shrink your tax bill, thereby potentially reducing your income enough to keep you under the Medicare high-income surcharge threshold. Furthermore, it can reduce the percentage of your Social Security benefits that may be subject to tax.
Maximize Your 401(k) Contributions
Setting aside money from your paycheck into 401(k) plans is an easy way to reduce taxable income. If you have an employer that matches 401(k) contributions, this is an incredible tool to boost retirement savings.
Your employer may also offer a Roth 401(k) plan. If so, you can make contributions to this as well. Although these contributions won’t lower your taxable income, you can withdraw from them tax-free once you hit retirement.
Make sure you are privy to the 401(k) contribution limits and take advantage of this option if it makes sense for you. Note that the contributions limit is changing for 2023 – it has increased to $22,500 per year. If you are over 50, the total limit is $30,000, as the catch-up contribution limit has increased to $7,500.
If you happen to be self-employed or receive any freelance income throughout the year, you can take advantage of a solo 401(k) plan. The same contribution limits apply. However, if you’ve made other contributions to an employer’s 401(k), the contribution limit of $22,500 applies in total (between both plans).
The major reason to take advantage of a solo 401(k) is that, as a self “employer,” you can make an additional profit-sharing contribution to your plan. Thus, having the solo 401(k) can come in handy when working to reduce taxable income.
Contribute to a 529 Plan
An additional saving option to reduce your tax bill is to contribute to a 529 plan. These education savings accounts are handy for putting away money for college and can provide a bit of a tax break.
The 529 plan can’t reduce your federal taxes, but there are 30 states which allow state income tax deductions on at least a portion of your contributions to these accounts. If this applies to you, make sure to educate yourself on the potential tax benefits of your plan.
If you find yourself in a situation where you can defer income, this could be a worthwhile option for you. After all, the lower your income, the lower your tax liability. So, if you can elect to receive a paycheck in January instead of in December, it might be best to do so. Income deferment can be particularly valuable to you if you find yourself on the cusp of a new tax bracket.
One caveat to this is that if you expect to be in a higher tax bracket next year, this strategy wouldn’t make sense. You would just be raising your taxes for the following year. Keep track of where you are in terms of earned income for the year and defer your income if it makes sense for your circumstances.
Maximize your Withholding
Maximizing your withholding is another important part of planning your taxes. If you find yourself getting stuck with a large tax bill, it could be because you didn’t have enough money withheld from your paychecks throughout the year.
The IRS offers a Tax Withholding Estimator you can use to estimate what you might owe. If you find yourself owing more, it may be time to file a new W-4 with your employer to increase how much is withheld from your pay. This will decrease the net pay of your check, but could keep you from getting hit with a surprise come tax filing.
Offset Taxable Gains with Losses
It’s unlikely that all of your investments are winning (that’s why we diversify). But, for those investments that are bringing financial success to your portfolio, you’ll find yourself paying taxes on their capital gains.
To offset capital gains taxes on accounts that are making you money, you can sell some of your losing investments. The tax code allows individuals to sell assets that have lost money and use the monetary loss to offset capital gains they’ve acquired in accounts that are taxed.
If you pursue this course of action, note that you are required to wait 30 days before purchasing the same asset.
Convert Traditional IRA to Roth IRA
You may or may not have considered this option in the past, but converting traditional IRA funds to Roth IRA funds (or at least some of them) can help reduce future tax bills. The reason for this has to do with the rules of traditional IRAs and Roth IRAs. Traditional IRA contributions are tax-free and then taxed upon withdrawal. Roth IRA contributions are taxed now and withdrawn tax-free.
A benefit of converting traditional IRA funds to Roth IRA funds comes when you expect to be in a higher tax bracket later in life. You will avoid paying taxes at your higher future tax bracket because you’ve already paid them upfront (thanks to the Roth IRA conversion).
One caveat is that you may not want to convert your entire traditional IRA all at once because that might bump you up to a higher tax bracket for the year. It may be wise to spread the conversions over a few years.
Take Control of Your Finances with Lafayette Federal
At Lafayette Federal Credit Union, we understand the stress of tax time. As your financial partner for life, we keep our members updated on the latest tax tips/tools to maximize your money when it comes time to file.