Time is running out on making your year-end tax decisions. These decisions can make a big impact on your tax bill come April. It's even more important if you are saving for retirement, have investments outside of retirement accounts, or even if you itemize your deductions.
As a former financial consultant, I know there are many things which can impact your tax liability with Uncle Sam, and even your state taxes. Here are a few things to consider before January 1, 2022.
lt's important to check your withholding amount, and the number of deductions you are claiming on your W-4 form. If your preliminary figures are showing you owe more than you had voluntarily contributed in withholding you should reduce deductions or have extra taken out of your paycheck.
If you are expecting a large refund because you have too much taken out, you need to adjust this. There is no reason to give the federal government an interest-free loan. You'd be better off taken the extra amount and putting into a CD or a savings account to earn you some interest. I realize many use this strategy to get money back each year to use on vacation or other things, but you are doing yourself a disservice. Kiplinger advises using the IRS's Tax Withholding Estimator to determine if you need to file a new W-4 with your employer. Have your last recent pay stub and a copy of your 2020 tax return on hand. It can help estimate your 2021 income. The IRS tool will tell you how much extra you should put down on Line 4(c) of Form W-4. This will help you for next year.
Normally if you don't have to worry about penalties if you owe less than $1,000 more than you've already paid, at least 90% of your tax bill (which ever is the lesser amount).
Plan to pay bills before the 1st if you itemize
Most people know if they will itemize vs. claiming the standard deduction. If you pan to itemize your return for the 2021 tax year, or think you are close enough to the limit to itemize, pay all of your deductible expenses now before January 1st. Mortgage payments, medical bills, and all other deductible expenses should be paid - or as much as you can afford. Don't forget your state and local property taxes. These are usually deductible.
Review your medical bills. If you have enough unreimbursed medical expenses, you may be able to deduct them. You can only deduct unreimbursed medical expenses that exceed 7.5% of your adjusted gross income. That puts this tax break out of reach for most taxpayers, but if you had extraordinarily high medical expenses this year — due to a major illness, for example — you may qualify.
IRS Publication 502 provides a list of deductible expenses. If you find some here that you haven't been tracking, make a note and begin tracking them in 2022. It could save you money next tax year.
Savings and special accounts
Save money and allocate it where you can. Even if you establish a 529 saving plan for your children or grandchildren, you can often use the contributions to lower your state tax bill. 529 plans are investment accounts for the benefit of a minor, to use toward their higher education. Should the minor choose not to pursue higher ed, there are other options.
The 529 plan doesn't get a federal deduction, but over thirty states allow at least a portion of 529 contributions to be deducted. These are usually limited to the state's plan in order to be able to claim those benefits, while some states do allow you to contribute to other plans sponsored by other states and still claim the deduction. Check with you local tax, accounting, or financial professional for details on your situation.
You may be one of the many families with an person who has special needs. An ABLE account allows people with qualifying disabilities to save money without effecting their government benefits. You can contribute up to $15,000 each year, and the beneficiary of the account can contribute even more. It's not necessary to invest in your own state's plan, but residents of a state sponsoring their plan get the tax break. Check out the ABLE National Resource Center for more information.
Balancing capital gains
Believe it or not, you can sell investments (stocks, bonds, mutual funds) that have lost value since you purchased them and use the loss to offset capital gains in taxable accounts (non-retirement accounts). Always check with your financial advisor on this before taking any action, as assets held longer than a year are tax at the capital gains rate. Those held less than a year are taxed at the rate of ordinary income. There are exceptions - so always check with your financial and tax professionals before making a decision.
Make the most of your retirement savings. It's important to squeeze as much as you can our of our paycheck and contribute to your retirement accounts. You can contribute up to $19,500 to a 401(k), 403(b) or federal Thrift Savings Plan in 2021, plus $6,500 in catch-up contributions if you're 50 or older. They amounts for 2022 will be going up, so plan to increase your contributions next year too.
These pre-tax contributions in a 401(k) reduce your take home-home pay and your taxes up front. You'll still have to pay taxes on the money and the earnings when you begin taking the money out at retirement. Should you get into an emergency and need to take the money out, you may have to pay penalties too, with some exceptions.
You may also consider an after-tax option. Should your employer offer a Roth 401(k) you can make contributions that don't lower your taxable income up front, but you can withdraw funds tax-free when you retire, since you'll have already paid tax on the money.
Your employer's human resources or accounting department should be able to help you determine where you are in making the maximum contributions, and making any year-end additions to your account.
Should you have an Independent Retirement Arrangement (IRA), either traditional or a Roth IRA, you'll be able to make contributions to your account credited to this tax year until April 18 of next year. Consider putting a portion of any year-end bonuses into your account, if you haven't already maxed out contributions. You'll have until the tax filing deadline to withdraw any excess contributions, or face paying taxes on it again when you take it out.
You can actually deduct a cash donation up to 100% of your adjusted gross income for this tax year. It had been 60% before 2020, and will go back to it again next tax year. You can even get credit for a $300 donation if you are taking the standard deduction - this is per-person, so it's $600 if filing a joint return.
If you're itemizing, you can count clothing, kitchenware, furniture, and cash you've donated to recognized charitable organizations. You can declutter your home and help a worthy cause by giving things in addition to money. The amount of credit for donated items is based upon their "fair market value" - which means, what you'd expect to pay for it at a second hand store.
If you're unsure of the worth, you can use guides found online, such as TurboTax's ItsDeductible tool to get an idea. Make sure you get a receipt if you're claiming contributions of more than $250. You will need a written acknowledgment from the organization. I'd recommend getting a photo an appraisal for large-ticket items - just to be ready in case of an audit.
The Home Office
Don't be afraid of the home office deduction. With millions of people forced to work at home and others choosing to in the midst of this pandemic, eligibility rules have softened. This allows more self-employed people to claim the home office deduction.
People without a fixed location for their business can claim the deduction if they use the space for administrative or management activity - even without meeting clients in their home. The requirements are still there. You still have to use the claimed space exclusively for business.
You can write off expenses like rent, utilities, insurance, and housekeeping based on the percentage of the area to your total home and applying that percentage to those costs. Keep in mind that you'll have to pay tax on any profit from the depreciation claimed for the office - which is taxed at up to 25 percent. As always, consult your tax professional for details specific to your situation.
I hope these tips give you some ideas that you can use as you prepare for the end of the year and tax season in April!