As we get close to the end of the year, you still have time to improve your financial position with a few well-placed year-end moves.
Maybe because we are working against a deadline, many year-end planning opportunities seem to be tax-related. However, tax moves should be made within the context of your overall long-term financial and investment plan. Hence, make sure to check in with your financial and tax advisers.
Here are seven important areas to focus your efforts to help you make the best of the rest of your financial year.
1. Harvest Your Tax Losses
As of early November, the S&P 500 is up 24% and the Dow Jones is up 18% for the year. Unfortunately, some stocks and mutual funds are still posting a loss for the year. Therefore, it is likely that some items in your portfolio show up in red when you check the “unrealized gains and losses” column in your brokerage statement.
You could still make lemonade out of these lemons by harvesting your losses for tax purposes. It is worth remembering that the IRS individual deduction for capital losses is limited to $3,000 for 2021. In other words, if you don't offset your losers with your winners, you may end up with a tax loss carryforward that could only be used in future years. This is not an ideal scenario.
You can also offset your losses against your gains. For example, suppose you sell some losers and accumulate $10,000 in losses. You could then also sell some winners. Then, if the gains in your winners add up to $10,000, you would have offset your gains with your losses, and you will not owe capital gain taxes on that combined trade!
Bear in mind that wealth strategy is not all about taxes. Tax loss harvesting could be a great opportunity to help you rebalance your portfolio with a reduced tax impact. Beware though of the wash sale rule: If you buy back your sold positions within 30 days, you will have negated the benefit.
2. Review Your Investment Planning
Tax-loss harvesting can be used effectively for short-term advantage. However, it also provides the opportunity to focus on more fundamental issues. In the first place, why did you buy these securities that you just sold? At one time, they probably played an important role in your investment strategy. And now with the cash from the sale, it’s important to be mindful when reinvesting.
You may be tempted to wait for a while to see how the market evolves. We may have been spoiled into complacency with the bull run that we have experienced since the Great Recession. However, we should not forget that volatility does happen.
It's almost impossible to predict accurately when the next bear market will start. And after more than 18 months of strong gains, it is time to reassess if you and your portfolio are well-positioned for a potential downturn.
You will want to ensure that your portfolio risk is aligned with your goals, and that your asset allocation is aligned with your risk target. Reach out to your wealth strategist to review.
3. Review your Retirement Planning
There is still time to top out your retirement account! In 2021, you can contribute up to $19,500 from your salary, including employer match, to a standard defined contribution plan such as 401(k), TSP, 403(b) or 457, subject to the terms and conditions of your plan. And if you happen to be 50 years old or older, you can contribute an additional $6,500 for this year.
If you have undercontributed to your plan, there may still be time. You have until Dec. 31 to boost your retirement planning by topping off your 2021 contributions. This will also have the benefit of reducing your 2021 taxable income, if you contribute pretax money to a traditional plan.
As an alternative, you could contribute to a Roth account if that plan option is offered by your employer.
Many employers offer a Roth in their employee retirement plans. If yours does not, schedule a chat with your HR department!
Many people think of the Roth account as tax-free. However, you should bear in mind that although Roth accounts are popularly designated as "tax-free" they are merely taxed differently, since you would be contributing after-tax funds. Double check with a Certified Financial Planner professional to determine whether choosing to defer some of your salary on a pretax basis or post-tax to a Roth account better fits your situation.
4. Roth Conversions
The current tax environment is especially favorable to Roth conversions. With the Tax Cuts and Jobs Act set to sunset, income tax rates will be going back up in 2026. Therefore, Roth conversions could cost less in current taxes until then. Of course, Congress could vote for tax rates to go up before the end of the year. There is even the possibility that Congress will remove the ability to do a Roth a conversion after 2021.
To do a Roth conversion, you withdraw money from a traditional tax-deferred retirement account, pay income taxes on the distribution, and move the assets into a Roth account. Then the assets can grow and be distributed tax-free, provided certain other requirements are met. If you think that your tax bracket will be higher in the future than it is now, you could benefit from a Roth conversion.
5. Choose Your Health Plan
With health insurance re-enrollment season, the annual ritual of choosing a health insurance plan is with us. With health insurance getting ever more expensive, this could be one of your more important short-term financial decisions.
Your first decision is to decide whether to subscribe to a high-deductible option or stick with a traditional plan with a “low” deductible. The high-deductible option will have a cheaper premium. However, if you have a lot of health issues, it may end up costing more. High-deductible plans allow access to health savings accounts (HSAs).
The HSA is a special instrument. With it, you can contribute money before taxes to pay for qualified health care expenses tax-free. Unlike with flexible spending accounts (FSAs), balances in HSAs can be carried forward to future years. They can also be invested to allow for potential earnings growth. This last feature is exciting to wealth managers, because in the right situation, clients could end up saving a lot of money.
If you choose a high-deductible plan, you should plan to fund your HSA to the maximum. Many employers will contribute as well to encourage their employees to pick that option. If you choose a low-deductible plan instead, make sure to fund your flexible spending account. FSAs are used to pay for medical expenses on a pretax basis. The unspent amount cannot be rolled over to future years, unlike HSAs.
6. Plan Your RMDs
Don't forget to take your required minimum distributions (RMDs) if you are 72 or older. At 50%, the penalty for not taking your RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 72, and then by Dec. 31 for each year after.
Perhaps you don’t need the RMD? Then you may want to redirect the money to another cause. For example, you could fund a grandchild’s 529 tax-advantaged educational account. Contributions are post-tax, but growth and distributions are tax-free so long as they are used to pay for education.
You could also plan for a qualified charitable distribution from the IRA. That distribution must go directly from the IRA to a charity. Unlike a normal RMD, it is excluded from taxable income and may count toward your RMD under certain conditions.
7. Plan Your Charitable Donations
Charitable donations can also help reduce taxable income and provide financial planning benefits. However, the Tax Cut and Jobs Act of 2017 (TCJA) has made it more complicated. A significant result of the TCJA is that standard deductions for 2021 are $12,550 for individuals and $25,100 for joint filers. In practice, it means that the first $12,550 or $25,100 of deductible items have no tax benefits.
For example, if a married couple filing jointly (MFJ) pays $8,000 in real estate taxes and $5,000 in state income taxes for a total of $13,000 of deductions, they are better off taking the standard $25,100 deduction. The first $12,100 that they donate to charity would not yield a tax benefit. One way to get around this new situation is to bundle your donations in a given year and not spread them over many years. Or, within certain limits, to give directly from an IRA.
As an example, if you plan to give in 2021 as well as 2022, bundling your donations and giving just in 2021 could result in a deduction and the accompanying reduced tax. In this way, you are more likely to exceed the standard deduction limit.
If your thinking wheels are turning after reading this article, check in with your wealth strategist or financial planner: There may be other techniques that you could or should do before the end of the year!
Chris Chen CFP® CDFA is the founder of Insight Financial Strategists LLC (opens in new tab), a fee-only investment advisory firm in Newton, Mass. He specializes in retirement planning and divorce financial planning for professionals and business owners. Chris is a member of the National Association of Personal Financial Advisors (NAPFA). He is on the Board of Directors of the Massachusetts Council on Family Mediation.
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