All information in this post about your personal tax planning guide is provided for illustrative and educational purposes only and should not be considered tax or investment advice, or a recommendation to buy or sell any type of securities.
No one wants to think about 2022 taxes right now, but now is the best time to think about tax planning, right before you get into the holiday spirit and start wearing ugly sweaters. Spend some time finding ways to keep more of your hard-earned money. Here are some ideas for you.
We challenge you to think beyond today or this year. Tax planning should take a long view, as much larger gains can be achieved by taking consistent tax planning actions every year than trying to find an additional deduction this year. Some of our suggestions may not result in a reduction of 2022 taxable income, but acting today in some of these areas can mean reducing your taxable income for years to come: when retiring, when paying for college expenses, or when transferring wealth to your loved ones or your favorite charity.
Start with a tax projection
When it comes to taxes, no one likes bad surprises, like having to pay more than they were expecting. So start with a tax projection. Besides reducing or eliminating the chance of an underpayment penalty, a projection will help you quantify the impact of different tax planning strategies. Follow our guide to make a projection using the IRS withholding estimator. Start by getting your latest pay slip and your 2021 tax return. Then Use the YTD section of your last paystub and other information from last year’s tax return to help you go through the questions. The more questions you can answer the more precise the estimate. And if you find that you may owe money to the IRS, you still have a few months to prepare for it.
Harvest Gains and Losses, and Repurpose Your Investments
When you look across your investments, chances are some have increased in value while others have lost value, relative to the initial cost of the investments (or cost basis), particularly given the market volatility of this year. In a taxable account, selling investments that have lost value can help you reduce your taxable income. Why would you need to sell? One reason could be that you need liquidity for planned expenses. Selling only appreciated assets will generate capital gains and a tax liability. You can use losers to reduce that tax liability or even turn it into a deduction against ordinary income. After you have netted your realized gains and losses, you can use up to $3,000 in losses to reduce your taxable income this year. If your loss is greater than $3,000 you can carry that amount to future tax years, indefinitely, until the entire loss is used up.
Sales of appreciated assets aren’t the only source of realized gains. Distributions from the funds you are invested in can also be offset by harvesting losses, and you can have distributions from funds even if a fund has lost value this year.
Review your asset allocation, and for each investment, ask the question: Do I need this investment in my portfolio? If yes, is there a close substitute? The simplest example is with index funds. You can sell index fund A and buy a fund that tracks a similar market index from manager B. Your asset allocation hasn’t changed, but your taxable income is. You have realized a loss from a tax perspective but not from an investment perspective. Notice that there is no reason to wait until year-end to do this, like many investors or advisors do, as losses can occur any time of the year. You or your advisor can harvest losses this way throughout the year.
Avoid the surtax if you can
Capital gains are also included in the calculation of net investment income to which the 3.8% medicare surtax is applied, for earners above the thresholds defined here. Offsetting gains can reduce your modified adjusted gross income and your investment income.
Harvest gains too
There is a lot of focus on losses, but you should consider harvesting gains, too. In a year when you have a lower taxable income, it may be a good time to harvest your gains, not just losses. Capital gains rates depend on income. Suppose your income is below the 0% capital gains tax rate ($83,350 for married filing jointly), then it may make sense to sell your appreciated investments this year since you have no tax liability. If your investment has a close substitute, like funds A and B above, then you can harvest gains today to reduce your tax liability in the future. The same consideration applies to someone in the 10% cap gains tax bracket that expects to be in a higher bracket in the future.
Contribute to tax advantaged accounts
Start by making sure you have contributed to your 401(k) or similar plan to take advantage of the employer match. Contributing any amount up to the $20,500 limit (plus an additional $6,500 if you are 50 or older) will lower your adjusted gross income. However, tax planning isn’t just about reducing your taxable income this year. So if you are in a low-income bracket and can contribute to a Roth IRA, consider contributing to a Roth this year. Your tax rates may go up in the future, either because the 2017 Tax Cut and Jobs Act ends or because you will make more money, and having tax-free savings in a Roth account can help you grow a larger nest egg.
Fund your Health Savings Account
If you have an HSA, a great tax-saving strategy is to fully fund the account for the year. You can contribute up to $3,650 (single) or $7,300 (family) of pre-tax money. Contributions to an HSA are free of federal income tax and social security and medicare taxes. The HSA can be a great element of a retirement plan. If you are enrolled in a high deductible plan that meets the HSA requirements, you can open an HSA whether or not your employer offers one. In addition, regardless of when you become eligible for the HSA in the year (as late as December 1), you are eligible for the entire year, so you can make the full-year contribution to it. Fully funding your HSA is a great way to lower your taxable income and get ahead on your retirement plan.
IRA Planning
We suggested contributing to a Roth account if you are in lower tax brackets. Doing so will reduce future taxation and help you keep more of your growing investments. On the other hand, contributing to a traditional IRA can help you lower your taxable income this year, which may be useful for people in higher income brackets.
I meet a lot of people that don’t know this simple fact: Everyone with earned income can contribute to an IRA, regardless of whether you have a 401(k) plan or not. And if you don’t have earned income but your spouse does, you can still contribute to an IRA (called a spousal IRA). If you are NOT an active participant in an employer plan like a 401(k), your contribution is generally fully deductible. If you are an active participant in a 401(k), part of the contribution may be taxable, depending on your income. In that case, it is better to only contribute the deductible portion to a traditional IRA and the taxable part to a Roth IRA. After-tax contributions are always better in a Roth account than in a traditional IRA. The combined IRA (traditional + Roth) contribution for 2022 is $6,000 plus an additional $1,000 if you are 50 or older.
Consider ‘back-door’ Roth contributions
Roth contributions are phased out at higher levels of income. If your income is above the threshold for a Roth contribution, consider making a taxable traditional IRA contribution. Making the contribution can still save you on future taxes because your money grows tax-deferred in the account. But there is something else you can do: convert that non-deductible contribution to a Roth IRA. When you convert an IRA to a Roth IRA, you pay taxes on any amount converted that is above your basis. Your basis is the sum of all the after-tax contributions you made across your IRAs. If you have multiple IRA accounts, all accounts are aggregated and your conversion may be part non-deductible and part deductible, so you may have a taxable event when you convert. The upside is that that money will never be taxed again!
Fully fund your college plans
As an estate planning strategy, 529 plans are a great way to use your annual gift exclusion to pass your wealth out to loved ones without gift or estate tax consequences. Using the annual gift exemption, you can donate up to $16,000 (if single) or $32,000 (if married) per individual recipient. As a parent who is planning to send their kids to college, 529 contributions allow you to take advantage of tax-exempt growth and future withdrawals for qualified expenses. So while not a tax reduction today, a tax reduction in the future for acting today.
Check your Child Tax Credit and Other Credits
For 2022, the child tax credit returns to $2,000 per child. Families will get the full credit if they make up to $400,000 (joint) or $200,000 for single parents, so higher thresholds relative to prior years. Here you can check if you qualify. The IRS has a page with the most common credits and deductions for individuals, check it out and you may find something that applies to you.
Give it away
For 2022, the IRS has eliminated the charitable donation deduction of up to $600 (married, $300 for single filers) to a qualified charity for tax filers that take the standard deduction. But you ca still reduce your taxable income as an itemized deduction. So check if you will file Schedule A and plan your charitable contributions accordingly. You may consider bunching your charitable donation (either for 2022 or 2023) to get you across the threshold for itemized deductions. Taxpayers who itemize can generally claim a deduction between 20% and 60% of adjusted gross income depending on the type of contribution and the type of charity. Here is an article that can help you maximize the value of your charitable contributions.
Donate appreciated investments
Consider donating appreciated investments instead of cash. Say you are in the 15% capital gain tax bracket and want to donate $20,000 to charity. If your plan involves selling assets to raise the $20,000 in cash, you will have to pay a capital gain tax of $1,500 for every $10,000 in capital gains. But you can save that by donating the assets directly; and since charitable institutions do not pay taxes on appreciated property, the charity gets the full $20,000 value. Your investment custodian can help you donate your investments. See, for example, the various ways you can do it through Betterment. There is a limit on donating appreciated property, typically 30% of your adjusted gross income or AGI.
Qualified charitable distribution from IRAs
If you are 70 and ½ or older in 2020 and have traditional IRAs, there is one more way to benefit from charitable donations. You can make distributions directly to charities from your IRA, and the amount directly reduces your AGI, up to $100,000. Reducing your AGI reduces your taxable income and can reduce the taxability of your Social Security benefits. Check this article on Retirement Daily for more ways to donate.
Donor advised funds
A good way to donate is to open a donor-advised fund account, which can easily be done online. You can donate several types of assets, depending on the institution. Your investments in a donor-advised fund can grow tax-free over time, and when you are ready to make a grant to a particular charity, you can do so directly from your account. Donor-advised funds are a great vehicle to bunch up contributions in one single year and use itemized deductions to reduce your taxable income.
Standard or itemized
Because of the higher standard deduction contained in the TCJA and the new limits on state income taxes, more people are opting for standard deductions (about 84% of all taxpayers). But if you have planned itemizable expenses, consider bunching them together. For example, make a multi-year charitable donation this year (perhaps using a donor-advised fund). Or consider pre-paying for deductible expenses that you know you will incur in 2022, such as medical expenses. If you have planned any surgery or larger medical expense for 2022, consider paying before the end of 2021.
We tried to list some of the more common items that can have a larger impact on your taxes throughout your life. Not all of these may apply to you, and the ones that do may not lead to a tax-saving this year, like a Roth contribution. But you should see tax planning as helping you keep more of what you earn throughout your life. Finally, a warning. The tax code is complex and each situation is unique. Make sure you consult with a tax professional to see if and how any of these ideas apply to your situation.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner and a lecturer of finance and economics at Texas State University. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
