As 2021 nears an end, you can use strategies that will greatly benefit you when you file your taxes next year. Notice that I said “benefit you,” rather than “reduce your taxes,” because the goal is to make more money after taxes. Here are a few ideas to consider, along with some caveats.
1. Support your favorite charity
Most retirees will take the standard deduction, so they won’t itemize. But for 2021 you can still claim a deduction as part of the CARES Act. That amounts to up to $600 for married people filing jointly and $300 for those of other filing statuses. Mike Piper, a CPA and author of the Oblivious Investor blog, notes that another alternative for those over age 70 1/2 is to make a direct contribution from an IRA to a charity. You won’t owe taxes on the amount you withdraw and give to charity.
2. Harvest your tax losses from investments held in a taxable account
I’m sorry for your loss, but you can make the most of it by selling and taking a tax deduction. Bonds and bond mutual funds haven’t done well this year, and you may have some losses there. You can use an unlimited amount of losses to offset taxable gains. You can usually deduct up to $3,000 in additional losses from your income and carry forward the remaining amount to future years. Wait at least 31 days to buy your losing investment back; if you don't, the IRS will disallow that loss and consider it a tax-wash sale.
3. Sell your investment winners without paying federal capital gains tax
If you’ve held your investments for more than one year, you pay a long-term capital gains tax. But the capital gains tax rate happens to be zero at or below the following taxable income:
|Filing Status||Taxable Income|
|Married, filing jointly||$80,800|
|Married, filing separately||$40,400|
|Head of household||$54,100|
For example, a married couple, with both spouses being age 65, would have a standard deduction of $27,800, so they could reap an $80,800 gain and have $108,600 to spend without paying federal income taxes. If they had $60,000 in income, they could realize another $48,600 in long-term capital gains and owe no additional federal income taxes.
People eligible for the zero percent capital gains tax could also sell their winning investments (up to the limits above) and repurchase those investments seconds later, because the wash-sale rules apply only to investments sold at a loss. Why do that? You would reset your cost basis to the investment’s current price, potentially reducing your capital gains taxes if you sold your investment later for a profit. Be aware, however, that you might owe state income taxes on these gains.
If your taxable income falls within the levels above, harvesting gains is usually not a good idea in the same year in which you harvest losses, Piper says. You would be using up losses to offset gains that weren't going to cost you any tax money anyway.
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4. Contribute to your retirement account
If you are still working and have some earned income, one way to lower your taxes is to contribute to your 401(k) or 403(b) or even your IRA. Dec. 31 is the deadline for contributions to a 401(k) and 403(b), but you have until April 18, 2022, to contribute to an IRA.
5. Earn tax-free and risk-free income by paying down the mortgage
As I mentioned in an earlier column, most of us don’t itemize and get no tax benefit from mortgage interest. So if your mortgage is at a 3 percent interest rate, this is the equivalent of a 3 percent tax-free return (or mostly tax-free if you are able to itemize). Why own bonds earning about 1.6 percent in taxable interest while you are borrowing at a much higher rate without a tax benefit? Make sure, though, that you have enough liquid assets to sleep comfortably at night.
The next two ideas are based on the fact that it’s sometimes better to pay taxes sooner at a lower rate than later at a higher rate (assuming that taxes will be higher in the future). These two ideas work best if you have delayed Social Security (typically the ideal option) and haven’t started required minimum distributions yet. RMDs are required on April 1 following the year in which you reach age 72 (70 1/2 if you turned 70 1/2 before Jan. 1, 2020).
With lower income before taking RMDs and Social Security, you may be in a lower tax bracket than you will likely be in a few years. Tax rates jump to 22 percent from 12 percent at $40,525 for individuals and $81,050 for couples filing jointly, so you may want to consider using up that 12 percent rate.
6. Consider partial Roth conversions
You could take some money from your traditional IRA and convert it to a tax-free Roth IRA. The IRS will generally tax you on the amount you convert as ordinary income. But then, under current law, the money in your Roth could grow tax-free for the rest of your life and even for 10 years beyond if it is inherited by your children after you and your spouse die.
7. Consider withdrawals
You could just take money out of your tax-deferred accounts and use that to live on, under the assumption that you’ll pay less in income taxes on your withdrawals now than you will in the future. Don’t do this before you are 59 1/2 or you will likely be subject to a 10 percent penalty. Both methods result in lower RMDs later on.
Now, a few warnings. First, I’ve always said investing is simple, but I’ve never said taxes were. Any of these tactics could potentially result in unintended surprises, such as higher income-related monthly adjustment amount (IRMAA) Medicare premiums or lower Affordable Care Act health care subsides. And, of course, tax laws can and will change. Thus, you may want to discuss these ideas with a tax expert before implementing them.
Allan Roth is a practicing financial planner who has taught finance and behavioral finance at three universities and has written for national publications including The Wall Street Journal. Despite his many credentials (CFP, CPA, MBA), he remains confident that he can still keep investing simple.