It’s time once again to start giving some thought to paying taxes. Who’s excited? Okay, even though it may feel like a chore it’s wise to do a little analysis at the end of the year to see if there are any year-end tax planning moves you need to make.
Remember, corporate returns are due on March 15th. Personal tax returns are due on April 15th. This is the last day to file taxes on time, but you can file your taxes with the IRS as soon as you have them prepared and as soon as they are ready to start accepting returns.
Before this year ends, you’ll want to think about some things you can do to decrease the amount of taxes you’ll owe. Generally, I like to divide year-end tax planning strategies into three distinct categories.
You can often reduce your upcoming tax bill with a little pre-planning. Maxing out your retirement contributions, paying deductible expenses, and making extra charitable contributions will all reduce your income, allowing you to owe less in taxes. Business owners can also prepay expenses and delay income into next year to reduce their taxable income this year.
3 Ways to Think About Year-End Tax Planning
When it comes to end-of-the-year tax planning, it’s best to focus your efforts on three main areas: deferring or accelerating revenue, deferring or accelerating expenses, and reviewing tax law changes.
Let’s take a look at each of these categories and I’ll follow that up by giving seven specific examples that I find useful.
Category 1: Deferring (or Accelerating) Revenue
Generally speaking, the more revenue you have, the more taxable income you’ll have, and the more you’ll pay in taxes. In most cases, it doesn’t make sense to purposely reduce your revenue (“I want to earn less”– said no one ever!). But you may want to defer your revenue until next year. This strategy is most effective when you anticipate that next year’s income will be lower, tax laws will be more favorable, or there are some other circumstances that will allow you to pay less if you defer the income. If you think the opposite is true, then you may decide to accelerate your income instead.
It’s hard for a salaried employee to pull this off because your employer has all of the control. One thing you could do is request that any end-of-year bonus you have coming to you is paid in January instead of December. This would effectively defer that income to the next tax year. If you’re are a contract employee or if you have revenue from a small business, it’s likely that you have more options for controlling when revenue comes in. In this case, it makes sense to optimize your year-end invoicing schedule to stack the deck in your favor.
If you have taxable investments that have seen positive gains, waiting to sell them until after January 1st will also defer these gains.
Finally, if you’re in retirement and you can manage it, stop taking retirement plan withdrawals from now until January.
Keep in mind, once you start deferring revenue, you’ll have to keep this practice up from year to year to keep pace. Otherwise, you’ll end up having 13 months of revenue reported in one tax year.
Category 2: Accelerating (or Deferring) Expenses
Generally speaking, the more deductible expenses you have, the less taxable income you’ll have, and the less tax you will pay. In most cases, it doesn’t make sense to increase your expenses just to avoid taxes. However, it may make sense to accelerate your expenses (i.e. spend money now instead of in the new year.)
Remember, not just any type of expense will work. For this strategy, I’m talking specifically about tax-deductible expenses. Some examples include medical expenses, mortgage interest, charitable donations, taxes (property, sales, state, local, etc.), education, job-related expenses, and childcare expenses. Take a look at this tax preparation checklist for more ideas.
Also, don’t forget about any losses you have from taxable investments. If you have taxable investments that are in the negative and you don’t mind selling them before the end of the year, you may be able to use these losses to offset taxable investment gains.
To accelerate your taxable expenses, you would simply need to pay them before midnight on December 31. Like revenue, once you start accelerating expenses, you’ll need to keep up this practice from year to year.
Visiting with a tax pro is always wise to help you discover more ways to accelerate expenses and to ensure that you’re implementing the strategy correctly.
Category 3: Reviewing Tax Law Changes
Finally, you’ll want to take a look at any tax law changes that go into effect in the coming year. Often, the tax code includes “expiring provisions.” This means that certain rules affecting how much you owe will no longer be applied in future years. This could include tax rate changes, changes in limits, deductions, or credits, and changes as to what is considered income. Just like that last “for sale” item on the retail shelf, expiring tax provisions have a way of encouraging taxpayers to act.
Rather than bore you will all of this year’s changes I’ll just point you to the Joint Committee on Taxation’s Expiring Provisions page. If you don’t feel like weeding through all of this information, consider consulting with a tax professional who can help you make sure that you take advantage of all the expiring provisions that are relevant to you.
Okay, so to sum all of this up, when you’re trying to do tax planning at the end of the year, it’s important to focus on three areas: revenue, expenses, and tax law changes.
Be sure to ask yourself:
- Based on my current situation, is it beneficial and possible to defer or accelerate my revenue?
- Based on my current situation, is it beneficial and possible to defer or accelerate my expenses?
- Are there any upcoming tax law changes or expiring provisions that I need to take advantage of?
Without further delay, here are my seven specific year-end tax strategies and moves you can make to maximize your tax season success.
Tax Planning Strategy #1: Maxing Out 401K (or 403B) Contributions
This is probably the biggest single move anyone can make at the end of the year to help their tax situation.
Take a look at your last paycheck and see how much you’ve contributed. Compare that to the annual maximum allowable contribution. Make an adjustment to your contribution percentage so that you get as close to the max as you can before the end of the year.
Unlike the rest of the deductions I’ve listed, for this one, it doesn’t matter if you think tax rates will be higher next year or not. You only get one shot at the annual maximum, so if you’re able, it’s always smart to take advantage of this option.
You should also strive to make maximum contributions to your other retirement (Traditional IRA) and health savings accounts (HSA). However, you don’t have to make these contributions by December 31st. You can actually make the year’s contributions up until July 15 of the next year. So, it may be smart to make these contributions in the next year, especially if you only have a limited amount of cash to work with right now.
However, you will need to have the HSA open before December 31st to qualify for contributions.
Deciding whether it makes sense to take advantage of the remainder of these personal deductions depends, in part, on whether you think tax rates will be higher next year, and/or if you think some deductions are going to go away (for example, a cap on deductions for charitable donations).
That said, I do not expect taxes to go down anytime soon. The voters have shown they want a bigger entitlement state and, to keep up with demands, there will be continued pressure to increase taxes.
When looking at my personal situation, I’m taking as many deductions as I can this year. My business income isn’t guaranteed and it’s constantly fluctuating. I have no idea if I’ll make more or less next year than I did this year.
Additionally, even if rates stay the same for me, some tax deductions may be capped based on my income. It’s hard to know what will happen, so I’m following a “take what I can get” strategy.
Tax Planning Strategy #2: Consider a Donor Advised Fund
With the higher standard deduction, it can be more difficult to have enough deductions to make it worth itemizing. One way to push your deductions over the standard deduction threshold is to set up a Donor Advised Fund.
A Donor Advised Fund is a charitable fund that you set up in your own name, you can then make large contributions every few years–large enough to allow you to itemize–and then dole out the funds as you see fit to charities over the next few years.
For example, let’s say you normally donate $500 a month to your church but you need $12,000 in deductions to allow you to itemize. In this case, you could contribute $12,000 every other year to a Donor Advised Fund. Each month you would still donate $500 a month to your church, but you’d itemize every other year (and take the standard deduction on the other years.)
If you want to learn more about donor-advised funds? Check out this great article from Philanthrophy.com
Remember that for charitable contributions to be deductible, they must be made to qualifying organizations. Here’s a list of the requirements, from the IRS website. When you file your taxes, your charitable deductions are reported on Schedule A (Form 1040).
Tax Planning Strategy #3: Pay Required Deductible Expenses Ahead of Time
There are some expenses, like property taxes and mortgage interest, that you have to pay no matter what. However, if you itemize, when you make these payments could have an impact on the amount of federal taxes you owe. For example, since Texas has no state income tax, our property taxes and sales tax are higher than average. However, you can deduct these costs as itemized expenses on this year’s federal tax return, as long as you pay them this year.
In Texas, our property taxes aren’t due until January 31st. But, if we make the payment before December 31st, we can take a Schedule A itemized deduction for the last tax year. I plan to write a check for mine in the next few weeks. If you escrow your property taxes (i.e. pay them with your mortgage payment), consider making an extra escrow payment or two prior to year-end.
While you’re at it, you might also consider prepaying your January mortgage payment. Since the payment you make in January is actually for December’s interest, it’s theoretically sound to deduct the interest in the current tax year. I’ve taken this approach for several years and it’s worked out nicely.
The total amount of interest you paid last year will be reported by your lender using Form 1098. Like property taxes, mortgage interest is a Schedule A itemized deduction.
Tax Planning Strategy #4: Make Large Purchases Before Year-End
If you’re planning to make a large consumer purchase (like a car or a boat) anytime soon, consider doing so prior to year-end. This will allow you to add the sales taxes incurred in the transaction to this year’s itemized deductions. Again, this one only works if you are itemizing your deductions this year.
A word of caution–take care not to let the “tail wag the dog” here. Unless you were already planning a big purchase, don’t shoot for this deduction. Making a big consumer purchase is best when you’ve had time to evaluate your needs and create a plan to get the best deal. Don’t go buy something big just to get a little tax deduction.
Now, let’s move to some ideas for those of you who run a small business. I run a couple of small businesses (this blog and FinCon), so I’m well aware of how important it is to be smart about your business income and expenses. Here are a few ways that you can make tax season happier.
Tax Planning Strategy #5: Spend Next Year’s Business Dollars Now
In the past, I’ve chosen to reinvest some of my earnings from the year back into the business. Last year I made a few small business purchases: a new monitor and a wireless keyboard. Both have helped to make my home office a more productive place and also helped to reduce my taxable business income.
A few years ago, I accelerated an expense that may also be one of your largest overhead items — rent. I did this by prepaying three months of rent at my new office. To take advantage of this strategy, think about your business expenses over the next couple of months. Is there anything you can purchase now that you absolutely know you’ll need next year? Doing so will increase your expenses and reduce your taxable income.
Tax Planning Strategy #6: Delay Billing for Business Services
I use the cash basis method of accounting, so I don’t count income earned unless I’ve actually received the payment. If you do your accounting the same way, then you may benefit from optimizing your year-end invoicing. If your goal is to minimize the reportable income for this year’s tax return, then consider waiting to send your invoices until December 30th or 31st. It’s likely that most clients who receive these invoices won’t pay them until the new year, which effectively reduces your taxable income.
Tax Planning Strategy #7: Opening and Contributing to an Individual (Solo) 401K
If you’re self-employed, it’s up to you to figure out your retirement savings. No one is going to provide a 401(k) or other company retirement plan for you, but that doesn’t mean you can’t take advantage of this major tax deduction. Before the end of the year, considering opening up an Individual (Solo) 401k.
These tax-deferred retirement plans work in much the same way as a traditional 401(k) but are exclusively for business owners with no employees. As long as you follow the rules, you can rack up some major tax deductions by maxing out your contributions to these types of plans. Here’s some more information from the IRS about Individual 401(k) plans.
I opened an Individual 401K for my business a while back. I contributed the maximum that I could afford before the end of the year. This reduced my current year tax burden by a significant sum. Since it worked so well, I plan to do the same for years to come.
Should You Seek Professional Year-End Tax Planning Services?
The end of the year is traditionally a time for many people to assess their financial situation and make some decisions that can result in lower tax obligations. This is often done with the help of a tax expert who can make recommendations you may not have thought of. For example, making a contribution to an IRA before you file your taxes can significantly reduce the amount you owe.
Of course, if you simply can’t justify giving any money to a CPA, there is a free tax service available that can provide a lot of information about your tax situation and whether you’re likely to owe any money to the government. One that comes to mind is the TurboTax free tool TaxCaster. A more expedient approach would be to just download the current version of TurboTax (or use TurboTax Online) and go through the “what if” scenarios.
As long as you have the information about your income, the software can do some quick calculations to estimate whether you should expect a check back from the government. You can even run through scenarios in which you make charitable contributions or contribute to an IRA to see the impact it has on your potential tax refund.
However, if you itemize your tax return, and/or you took advantage of any credits or exemptions on last year’s tax return, it makes sense to seek tax planning services from a professional. He or she can help you determine whether you should maximize current-year tax deductions, defer income, or take advantage of other smart tax-planning strategies.
What tax planning moves are you going to make before the year is over? I’d love to hear your approach.