Who wants to think about taxes around the holidays? What if a few simple year-end moves could save you thousands of dollars off your 2021 tax bill? For example, there’s tax loss harvesting, topping up retirement account contributions, and giving to charity. These are moves you can make even though the fate of the Build Back Better Act in Congress is uncertain. Senate Democrats say they’re trying to pass the proposal, which includes tax hikes on the rich and a possible increase to the cap on the deduction for state and local taxes, before Christmas. That might mean really last minute tax planning. In the meantime, to lessen your tax bite for 2021, consider these surefire steps you can make by year-end.
Give to charity. The charitable contribution tax deduction means you can give more to charity at a lower net cost, while lowering your tax bill. Usually taxpayers who take the standard deduction instead of itemizing deductions—and that’s most of us—can’t deduct their charitable contributions. But there is a special deduction for gifts of cash to charity of up to $300 for individuals and up to $600 for married couples filing jointly for 2021. This charitable deduction for non-itemizers is basically an extension (and for couples, a doubling) of the one-year $300 tax break Congress put in for 2020 under the pandemic relief CARES Act. Watch out for extra rules. Contributions eligible for the special deduction include cash donations made by check, credit card or debit card, but not donations of household goods. And gifts to donor-advised funds and private foundations don’t count.
If you do itemize deductions, there are more ways to maximize the tax benefits of your contributions. “Instead of giving cash, give appreciated securities,” says Jere Doyle, senior tax and estate planning strategist at BNY Mellon Wealth Management. “You can give away the gain.” When you make a gift of highly appreciated stock to a person, say a child, the low tax basis is carried over to the recipient, meaning they’ll eventually have to take a tax hit when they sell. So it’s better to give low basis assets to charities, which are exempt from capital gains taxes. The gain is never taxed, but you get to deduct the full market value of your stock at the time of the gift.
For the most generous individual givers, there’s another special incentive for 2021: the elimination of limits on the percentage of your adjusted gross income that can be wiped out by a charitable deduction for cash gifts to public charities (not to private foundations or donor-advised funds).
Give to family and friends. Thinking of whittling down your estate? The sooner, the better, so any growth in assets is outside of your estate. Seventeen states impose death taxes, and the federal estate tax exemption is scheduled to drop back to $5 million, plus inflation adjustments, in 2026. Using what’s called the annual gift tax exclusion, you can give away $15,000 to as many individuals—kids, grandkids, their spouses—as you’d like with no federal gift tax consequences in 2021. That jumps to $16,000 in 2022. Spouses can each make gifts, doubling the impact. A series of annual exclusion gifts can add up, and they don’t count toward the $11.7 million (2021) lifetime gift and estate tax exemption amount, which climbs to $12.06 million in 2022. If you’re making annual gifts to individual, don’t delay: the check must clear the bank by the end of the year, Doyle notes.
You also can make unlimited direct payments for medical and tuition expenses for as many people as you’d like, with no gift or estate tax consequences. Medical and educational payments must be made directly to the institution. You can’t, for example, transfer money to your daughter who pays the bill for your grandkids’ tuition.
Fund a 529 Education Savings Account. 529 college savings plans work best if college is a long way off but they can make sense even if the beneficiaries are already in college. Parents or grandparents can easily set them up for one beneficiary and then add or change beneficiaries as your family needs evolve. The money you contribute grows tax free and comes out tax free if used for educational expenses, including a computer. And more than 30 states offer state tax breaks for contributing too, according to SavingForCollege.com. The rich can supercharge a 529 account by contributing up to five years of annual gift exclusions up front.
Recent tax law changes make these plans even more powerful: The money in a 529 can be used for K-12 tuition (up to $10,000 a year per student), college, graduate school, and trade schools.
Fund a Health Savings Account. If you’re eligible for an HSA, double check that you’re contributing as much as you can, and look at the investment options in your plan. These accounts are the most powerful savings accounts out there, with triple tax savings: the money goes in tax free, grows tax free and comes out tax free when used for medical expenses. You can keep the account when you switch jobs and there’s no use-it-or-lose it problem as there is with flexible spending accounts. The catch: You’re only eligible to contribute if you have a high-deductible health plan. For 2021, you can contribute $3,600 as an individual, or $7,200 if you have family coverage, with an additional $1,000 if you’re 55 or older.
You do save by using the money in an HSA for current health care expenses. But the secret to making the most of one of these accounts is to pay your current medical costs out of pocket and to invest the money in the account, allowing it to grow tax-free into a retirement health care kitty.
Think about retirement now. The end of the year is a good time to check that you’re making the most of tax-advantaged retirement accounts for this year and next. If you have a workplace retirement plan, check that at a minimum you’re contributing enough to grab any employer matching contributions. For 2021, you can contribute $19,500 to a 401(k) plus a $6,500 catch-up contribution if you’re 50 or older. That jumps to $20,500 for 2022. The maximum amount you can contribute to an IRA (whether you choose a Roth IRA or a traditional IRA) is $6,000 plus a $1,000 catch-up contribution if you’re 50 or older. Those numbers are the same for 2021 and 2022. Self-employed workers and business owners can save even more in a SEP-IRA or solo 401(k).
Note: As long as you’ve got earned income, you can contribute to an IRA (the old rule that barred contributions past age 70 1/2 is no longer).
Check tax withholding. If you have gig income or if you’ve sold stocks at a gain, make sure you’ve withheld enough in income taxes. Typically you should be paying in estimates on a quarterly basis. The last date to pay in 2021 estimates is January 18, 2022. What if you haven’t been doing that? You could get hit with an underpayment penalty (it’s really just interest). But wage earners have a way to catch up without paying interest: You can withhold more on a year-end bonus or on your W-2 up to the full amount of pay, and it’s considered spread evenly over all four quarters.
Take advantage of tax loss harvesting. Meanwhile, to reduce your 2021 income, take advantage of tax loss harvesting. Pay attention to the types of gains and losses in your taxable investment accounts when selling at the end of the year. Short-term capital losses offset short-term capital gains, for example. You can deduct $3,000 of losses against your personal income, and carry over additional losses to future years.
Watch out: The wash-sale rule says you have to wait at least 31 days to buy back the same investment.
Consider Roth IRA conversions. A Roth IRA conversion doesn’t have to be a one-time move. It can work better to do a series of partial Roth conversions, so it’s something to consider every year. You move some—or all of the money—from your traditional IRA into a Roth IRA, paying income tax on the amount you moved or “converted”. The amount converted is added to your income for the year. The aim with a partial conversion is to move just the amount of money that keeps you in the same tax bracket, rather than bumping you into a higher one. Yes, you’re paying taxes on the converted amount before you otherwise would have too. But the Roth IRA grows tax free for your lifetime—and your spouse’s, and there are no required minimum distribution rules as there are for a traditional IRA.
Check Flexible Spending Account balances. If you contribute to a healthcare flexible spending account at work, check your remaining balance for 2021, and whether your employer lets you carry over unused amounts into the next plan year. You usually have to spend all the money in the account—or carry over no more than $550. But Congress loosened the rules because of the pandemic. Employers don’t have to allow it, but you might be able to carry over the full remaining balance for 2021. At the same time, you can elect to contribute up to $2,850 into an FSA for 2022. The money you contribute is pre-tax, so you’re saving by contributing, as long as you spend the account down by repaying yourself for out-of-pocket health care expenses like deductibles, co-insurance, and many things you pick up at the drugstore. Congress recently added masks and hand sanitizer to the list of eligible products that includes tampons, hearing aids, and contact lenses and solution.
Get your estate documents in order. Family get-togethers over the year-end holiday and the pandemic are driving folks to review and beef up their estate plans—not just to save taxes, but to provide peace of mind for themselves and their heirs. At a minimum, make sure you have basic documents in order. That includes a durable power of attorney, a will and revocable living trust if applicable. On the healthcare front, you need a healthcare directive and a living will. These are the foundations that you need to have in place to protect yourself and your family in the near year. After all, there’s more to life than looking for tax savings.