- There’s still time left in 2020 to take stock of your financial situation and make some tax-savvy moves.
- You may want to review where you stand year-to-date with your tax payments and retirement contributions and adjust as needed.
- Now is a good time to assess your investments and see if you need to rebalance or have any opportunities to offset gains with deductible losses.
- If you are over 72, make sure you understand the rule changes for required minimum distributions this year, and consider ways to make the most of the pause.
- Make a charitable giving plan that aligns with your values and is as tax-efficient as possible.
Nothing about 2020 has been predictable or routine, so you might as well shake up your year-end tax preparations. Depending on what happens to the balance of power in the US Senate, there may be changes afoot to tax laws in 2021, so now may be a good time to take stock of your financial situation and see what moves you want to make in the last few weeks of the year.
Here are 4 tips to help you get started:
1. Do a financial checkup
Many people will find that their income has fluctuated in some way in 2020, because of job loss, a change in hours, or a shift in your bonus. The best place to start is with your latest paystub and see how your year-to-date column is shaping up.
You may be out of whack with the amount of taxes you have paid so far, and if so you can adjust your tax withholding before the end of the year. If you do this, you could potentially avoid a large tax bill in April when you file your return, or a large refund when you could use the cash now. You may also reduce underpayment penalties if you have not paid in enough taxes during 2020. If you received any untaxed unemployment payments, you could adjust your withholding to have extra taken out for the last few weeks of the year if you are now working again. The same goes if you have a bonus on the way: Those are typically only withheld at 22%, so if you are in a higher bracket overall, you may owe an additional amount you aren’t expecting.
You also may be off-target for your retirement account contributions for the year. On the one hand, it can be unwieldy to fix if you contribute more than the maximum $19,500 allowed by the IRS to workplace plans. On the other, it can be a missed opportunity not to contribute as much as you are able for the year.
Tip: Don’t forget: If you are over 50, you can make catch-up contributions of an additional $6,500 to 401(k)s and other qualified workplace retirement plans until December 31. For more see: 50 or older? 4 ways to catch up your savings.
It’s possible that you have additional savings you weren’t expecting because of restricted spending opportunities in 2020. If you have your current budget and debt under control, you may want to think about investing the funds you don't need in cash for an emergency fund for the long term. To maximize your tax advantages, and assuming it’s appropriate for your goals, you can consider a contribution to a 529 educational savings account or a health savings account (HSA), both of which are due by December 31. You could also contribute to a traditional IRA or Roth for 2020, if you have qualify,1 but those 2020 contributions can be made through April 15, 2021.
2. Harvest and rebalance
If you have realized capital gains in taxable accounts during the year, you may want to look at tax-loss harvesting, which is selling positions at a loss to offset those gains, plus up to $3,000 in taxable ordinary income annually. You can then reinvest the proceeds in a similar (but not substantially identical) security to maintain your investment strategy, but be sure to comply with IRS "wash sale" rules.
However, the tax benefits of this may not outweigh the potential growth of your holdings right now, so consider your options carefully. “This year in particular, you don’t want to let taxes rule your decisions. Do you really want to sell something that’s down now just for tax purposes and lose out on the potential market upside?” asks Christopher Williams, principal at EY Private Client Services.
For both your taxable and tax-deferred accounts, you may want to look at rebalancing if your positions are no longer aligned to your long-term goals. Above all, look at whether your asset mix is where you want it, because the current run-up of the market may have skewed the allocation in your accounts.
If you are a high earner, and particularly if you live in a high tax state like New York or California, you may want to look at municipal bonds. Interest from tax-exempt municipal bonds is generally free from federal income taxes, and in some cases state and local income taxes as well.2
Tip: You may want to avoid buying a mutual fund right before it makes its year-end distribution, or you may have an unexpected tax bill. Read: Mutual fund taxes.
If you find that you are out of balance, you may want to consider prioritizing the sale of holdings in your qualified accounts (those containing money that has not been taxed as income). If you sell appreciated stocks in your taxable accounts now, taxes on the resulting capital gains would be due in just a few months, whereas sales of appreciated securities in qualified accounts are not taxable.
“In any qualified account, you can think about rebalancing any time of year,” says Williams.
3. Make the most of the RMD pause
If you’re over 70, you’re probably used to seeing reminders at the end of year to make sure to take your required minimum distributions (RMDs) before December 31 or face big penalties.
The IRS now requires most people to start taking money out of their tax-deferred retirement accounts once they reach age 72, rather than age 70, but that is on pause this year. If you are a 74-year-old who has around $1 million saved in an IRA, that amounts to about $42,000 less in income for the year, which in turn could yield as much as $15,500 or so in reduced federal income tax for the year, depending on your financial situation.
A Roth conversion could be a benefit in this situation, since the reduced income might mean that you’re in a lower tax bracket than usual. Because you pay taxes on your conversion amounts up front, rather than when you withdraw money, you'll owe no taxes on future earnings if your withdrawals are qualified. In general, if you believe that your future tax rates may go up, either because of legislative changes or because of higher future growth, a Roth conversion could save you money—so this could be a good move this year, and may potentially seem ever better down the road. Another potential advantage: Roth IRAs don't have required minimum distributions (RMDs) during the lifetime of the original owner.
"The so-called RMD vacation in 2020 may push some retirees into a lower tax bracket, and that creates an opportunity for them to look into converting some of their tax-deferred savings to a Roth IRA at a lower rate than usual," says Matthew Kenigsberg, vice president of taxes and investments at Fidelity.
Tip: For more on RMD vacation strategies, read Make the most of your RMD vacation.
4. Make a giving plan
In the midst of a global crisis, charitable giving will be a major focus at the end of the year. The CARES Act for COVID-19 relief provides a $300 deduction from income for charitable giving on the 2020 income tax return, regardless of whether you take the standard deduction or itemize. If you plan to give more generously than that, you may want to consider ways to make use of existing tax advantages, especially if you think your income tax rate may go up in the future.
“When it comes to year-end, people know what their itemized deductions look like. If you’re getting close to the standard deduction cap, a charitable contribution can push you over,” says Williams.
If you’d need more than your usual charitable contribution in order to exceed the standard deduction, consider "bunching." That means concentrating charitable contributions into a single year, then skipping them for a few years. The catch is that this strategy requires having the financial capacity to pack all your deductions into one year.
If you're considering a bunching strategy, a donor-advised fund may be appealing. That way you can contribute several years of charitable contributions in one year, making the most of the deduction in that year, but spread your giving over multiple years.
Tip: Donating highly appreciated assets that you’ve held more than a year helps you avoid capital gains taxes. Try our calculator to model the potential impact of bunching in different financial situations.
The bottom line
The end of the year is a good time to check on your financial accounts. The last day of December is sometimes a significant deadline so it can make sense to do some year-end housekeeping, including evaluating tax strategies and making plans for the coming year.
Of course, tax planning is not a one-and-done exercise. To help reduce taxes, it makes sense to be planning throughout the year. Need help? Fidelity advisors can help you build a tax-smart investing plan that works for you.