If tax time brings you stress, read on. First, take heart that you can act before the end of the year to help minimize the pain of April 15 (April 18 in 2017). Then, consider the tax tips below affecting key areas of your financial life—from your portfolio to your retirement and more.
Whether you do your own taxes or rely on a tax professional, these tried-and-true strategies may help you keep more of your hard-earned income and boost your after-tax returns. After all, it’s what you keep that counts.
Get started: Six simple steps
Use last year’s tax return as a starting point, and begin by updating some of the key inputs: your salary and other income, deductions and the dependents you’ll claim. You can use tax preparation software to see where you stand, or ask your accountant for an estimate. If the initial estimate seems high, don’t panic. Instead, get going on your taxes by taking these six simple steps.
- Double-check your withholding. You want to pay the IRS its due but not a penny more. So make sure you’re not having too much (or too little) taken out of each paycheck. The same holds if you make quarterly estimated tax payments.
- Consolidate debt. Consider replacing credit card debt, which generally has a higher interest rate, with a lower-rate, tax-deductible home equity loan or line of credit (HELOC).
- Account for refinancings. If you lowered your mortgage interest rate in the past year, you may now have a lower-interest deduction. Also, if you used any of the proceeds for something other than physical improvements to your home, that amount may be subject to the alternative minimum tax (AMT). Remember that points paid in prior refinancings that you haven’t already deducted can be deducted the year you refinance again.
- Prepay quarterly estimated state tax payments. Consider paying your fourth-quarter 2016 estimated state income taxes and any outstanding balance by December 31. Your payments will be tax deductible for the 2016 tax year if you’re not subject to the AMT.
- Prepay property taxes. Many counties bill taxpayers twice, in November and February. If you pay your February installment by December 31, you can take it as a deduction on your 2016 return. Again, watch out for the AMT, which disallows these deductions.
- Avoid the AMT if you can. More taxpayers are facing the AMT, particularly dual-income homeowners who have children and live in high-tax states. If you’re one of these taxpayers, try to defer payment of state and local taxes and accelerate income to the point where you’re no longer subject to the AMT. Also, multiyear planning is a must, so talk to a tax professional.
Portfolio planning: Three tax-smart rebalancing strategies
Year-end is a great time to give your portfolio a checkup. Consider these tax-smart strategies to help boost your after-tax returns.
- Harvest losses. No one likes a losing investment but at tax time, they can be blessings in disguise. You can use capital losses to offset taxable capital gains, plus up to $3,000 in ordinary income ($1,500 for married couples filing separately). Look in your taxable accounts for investments with relatively large losses where you don’t expect a comeback. Remember, any losses you can’t use to offset gains this year can be carried over into future tax years. One word of caution: Watch out for the wash sale rule, which prohibits taxpayers from recognizing losses on sales of securities that are repurchased within 30 days.
Note: High earners stand to benefit the most from harvesting losses, given the increased capital gains tax rates for taxpayers in the top bracket and the 3.8% surtax on net investment income over the modified adjusted gross income (MAGI) threshold of $200,000 for single filers and $250,000 for married filers. When the surtax is included, long-term capital gains for most sales are taxed at a top rate of 23.8% and short-term gains are taxed at a top rate of 43.4%.
- Make the most of tax-advantaged accounts. You may be able to bring your asset allocation back in line without incurring taxes by rebalancing tax-deferred retirement accounts like IRAs or 401(k)s.
- Consider cash flow. If you’re living off your portfolio in retirement, remember to set aside any cash you might need for the next 12 months as you rebalance. For example, if your portfolio is overweighted to stocks, you could take out what you need to live on from that overweight portion and then reinvest the rest in bonds until you’re back on target.
Cost basis reporting
Financial institutions are required to report gain/loss details to you and the IRS for certain investments you sell. These include:
- Equities acquired on or after January 1, 2011.
- Mutual funds, ETFs and dividend reinvestment plans acquired on or after January 1, 2012.
- Other specified securities, including most fixed income and options acquired on or after January 1, 2014.
We recommend saving your purchase and sale documentation, including records of any automatic reinvestments, to make sure it matches the information financial institutions will report to the IRS. You should also make sure your financial provider is using the accounting method of your choice. Even though FIFO (first in, first out) is the IRS default method for both individual securities and mutual funds, most institutions (including Schwab) will report individual securities using the FIFO default method and report mutual funds using the average cost single-category method.
Retirement: Four tax-savvy planning ideas
- Take full advantage of your employee retirement plan, at least to the point of any employer match. And if you’re 50 or older, make a catch-up contribution (see table below). If you expect to be in a higher tax bracket down the road (for example, if you’re a younger worker who has yet to reach peak earning years) and your employer offers the Roth 401(k), consider it. You won’t get any up-front tax benefits, but after you retire, qualified distributions will be tax-free.
2016 federal limits for retirement accounts
Account Contribution limit Catch-up contribution 401(k), 403(b) and 457* $18,000 $6,000 SIMPLE IRA* $12,500 $3,000 Qualified Retirement Plans/Keogh and SEP-IRA* 20% of net self-employment income (or 25% of compensation), up to $53,000 None Individual 401(k)** 20% of net self-employment income (or 25% of compensation) plus $18,000, up to $53,000 $6,000 Traditional IRA and
* Source: http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions
** Source: http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans.
*** Source: http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits.
- If you’re self-employed, consider a small business retirement account such as a SEP-IRA, SIMPLE IRA, Individual 401(k) or other qualified retirement plan. Contributions are tax-deductible and grow tax-deferred. If you open a qualified retirement account by December 31, you have until the day you file next year, including extensions, to make this year’s contribution.
- Be sure to make your annual IRA contribution. Even though you have until next April 15 to make your 2016 contribution (April 18 in 2017), early contributions will give your money more time to benefit from potential long-term compound growth. So consider making your 2016 and your 2017 contribution early next year. If you’re eligible, a Roth IRA might be a good option as well, especially if you’re not eligible for a deductible traditional IRA contribution.
- If you’re age 70½ or older and have to take required minimum distributions (RMDs) from your retirement accounts, you need to do so before year-end. If you just turned 70½ this year, you have until April 1 to take your first RMD (April 3 in 2017). However, if you wait until next year to start, you will have two distributions in the same year—which might bump you into a higher marginal tax bracket.
Education: Two tax-preferred savings plans
- Coverdell Education Savings Accounts. If you’re eligible, for 2016 you can contribute up to $2,000 to a Coverdell account on behalf of a child. Contributions grow tax-free and qualified K-12 and higher-education-related withdrawals are also tax-free. You have until next April 15 to contribute for income-tax purposes (April 18 in 2017), but if you make the contribution by December 31, it will count as a gift for this year instead of the next for gift-tax purposes.
- State-sponsored 529 plans. Anyone, regardless of income, can contribute up to $70,000 (or $140,000 for married couples) to a 529 plan in 2016 without incurring gift taxes—but only if they have the gift treated as though it were made over five years. Because you don’t have to invest in your own state’s plan, we recommend that you shop around—especially if you live in a state with no deduction (such as California) or one with no state income tax. If your state offers an income tax deduction on in-state 529 plan contributions, make your contribution by December 31. However, if you invest in an out-of-state plan, you may lose tax benefits offered by your state’s plan.
Giving: Four tax-smart tips
- Act before year-end. For 2016, you can give up to $14,000 each to as many individuals as you wish and pay no gift tax. Spouses can “split” gifts for a total of $28,000 per beneficiary, per year. Gifts beyond that are taxable, but only if they exceed the lifetime gift tax exemption of $5.45 million over a donor’s life. As for the lucky recipient, they’ll owe no gift or income tax and don’t even have to report the gift unless it comes from outside the United States.
- Pay someone’s education or medical bills. You can also make unlimited payments directly to medical providers or educational institutions on behalf of others without incurring a taxable gift or dipping into your $5.45 million lifetime gift-tax exemption.
- Shift income to tax-advantaged children. Consider gifting appreciated securities and stocks whose dividends are taxed at low long-term capital gains rates to children, at least to the extent that the “kiddie tax” will not apply.1
- Give appreciated securities to charities. Consider donating appreciated securities that you’ve held for more than a year for a full fair market value deduction and no capital gains tax. On the other hand, if you’re holding securities at a loss, sell them first and then donate the cash. That way, you can claim the capital loss on your tax return.
Whether some or all of these suggestions fit your situation, we’re only scratching the surface here. Get advice from a qualified tax professional if you need it.
After you decide what to do this year, resolve to make financial planning a year-round exercise going forward. That way, it’ll be easier to check your progress, update your plan and, if necessary, take action long before the ball falls in Times Square on New Year’s Eve.
I hope this enhanced your understanding of year-end tax strategies. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
1 The so-called kiddie tax applies to children under 19. In addition, full-time college students under the age of 24 will also be taxed at their parents’ rate on unearned income in excess of $2,100 unless the students’ earned income is greater than one-half of their support.