It’s been a crazy year so far, with a lot of changes in personal finances, retirement planning, tax planning as well as business finances. As we move toward the end of the year, it’s a good time to start understanding what you need to do to maximize tax efficiency in these unprecedented times.
Tax efficiency is all about figuring out how to minimize your legal tax liability. It’s about making decisions that can help you reduce your tax bill, whether that means making the right money moves during market volatility, picking from the best tax software, or just tweaking the way you spend on business costs.
Let’s take a look at some of the things you can do right now to ensure you’re on track for a tax-efficient finish to 2020.
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1. Check your current withholding
Your withholding is how much is being withheld from your paycheck to pay state and federal income tax, as well as your payroll taxes, which include Social Security and Medicare taxes.
When you filled out your employment paperwork, you filled out a W-4, which allowed you to share your filing status and choose the level of withholdings from your paycheck. Now is a good time to review your withholding and make sure it’s accurate.
If you’ve lost income, any extra withholding might be more than you should be paying, and though you might get a bigger tax refund later, you could improve your cash flow today by making an adjustment. The IRS even has a tax withholding calculator that can help you make a better estimate.
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2. Pay your estimated taxes
If you’re an independent contractor or business owner, you need to know how to pay your quarterly estimated taxes. Generally, your estimated taxes are due by September 15, but if you’ve forgotten, get them paid ASAP. When figuring out how to manage your money as a business owner, understanding and planning for estimated taxes is one of the most important things you can do.
Realize, too, that those collecting unemployment but who choose not to have it taxed also owe estimated taxes. Review your unemployment payment to see whether tax has been withheld. If it hasn’t, make a plan to pay your estimated taxes.
Penalties and interest can add up when you miss estimated tax payments, so paying as soon as possible can help you avoid bigger costs.
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3. See if you qualify for the stimulus
You might not have qualified based on your 2018 or 2019 tax return when you originally applied for the stimulus check, but if your 2020 income is lower you could now qualify. There’s a phase-out, so you might not get the full stimulus amount, depending on your income and filing status:
- Joint filers: Receive stimulus for income between $150,000 and $198,000
- Head of household: Receive stimulus for income between $112,500 and $136,500
- Single filers/everyone else: Receive stimulus for income between $75,000 and $99,000
Stimulus payments were designed to be an advanced tax credit on your 2020 tax return. As a result, if your 2020 income is low enough that you now qualify for a stimulus payment, you can file for a tax credit on your 2020 paperwork. The draft form for the 2020 version of the 1040 has a line to claim the recovery rebate credit. This won’t provide you with immediate relief, but it will provide you with a tax credit on your next return.
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4. Organize your deductions
I work from home and have a dedicated office space, so I can deduct that. If you’re self-employed and had to set up a home office, you might have tax deductions that you can use.
There are other costs you might be able to claim as well, depending on your usage and your business use.
- Mileage driven for business
- Portion of your home internet costs, based on how much of your internet is used for business purposes
- Equipment used for your business, including a laptop
- Other business expenses
Start organizing your receipts and getting this info together for your tax filing. Just make sure that what you’re deducting is for strictly business use.
When it comes to the amount you can deduct, the IRS offers two different methods for figuring your deduction:
- With the simplified method, you can claim $5 per square foot, up to 300 square feet. So, that’s a deduction of up to $1,500. In my case with a home office that is about 10 feet by 10 feet (100 square feet total), I can claim $500.
- The regular method requires that you add up your expenses related to mortgage or rent, utilities, insurance and other costs, and then figure your deduction based on the percentage of your home that your office takes up. If you have a home that’s 2,000 square feet, and your home office takes up 100 square feet (as mine does), that amounts to 5% of the space. Therefore, I could claim 5% of the costs associated with my home.
You can run the numbers to see which method of figuring your deduction makes the most sense for you, and whether you could make a bigger claim based on the regular method.
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5. Check your medical expenses
If you had a low-income year with high medical expenses, you might qualify for a medical deduction. You can deduct out-of-pocket medical and dental costs above 7.5% of your adjusted gross income. Additionally, you have to be eligible to itemize on Schedule A in order for this to work.
Let’s say your adjusted gross income is $50,000 per year. If that’s the case, 7.5% would be $3,750. Anything you spend on medical and dental expenses out-of-pocket above that threshold would be deductible. So if you spent $5,000 on these costs, you could deduct $1,250.
Double-check the standard deduction and your other deductions. You’ll need to take a look at Schedule A and make sure all of your totals are more than the standard deduction in order for this to be of benefit to you.
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6. Adjust your 401(k) contributions
Are you making contributions to an employer-sponsored 401(k)? If so, you could lower your taxable income. Current 401(k) contribution limits allow you to contribute up to $19,500 in 2020 — with a catch-up contribution of up to $6,500 if you’re at least 50.
Your contributions to a traditional 401(k) come out of your paycheck before taxes, so if you still have some contribution room, you can increase how much is taken out of your paycheck and reduce your taxable income. That means a lower tax bill because you have less income to tax.
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7. Stay on top of your hardship loan payments
If you took advantage of the changes to 401(k) loans this year, make sure you are making arrangements to pay back that loan so you don’t incur penalties and taxes.
The good news is that there are special conditions as a result of the CARES Act, so you have some options when it comes to your 401(k) loan. You can convert the loan to an early withdrawal without paying the 10% penalty and then spread your tax payments on the money out over three years.
However, you’re likely to be in better shape if you repay the loan so you don’t even have to pay taxes on the amount. Check with your plan administrator to ensure you’re on track and making payments as required.
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8. Pause your RMDs
You’re required to take the minimum distributions from your traditional IRA or 401(k) at age 72. These distributions count as income and can push you into a higher tax bracket, or even just increase your taxable income.
The CARES Act allows you to suspend RMDs for 2020. If you want to reduce your income for tax purposes, you can stop taking RMDs for now. Additionally, depending on your situation, you might be able to return some of your RMDs to your retirement account. Check with a tax professional to see whether you’re eligible.
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9. Address your small business taxes
If you have a small business, you could have been impacted by the Paycheck Protection Program (PPP) or Economic Injury Disaster Loans (EIDL), and there will be paperwork to fill out for those when it comes tax time.
Although the process and paperwork hasn’t been entirely worked out yet, it’s a good idea to pay attention to developments. Your lender should be able to help you through the process. The idea is that you can convert some or all of that loan relief into a grant, as long as you meet certain conditions. Document your payroll and other expenses so you’re ready to fill out the paperwork when the time comes.
Additionally, you might be able to qualify for the Qualified Business Income Deduction this year. Depending on your situation, and the impact to your business, you might be able to deduct up to 20% of your income from certain business activities. Speak with a tax professional to determine what you qualify for, and how this can improve your tax efficiency.
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10. Explore tax-loss harvesting
Assess your investing portfolio and see whether there are opportunities to take advantage of tax-loss harvesting. With this strategy, you use losses from your investments to offset the gains you would normally pay taxes on.
If your portfolio took a hit and you sold some investments during the stock market drop in March 2020, or if you have some stocks that you’re unloading because of underperformance, you can use those losses to reduce your taxes in other areas.
If you benefited from stock market gains this year, you can use your losses to reduce those gains — and your capital gains tax. For example, if you sold investments for a profit of $2,000, but you had losses amounting to $1,000, you can use those losses to reduce your gains. Now you have to pay only capital gains taxes on $1,000.
If your losses are bigger than your capital gains, you can move that excess to your income. You’re allowed to reduce your taxable income each year by $3,000 using investment losses. Even better? If you have even bigger losses, you can carry them to another year.
Keep good records and work with a tax professional to help you document your investment losses so you can use them this year and in years to come.
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11. Convert your IRA
If your income was lower this year, you might convert your IRA to a Roth IRA and see a long-term advantage. When you convert a traditional IRA to a Roth, you have to pay taxes on a portion of the conversion, as your traditional contributions might have resulted in a tax deduction.
Paying taxes now, when you’re in a lower bracket, can make sense if you think your tax bill will be higher in the future. Earnings from a Roth IRA are tax-free, so your money can grow without you worrying about paying taxes when you withdraw it later.
Evaluate your current situation and consider consulting with a professional to see whether it makes sense to take a bit of a tax hit today in order to reduce your overall taxes down the road.
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12. Make a charitable donation
Many people might not have been as fortunate as you. If you want to help others, you can donate to charity — and help yourself with a potential tax deduction.
You can deduct the amount of your donation from your taxes using Schedule A. Again, this is one of those deductions that you list out on Schedule A along with other deductions to see if it all adds up to an amount that exceeds the standard deduction.
For example, in 2019, I had a lot of medical expenses. I qualified for the medical deduction, and, when combined with my charitable contributions, my total on Schedule A was bigger than the standard deduction offered to head-of-household filers. So I was able to get a larger deduction because of my charitable contributions.
If you have available funds and you want to make a donation to a good cause, you can make a substantial contribution and claim the deduction. Verify that your donation is actually tax-deductible by checking the organizations 501(c)(3) status. Donations to political parties and political candidates are not tax-deductible.
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13. Spend your FSA money
Money in your Flexible Savings Account is a use-it-or-lose-it situation in many cases. You can still use that tax-free money to pay for medical expenses for the remainder of this year, so if there’s a procedure you’ve been holding off on, or even if you just need new contact lenses or some other eligible item, you might consider making those purchases now.
It’s important to note that some employers allow for a rollover of up to $550 to the next plan year, but any amount you have left above that will go to waste (and your associated tax savings too) if you don’t spend it. The IRS has a list of qualified expenses that can help you figure out how to use your FSA dollars so they don’t end up lost.
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14. Invest your savings
For many Americans, the coronavirus pandemic changed spending habits. If you didn’t spend as much this year due to not traveling or not dining out, then put that money somewhere that has tax benefits.
Depending on your goals and what you qualify for, there are some great places to put extra cash:
- Roth IRA: If you meet the income criteria and still have the contribution room, you can put more money into a Roth IRA and see tax-free earnings growth in the future. It won’t reduce your taxable income today, but it can provide you with tax savings in the future.
- Traditional IRA: If you’re looking for the tax deduction today, a traditional IRA can be one way to go. As long as you haven’t maxed out your IRA contributions and you aren’t in the area of a phase-out, you should be able to claim a deduction for an IRA contribution.
- SEP IRA: Business owners can make larger contributions to a SEP IRA. For 2020, you can contribute up to 20% of your compensation or $57,000, whichever is less. If you’ve already maxed out your traditional or Roth IRA contributions, you can use a SEP if you’re self-employed.
- Health Savings Account (HSA): For those who are eligible, it’s possible to put money into an HSA and claim a tax deduction. Even better? Your money grows tax-free as long as you use it for qualified medical expenses later. It’s one way to get more bang for your healthcare buck down the road.
- 529 plan: If you’re saving for college, whether for your child or even yourself, you can contribute to a 529 plan and see tax-free growth. You won’t get a federal tax deduction for your contribution, but some states offer deductions. Check to see if you can get a break on your state income taxes for making a contribution, and remember that your investment earnings are tax-free as long as the money is used for qualified education expenses.
I’ve used all of these accounts at various points to increase my tax efficiency. Work with a professional to run the numbers and see what makes sense. One year, I reduced my tax bill by maxing out my HSA contributions and boosting my SEP IRA contributions. Not only does this offer a potential benefit for now, but it also provides the potential for tax-efficient investment earnings.
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15. Plan for your tax filing
Figure out how you’re going to file your taxes so you know how to best prepare. Don’t wait until the last minute, as you might miss some important deadlines. By planning ahead, you can make your moves now, and increase your tax efficiency.
Consider hiring a professional or using some of the best tax software to help you with your taxes. I use an accountant, and it’s worth every penny. They can help you strategize and make better financial choices.
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By paying attention to your personal and business finances, and knowing how your choices impact your tax bill, you can tweak the way you do things and make the most of your financial resources to improve your tax efficiency and get more bang for each buck.
Just be sure to consult a tax professional before moving forward so you’re more likely to make the best decisions for you.
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