Updated: Jan 3
A common question I get this time of year is “what can I do to lower my tax bill?” It’s a fair question considering spending is generally up this time of year because of the holidays, and folks start looking forward to their spring tax refunds, or at least minimizing their tax liability. I wish I had a magic answer that applied to everyone, but the answer is really going to depend on each person’s individual situation. What works for one person might not be available for another. Below are a few best practices that can help you minimize your tax liability, or increase your refund, depending on which side of the fence you sit on.
Maximum contributions. Contributing to both a company sponsored 401k and Health Savings Account (HAS) plan reduces your Adjusted Gross Income (AGI). AGI is a “magic” number, if there is one, within the IRS, as it is generally the number that is looked at when setting various thresholds, like with stimulus check eligibility. Lowering your AGI will ultimately lower your taxable income, as well as your tax liability. Contributing to such plans does not only reduce your AGI now, but the contributions are pre-tax and in the case of a HSA plan will continue to grow tax-free, as long as the dollars are put towards qualified medical expenses. Whether or not you have current medical needs now, chances are you are going to grow old, and growing old leads to medical issues, whether we like it or not. The HSA is a great pre-tax savings vehicle to plan for those future medical expenses. A 401k is also a pre-tax savings plan, but those dollars will need to be taxed, at ordinary rates, once they are withdrawn. contributions – 2021 max increased.
Many employees that have access to a 401k savings plan do make contributions, but most do not contribute the maximum amount. The max for 2021 is $19,500, which is the same as it was in 2020, but increased from $19,000 in 2019. If you are in a position to contribute a little more to your 401k this year, go ahead and take advantage of lowering your AGI this year, and setting aside pre-tax money for later. If you are in a position where you do max out your annual contributions, keep in mind that the 2022 maximum will be increased to $20,500.
Likewise, HSA plans have a maximum annual contribution. For 2021, the max is $3,600 for an individual, or $7,200 for a family. That’s up from $3,550 / $7,100 in 2020. The 2022 max is expected to increase to $3,650 / $7,300. HSA plans also allow for a $1,000 “catch-up” contribution for individuals who are age 55 or older. This means that you can increase your pre-tax contribution by $1,000 for the current year. 401k plans also have a catch-up provision, which are much more attractive at $6,500 for individuals 50 or older. A worker over 50 who wants to max out their 401k contribution can put away a total of $26,000 for 2021 – a significant adjustment to gross income!
Unfortunately, not everyone has access to these types of plans, but there may be something similar available to you. Contact the Law Office of Doug Peterson to determine what plans are available to you, and how you can maximize your benefits.
Sell securities at a loss. Many people may scoff at the suggestion of selling anything at a loss. And I generally would not advise anyone to sell anything at a loss, unless you need access to cash. However, selling securities at a loss can be used to offset any gains you may have experienced throughout the year. Securities, for simplicity let’s just think of stock, when sold are going to contribute to capital gains. Currently, long-term capital gains tax rates are lower than ordinary income rates. I would venture to say that most of my audience is in the 15% long-term capital gains tax bracket, but their ordinary income is likely taxed in the mid-to-high 20%’s. Single taxpayers with income between $40,401 - $445,850 are going to fit in the 15% long-term capital gains bracket, as are married filing jointly taxpayers with income between $80,801 - $501,600.
Capital gains are generated when you sell a security, again think stock, for more than you purchased it for. A loss would be generated when you sell the security for less than you purchase. At the risk of stating the obvious, you do not pay capital gains tax on your investment – those dollars, referred to as your basis, have already been taxed. So, for example, say you buy a stock for $50 and a year later sell it for $75. You have just generated a $25 gain. Only that $25 gain will be subject to long-term capital gains tax. Say you purchased another stock for $40 that you ended up selling for $30. Because you sold that stock for less than you purchased it, you now have a $10 loss. The tax code let’s you offset your gains with your losses, so your $25 gain can be reduced by the $10 loss so that you now have a $15 capital gain to be taxed. This is how selling at a loss can help reduce your tax liability.
For more information on capital gains tax in general, see What is the long-term capital gains tax? Bankrate.com/investing/long-term-capital-gains-tax/, or schedule a consultation with the Law Office of Doug Peterson
Itemization issues. Prior to the Tax Cut and Jobs Act of 2017 (TJCA), many of you probably itemized your expenses on your tax return. This itemization included such items as mortgage interest, charitable contributions, and property tax, among other items. The impact of the TJCA was that the standard deduction for all taxpayers was significantly raised, to the point where it no longer made sense to itemize deductions. The tax code has always provided an “either or” scenario, where taxpayers can take the higher of either their itemized expenses or the standard deduction. After the TJCA, most taxpayers are taking the standard deduction, which for 2021 is $12,550 for individuals and $25,100 for married filing joint. The significance of the standard deduction is that it reduces your AGI to reach Taxable Income. In other words, your AGI less the standard deduction will generally determine your tax liability. Even though most taxpayers are taking the Standard Deduction, some are still able to itemize their expense. If you are itemizer, you should seek to increase your expenses as much as possible to increase your deduction and decrease your taxable income.
Charitable Giving. As discussed, charitable contributions can increase your deductions if you itemize. For those that do not itemize, you can still receive benefit from your charitable deductions thanks to the various stimulus packages that Congress has passed. In 2020, taxpayers were allowed to take up to a $300 adjustment that reduced AGI. This year taxpayers will still be able to take an adjustment for charitable contributions, but the deduction is “below the line,” meaning it does not reduce your AGI, but will reduce your taxable income and ultimately your tax liability. The maximum deduction for 2021 is $300 for individual taxpayers and $600 for married filing joint.
Another question I often get, specific to charitable giving is, what qualifies as a charitable contribution? For a full answer, see IRS Publication 526. The short answer is, if it’s a GoFundMe account or a contribution to a needy neighbor who just experienced a hardship, it’s probably not a qualified charitable organization for IRS purposes. IRS Publication 526 breaks down charitable contribution examples as follows:
Deductible as Charitable Contributions: Money or property given to churches or religious organizations; federal, state, and local governments if the contribution is for a public purpose; non-profit schools and hospitals; The Salvation Army, American Red Cross, CARE, Goodwill, United Way, Boy Scouts of America, Girl Scouts of America, Boys and Girls Clubs, etc.; and war veterans’ groups.
NOT Deductible as Charitable Contributions: Money or property given to civic leagues, social and sports clubs, labor unions, and chambers of commerce; foreign organizations (with exception); groups run for personal profit; groups whose purpose is to lobby for change; Homeowner’s associations; Individuals; Political groups or candidates for office; cost of raffle, bingo, or lottery tickets; dues, fees, or bills paid to country clubs, lodges, fraternal orders, or similar groups; tuition; value of your time or service; or value of blood given to a blood bank.
Make an extra mortgage payment. As discussed, the mortgage interest deduction is still available for itemizers, but most taxpayers will not benefit from it because of the much higher standard deduction. Even if it is more likely the standard deduction will apply to you, it just makes good financial sense to make an extra mortgage payment if you have the financial means. Doing so will shorten the life of your loan period and reduce the overall mortgage you end up repaying. If you are an itemizer, an extra payment will increase the amount of mortgage interest paid, increasing your deduction. To take advantage of the mortgage interest deduction, make sure you are making a coupon payment, and not just applying extra towards your principal. Both will shorten the life and reduce the overall interest you pay, but only making the regular coupon payment, which is split in interest and principal, will increase your mortgage interest expense.
These are just a few ways you can adjust your tax liability now. For a full review of your tax situation, schedule a consultation with the Law Office of Doug Peterson today.
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