By the time a lot of taxpayers (and their accountants) get around to thinking about taxes, it’s too late to be proactive, and all you can do is close your eyes and write that check! If you take a look at your financial situation now, there are still a lot of moves you can make before the end of the year to improve your tax outcome.
When it comes to year end tax planning, the first thing to do is project what your taxable income will be at the end of the year, what your tax liability will be, and how much you will have paid in, either through withholding or estimated payments. In the case of a salaried taxpayer with only W-2 wages, use your most recent paystub for total wages, pre tax deductions (e.g., 401k contributions), and income tax withheld to date. Calculate the number of pay periods you have left during the year, calculate what your additional wages, pre tax deductions, and withholding will be for those pay periods, and add it to the year to date amounts. If there are no significant changes from the previous year, you can use your 2016 tax return to estimate your other income items (e.g., interest and dividends, social security), deductions, and exemptions to arrive at your taxable income. If you receive an end of year bonus, make sure you include it in your calculation. Use an online 2017 tax calculator (available from many banks, investment advisors, and tax preparers) to calculate your tax. Deduct any credits you expect to have, taking into account that you might have phased out of some if you made more money than in 2016, and see if your withholding is sufficient to cover your projected tax liability. If it’s not, you have some choices. You can do nothing and accept that you will have a balance due. As long as you have paid in enough to avoid a penalty, which is 90% of your estimated 2017 tax or 100% or 110% of your 2016 tax liability (dependent on your income), it won’t make a difference and you can hang onto your money longer.
Adjust your withholding
Most of us don’t like writing big checks. In that case, you can increase your withholding for the rest of the year by the amount of tax you are short divided by the remaining number of pay periods. It won’t change the amount of tax you pay, but you’ll feel better about it! If you do this, remember to re-adjust your withholding after the end of the year so you are not withholding too much for 2018. The longer you wait to assess your withholding, the fewer pay periods you have remaining in the year to spread the pain across so I encourage you to do this projection now. If you make estimated payments, increase the remaining quarterly payment so that your total estimated payments for the year are adequate.
Reduce your taxable income
Doing a projection and adjusting your withholding or estimated payments based on your projection are good for eliminating unwelcome surprises, but they don’t change your tax liability. The other side of the equation is to reduce your taxable income. Here are a few easy ones that apply to most taxpayers.
Increase your 401(k) contributions
If you aren’t maxing your 401(k) contributions ($18,000 or $24,000 if you are 50+), increase your contributions as much as you reasonably can. Only pre-tax contributions will reduce your taxable income so keep in mind that if your plan offers a Roth option, those contributions are after-tax and won’t reduce taxable income. Besides socking away more for retirement, you are paying yourself instead of paying the government. Consider a taxpayer in the 25% tax bracket. If she increases her 401k contribution by $5,000, she saves $1,250 in tax dollars (25% x $5,000). So she put away $5,000, but it really only cost her $3,750. This is a quick and dirty calculation—depending on whether the taxpayer is in the top or bottom of the bracket, the result could be a little more or little less, but you get the picture.
Make your charitable contributions now—including Goodwill
As long as you itemize your deductions and your deductions are not limited due to your income, charitable deductions will lower your tax bill. However, most GoFundMe contributions are not tax deductible! So make sure the organizations you are donating to are bona fide 501(c)3 charities. Here’s a link to a great article by my colleague, Alyssa McBride, CPA, that can help you ascertain if a charity is legit.
Remember, non-cash contributions to Goodwill and the Salvation Army are every bit as valuable from a tax perspective, and we all have too much stuff! So get busy now, clean your closets, your house will have less clutter, and you’ll reduce your taxes. There are different record keeping requirements for non-cash so make sure you are aware of them. As long as you itemize your deductions, your tax savings from charitable contributions can be estimated in a fashion similar to the 401(k) contributions—a taxpayer in the 25% tax bracket will save $125 on his tax bill with a $500 donation, and if it was from his closet, it didn’t cost him anything.
Itemized deductions in general
With a new tax bill being hammered out in Congress, I’d also like to point out that there’s a strong likelihood that the standard deduction will be doubled in the future. This means that married folks filing jointly with itemized deductions in the range $12,700-$25,400 and single filers with itemized deductions in the range $6,300-$12,600 will likely be taking a standard deduction in the future. The reason I point this out is that if you find yourself in this range, you should consider accelerating as many of your itemized deductions into 2017 as you can. If you do this, you get the benefit of them, whereas if you leave them until 2018 and the standard deduction is doubled, they won’t be useful to you in 2018. I make no guarantees here—everyone has to look into their own crystal ball and see what they think the final outcome of the tax bill will be!
If your crystal ball says the standard deduction is indeed doubling, here are some easy examples of accelerating your deductions into 2017: Make your 2018 charitable contributions in December 2017 on your credit card. This allows you to deduct them on your 2017 tax return and pay them in January 2018. If your real estate taxes are due in early 2018, pay them by December 31, 2017. Pay your January 2018 mortgage payment in December 2017. On this one, you need to mail it early enough so that they receive it in December in time to include the mortgage interest, which is the deductible piece, on your 2017 Form 1098.
I wrote a recent article extolling the virtues of Roth conversions (click here to read it). If you find yourself with lower income than usual in 2017, it might be an ideal time for you to make a Roth conversion and take advantage of the lower tax bracket you find yourself in. You need to make the conversion before the end of the year. However, you have until April 15, 2018 to undo it if you decide it’s not advantageous. I love it when the IRS allows do overs!
Timing of retirement distributions
In the case of a retired taxpayer who is not yet required to take minimum distributions, they may want to draw down retirement plan accounts in an amount that keeps them from going into the next higher tax bracket. For example, if our taxpayer is married and right in the middle of the 15% tax bracket and decides haphazardly to withdraw $30,000, $11,450 of that distribution will be taxed at 25% instead of 15%. If the taxpayer had planned ahead, and perhaps consulted his accountant, he might have decided to only withdraw the amount that would keep him in the 15% bracket this year and take out that additional $11,450 at 15% in the following year, resulting in a tax savings of $1,145 over the two years.
Get help if you need it
These are some simple examples. As you get into higher income levels, there are phase out ranges and limitations for credits, deductions, and exemptions, and depending where the taxpayer is, they may encounter these limitations. Sometimes utilizing the techniques above can get a taxpayer below those thresholds as well, which makes them even more powerful in reducing tax liability. But no matter how you slice it, it’s always better to know where you stand before April 15! So do a tax projection to see where you stand, call if you have questions, or just have your accountant do it. You’ll have no surprises in April and peace of mind until then.
And a happy holiday to all my readers!