The tax landscape has changed dramatically in recent years. New lower tax rates and higher standard deductions have helped some taxpayers, but other changes have limited the use of deductions for millions of taxpayers—particularly high income earners in high tax states.
Still, there are several powerful planning strategies that may be able to help you save on taxes, whether you are using the new standard deduction or still itemizing.
"Take some time to review the rules, strategies, and your situation," says Ann Dowd, CFP®. "A little work now can make a big difference in your bottom line when the tax man comes around."
1. Bunch deductions
Starting in tax year 2018, the standard deduction increased and many itemized deductions were eliminated or capped. For example, deductions for state and local taxes are capped at $10,000, the limit for deductibility on qualified home loans is down from $1 million to $750,000, and no one can deduct tax prep fees, investment expenses, or moving costs anymore.
Taxpayers with total itemized deductions below the new standard deduction—$12,000 for singles and $24,000 for married couples filing jointly—will most likely use the new standard deduction.
That means a simpler tax filing, and possibly a lower tax bill for some. But it means others may lose some of their deductions for charitable gifts, home mortgages, and state and local taxes.
To make the most of the potential tax deductions that still exist, consider "bunching." That means concentrating deductions in a single year so they can exceed the standard deduction, then skipping itemization for 1 or more years. This strategy can work well when total itemized deductions fall below the new standard deduction in most years.
Here's an example of how it could work: Instead of making annual charitable gifts, concentrate 2, 3, or even 5 years' worth of donations in a single year, then take a few years off. Focusing all donations in a single year can increase the value of deductions beyond the standard deduction for a single year. Then you could take the standard deduction in the "skip" years.
Consider the hypothetical example below. This couple makes annual $10,000 charitable donations. By gifting 3 years' worth of contributions in 1 year, they can save more than $6,000 in taxes over those 3 years.
Investors considering a bunching strategy for charitable gifts may want to look at a donor-advised fund.
A donor-advised fund (DAF) can let you make tax-deductible contributions of cash or appreciated assets in a given year, but recommend grants to charity over several years. This has multiple potential benefits. You can completely avoid long-term capital gains taxes on the value of any appreciated assets you contribute. You are eligible to take a tax deduction for the whole amount in the current year even though the funds can be granted over future years. (If the security was held for a year or more, you can deduct its current value, otherwise the deduction is limited to the cost basis.) Also, money in a DAF can be invested for potential tax-free growth. That could increase the value of future donations relative to saving in a taxable account.
Investors may also want to consider bunching medical expenses. Medical expenses can be deducted if they exceed 10% of adjusted gross income (AGI). If your medical expenses are close to the threshold, and you're considering elective medical expenses, you may want to consider bunching those expenses in a single year and itemizing.
Bunching medical expenses won't make sense or be possible for everyone. But it may work particularly well for people who have large medical expenses or who plan to make annual charitable donations. Try our calculator to model the potential impact of bunching in different financial situations.
2. Consider a Roth conversion
The new tax law lowered income tax rates and changed the income thresholds for different tax brackets, but those changes are set to expire in 2025. If you have saved money in a traditional IRA, you may be able to effectively lock in today's rates by converting portions of your savings to Roth accounts.
Because you pay taxes on your conversion amount up front, rather than when you withdraw the funds, you'll owe no taxes on future earnings as long as your withdrawals are qualified. If taxes go up, or your income is higher in the future, a Roth conversion could save you money. Another potential advantage: Roth accounts don't have required minimum distributions, so they can be helpful in estate tax planning.
One strategy is to convert up to the limit of your tax bracket. For example, a couple with taxable income of $125,000 would have a 22% marginal tax bracket (which tops out at $168,400 for married, filing jointly, filers in 2019). So they could convert up to $43,400 before maxing out of the 22% bracket. Of course, it's impossible to predict future tax law, but income tax rates are now near historic lows, so it may be a relatively good time to consider a Roth conversion.
3. Remember municipal bonds
For most people, the new tax rules lowered their tax rates and bills—but not for everyone. For some higher income taxpayers, particularly in high tax states, tax bills are going up. For anyone who is concerned about taxes, now may be a good time to reconsider the role of municipal bonds in their portfolio.
Bond interest is typically taxed at ordinary income tax rates—that's up to 37%, and in some cases there could also be a Medicare surtax of 3.8%. Interest from municipal bonds is generally free from federal income taxes, and in some cases state and local income taxes as well.1
That can make interest from municipal bonds an appealing alternative to traditional bonds in taxable accounts, particularly for higher earners.
4. Harvest tax losses
One of the silver linings of volatile markets is the increased opportunity for tax-loss harvesting.
The new tax law did not reduce the value of tax-loss harvesting. A loss on the sale of a security can be used to offset any realized investment gains, and then up to $3,000 in taxable ordinary income annually. You may sell for a loss to offset gains, and then reinvest the proceeds to maintain your investment strategy, but be sure to comply with IRS "wash sale" rules. Tax-loss harvesting needs to be completed by December 31 of every tax year, but unused losses can be carried forward for use in future years.
The rules can be complicated, though, so be sure to consult your tax and financial advisor.
5. Be tax-smart about retirement savings
Fortunately for retirement savers, the new tax law did not change incentives for retirement savings. Pretax contributions to a traditional 401(k), 403(b), or similar workplace retirement plan can still generally reduce taxes. For those in the 24% tax bracket, for example, every $1,000 contributed could save $240 in current-year federal taxes. The 2019 contribution limit is $19,000, but if you're age 50 or older, people can contribute an extra $6,000, for a maximum contribution of $25,000. The deadline to contribute is December 31.
A traditional IRA and a Simplified Employee Pension (SEP) IRA offer potential tax breaks similar to those of a 401(k); however, you can make contributions until the tax filing deadline, typically April 15 following the end of the tax year. For 2019, you can contribute up to $6,000 to an IRA, and if you are age 50 or over an extra $1,000.
Another option for reducing taxable income is a health savings account (HSA). HSAs have triple tax benefits2: Contributions made with pretax dollars reduce federally taxable income, earnings are free of federal and potentially state taxes, as are withdrawals used to pay for HSA-qualified medical expenses. People enrolled in high-deductible health plans (HDHPs) are eligible to open an HSA. Those people can consider contributing up to $3,500 for an individual and $7,000 for a family, plus an extra $1,000 if you are age 55 or older for 2019.
6. Consider contributing RMDs to charity
If you are age 70½ or older and your itemized deductions add up to less than the standard deduction, you may effectively lose the deduction for charitable contributions. But there is another way to support your favorite charities and still get a tax break.
Consider a qualified charitable distribution (QCD). It's a direct transfer of funds from your IRA custodian and payable to a qualified charity, which counts toward your required minimum distribution (RMD) for the year, up to $100,000.
Making a QCD comes with tax advantages. QCDs are not included in gross income and do not require itemization to be effective. But, the rules are complex, so be sure to consult your tax advisor.
The bottom line
The new tax law should simplify filing for many people. While lots of deductions are gone or capped, the new higher standard deduction and lower tax rates should also mean smaller tax bills and simpler filing for most people. Still, there are some strategies to consider that may help you save more when the tax bill does come around, so it makes sense to take time throughout the year to get ready.
Next steps to consider
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