As wealth managers, we spend a lot of time helping clients keep more of what they earn, whether that be from their paycheck, a small (or not-so-small) business, or their investments. In the end, the important thing is that their net worth goes up, because that’s what is going to determine how much income their assets can produce in retirement. So it doesn’t really matter the source at the end of the day. And there are many things that can eat away at your hard-earned money, including inflation, unexpected health care expenses, and sudden repairs, but perhaps the easiest one to fight is taxes — if, that is, you know where to look. That’s why we spend a lot of time with our clients and their tax preparers thinking and planning out ways to cut that tax bill before its too late.
Now since it is getting closer to the end of the year, the clock is really ticking, but there is still time to take action. The key to all the tax strategies we use is to examine the client’s unique situation. No one strategy works for everyone, and a lot of thinking and planning has to go into each scenario in order to make the best decision.
And so, with all that in mind, here are just a few of the many tools we can choose from to reduce our clients’ tax bill when it comes to year-end tax planning.
Defer Your Income
If you have the ability to defer income from 2016 into 2017, it may be very smart to do so in certain circumstances. For instance, let’s say you are in a high tax bracket this year, but are planning to retire or take 2017 off from work. In that situation, it may make sense to defer your income into 2017, which may allow it to be taxed at a lower bracket. Since the current income tax system is very progressive, the savings can be significant. For example, you may reduce the rate from 39.6% (the highest rate) down to 10% (the lowest). However, watch out for Social Security and Medicare taxes, since they get capped at $118,500 (in 2016), but would apply to the first dollar of income in 2017. So if you’re self-employed and therefore pay both sides of FICA, this may not be a good fit for you if you’ve already maxed out on Social Security taxes for the year.
But even if you’re not going to earn significantly less income in 2017, it still may make sense if you consider that the new Trump administration wants to lower income taxes across the board. And with a republican-controlled Congress on their side, the chances of passing that legislation seem pretty high. So from that standpoint it may make sense to defer income to 2017, even if your situation from an income standpoint looks pretty stable.
Another way to defer income is into a retirement plan, such as a 401k, 403b, or SIMPLE IRA. Money can be diverted from your paycheck into these accounts, and taxes deferred on that money. The 401k and 403b have a maximum limit of $18,000 in 2016, so if you want to max out your tax benefit, consider funding as much of your paycheck into these accounts as possible over the final few pay periods. Some plans even allow 100% of your paycheck to go into the plan, so if you have plenty of cash to pay bills and buy Christmas gifts already, this might be a clever option.
Tax Loss Harvesting
Though it sounds complicated, tax loss harvesting is actually very simple. Basically, you just sell investments that have gone down in value to capture a “capital loss,” which you can then write off against “capital gains” you have realized in 2016. However, to keep your portfolio asset allocation from changing, you may want to consider buying a similar investment with the proceeds. However, just be careful to watch out for the “wash sale rules,” which you can read more about on the IRS website.
Required Minimum Distributions
Those that turn 70.5 or older in 2016 and have an IRA will probably need to take a “required distribution” from their account before the end of the year. Penalties for failing to do so are steep at 50%, so be sure you take care of this before the deadline!
Flexible Spending Accounts
Companies fund these plans to allow employees to divert money from their paychecks to specific fringe benefits, such as dental, vision, and child care needs. Due to the special tax benefits, these plans are “use-it-or-lose-it” under IRS rules. Now some employers have adopted a grace period permitted by the IRS, which allows employees to use money set-aside from 2016 as late as March 15, 2017. But if not, be sure to make a last minute trip to the dentist, optometrist, or drug store before time runs out.
Give the Gift of Securities
While everyone else is running around doing their last minute Christmas shopping, you can be both charitably inclined and tax smart by giving in a smart way. If you have securities that have appreciated in value, have owned them for at least one year, and are planning to sell them anyway, you can give them to a registered 503(c) charitable organization directly instead. The benefit of doing that (in lieu of just writing a check to the charity) is that you get two tax benefits instead of just one. First, you get the regular tax write-off that you normally would as a charitable gift on your itemized deductions. The value of that deduction is the same–it’s just based on the amount of the gift of stock or of cash. But the second benefit is an added bonus: because you gave the securities directly, and did not sell them first, you are not taxed on the capital gain of the stock at all.