Planning to Avoid Panic: How Careful Preparation Can Minimize Your Tax Burden

With the end of the year quickly approaching, we like to tell our clients that now is the time to plan for strategies that can minimize their tax burden. September is an excellent time to do some “pre-planning” to avoid any surprises in April and that dreaded last-minute rush in December, when you have to take actions before the end of the year (as if the holidays weren’t busy enough already).

Putting in a little extra time now will likely pay off when it comes time to file your taxes, and may even set you up for some long-term tax benefits down the road. Here are a few ideas that don’t have to wait.

1. Accelerate Your Charitable Giving

One of the easiest and most fulfilling ways to minimize your taxes is through gifts to qualified charitable organizations. The deductions apply to the year of the donation; if the donation is made with a credit card, the deduction will apply to the year that donation is made, even if payment is not made to the credit card company until the following year. Property and asset donations are also tax deductible. Appreciated property can provide a big boost, since the deduction in most cases is equal to the full market value of the property, and the taxpayer does not have to recognize the appreciation of the property as taxable income.

Whatever you choose to give, you will need to keep a record of the donations. The IRS requires that taxpayers obtain letters from charities acknowledging receipt of the gifts, when the gift is $250 or more to that charity. Otherwise, you may lose out on any potential deductions.

Another option for taxpayers who have to take required minimum distributions from their IRAs (Individual Retirement Accounts) is a qualified charitable distribution (QCD). A taxpayer can make annual direct transfers to a qualified charity up to $100,000 from a tax deferred IRA account. Please note that to qualify for the tax benefit the transfer must be direct from the IRA to the qualified charity to qualify for the tax benefits. The distribution does not need to be recognized as income, which essentially lowers the taxpayer’s adjusted gross income (AGI). Many calculations and limitations are based on AGI, so this could potentially lead to larger deductions. Keep in mind that because the distribution is not included as taxable income, the charitable contribution will not be shown on the tax return.

2. Pre-pay Expenses to Take Deductions this Year

Consider shifting expenses you expect to incur early next year to the end of the current year. Payments such as mortgages, planned charitable donations, miscellaneous investment expenses, state and local income taxes and property taxes from the early part of the following year can be paid in the current year and thus written off as deductions on the current year’s taxes.

Some deductions are subject to AGI limitations. For instance, charitable donations in most cases are limited to 50% of AGI. However, certain charitable donations are subject to limits of 20-30% of AGI. In addition, medical, investment and miscellaneous expenses are subject to limits ranging from 2-10% of AGI.

Finally, prepaying taxes, such as property and state income tax, is a great way to take an additional deduction in the current year. However, if a taxpayer is subject to the alternative minimum tax (AMT), they will not be able to receive a deduction for these expenses.

3. Increase Contributions to a Retirement Account

This is a perennial favorite of the Truepoint tax team! Contributions to traditional IRAs are tax deductible in the year that the contribution is made. Depending upon whether you (and your spouse, if married) are covered by an employer’s retirement plan, there may be a limit to the amount of tax-deductible contributions you can make in a given year. If you (and your spouse, if married) are not covered by an employer’s retirement plan, you can deduct all contributions, no matter your income level.

If you (or your spouse, if married) are covered by a retirement plan, the deductible limit is determined by your AGI; single individuals with a modified AGI under $71,000 are eligible for a full or partial deduction up to the contribution limit of $5,500 ($6,500 if you are over 50). Married taxpayers filing jointly with a modified AGI less than $118,000 may be eligible for a full or partial deduction up to the same contribution limits. Determine your limit, and fund your IRA accordingly. Other types of investments aside from retirement accounts can bring tax breaks as well; read more about them in our prior Viewpoint.

4. Convert Your Traditional IRA to a Roth IRA

Beginning in 2010, the IRS removed the income limit that barred many high-income earners from converting their traditional IRAs to Roth IRAs. Many people jumped on this opportunity to transfer funds in their traditional IRAs to Roth IRAs because of the promise of tax-free investment growth and tax-free withdrawals during retirement.

Contributions to traditional IRAs can potentially be deducted from taxable income, while contributions to a Roth IRA cannot. However, looking ahead, Roth IRAs can provide tax savings in the long run by having the IRA grow tax free, whereas traditional IRAs are merely tax-deferred. Withdrawals from traditional IRAs are also taxed during retirement years at the taxpayer’s ordinary tax rate. The up-front taxes that come with a conversion to a Roth IRA may be a bit higher, but down the road the tax benefits will add up. Still, depending upon how much you earn, you may not be able to contribute to a Roth IRA. However, this does not affect your ability to convert funds from a traditional IRA to a Roth IRA. For more details on Roth IRAs, please refer to this previous Viewpoint.

5. Double-check Your Withholdings

If you’re like most people, you probably pay the majority of your taxes through tax withholding on your wage income. Still, it’s a good idea to check exactly how much is withheld from each paycheck and compare that tax-withholding amount to your estimated income taxes. Why? Because many people either withhold too much or too little. If too little tax is being withheld from each paycheck, you may get hit with an unexpected tax bill. If too much is being withheld, you will receive a refund when you file your tax return.

Refunds may seem like a good thing, but they essentially mean that you have lent the government money during the year. You could have put those funds to better personal use – paying off debt, saving more for retirement, saving up for a special trip, etc. Making sure you have “goldilocks” withholding – an amount that’s “just right” – can help make next April (and every April) calmer, surprise-free and means more money in your pocket.

6. Defer Income

If you are expecting any year-end bonuses from your company, you can request that they be paid in January as opposed to December to minimize this year’s tax burden and delay the tax paid on this bonus for another year. If you are self-employed, pushing invoices into the following year may lessen this year’s taxes and allow you to pay the tax the following year. This approach is only advisable if you believe that you will be in either the same or a lower tax bracket the following year. Otherwise, it may come back to bite you in the form of a higher tax bill down the line.

At Truepoint, we don’t view tax planning as a once-a-year activity, but rather as a continuous process. And the more you look into your tax plan in the Fall, the less stress and scrambling you’ll face during the holidays or in early April.