2019 Year End Tax Planning

Tax filing season may be several months away, but it’s never too early to think about implementing a tax strategy that could save you money.  While there is still time to take corrective action, consider the following questions to help ensure you’re not missing out on potential tax benefits.

Questions about taxes that could save you money

1. What are my withholdings and estimated tax payments?
2. Have I maximized my retirement account contributions?
3. Have I taken my Required Minimum Distributions?
4. What is the cost basis of my investments?
5. Are my investments tax-efficient?
6. Have I maximized my charitable contributions?

Verify withholdings and estimated tax payments

Double-check your withholding and estimated tax payments.  With the tax law changes from the Tax Cuts and Jobs Act (TCJA) which went into effect in 2018, it’s more important than ever to review your withholding and estimated tax payments.

Many people think getting a big tax refund is a good thing.  Unfortunately, the IRS does not pay you interest on the refund it sends you.  Having too much money withheld from your paycheck – or overpaying your quarterly estimated tax payments – means you’re forgoing the potential interest or returns that money could have generated.

On the other hand, withholding too little can lead to a large bill at tax time, an unpleasant surprise if you haven’t planned for it, as many folks found out the hard way last year.  

Both scenarios can be avoided by checking whether your withholding is appropriate using this IRS Tax Withholding website.

Maximize retirement contributions

Be sure to maximize your contributions to tax-advantaged accounts and consider making your 2019 contributions sooner rather than later.  Even though you have until year-end to make contributions to your 401(k) or Tax Day (April 15, 2020) for your traditional or Roth IRA, making early contributions to your retirement accounts will give your money more time to benefit from potential long-term compound growth.

Consider Required Minimum Distributions (RMDs)

If you’re age 70½ or older and have to take RMDs from your retirement accounts, you must do so before the end of the calendar year.  Otherwise, you may have to pay a 50% excise tax on the amount not distributed.

If you turned 70½ this year, you have until April 1 of next year to take your first RMD.  However, if you wait until next year to start, you will have two distributions in the same year (for 2019 and 2020) – which might bump you into a higher marginal tax bracket.

If you’re charitably inclined and don’t need the RMD for your living expenses, consider making a qualified charitable distribution (QCD) from your retirement account directly to your favorite charity.  You can use a QCD to donate up to $100,000 a year and it won’t be included in your income – saving you taxes while simultaneously benefiting the charity. 

Understand cost basis

Know the tax implication prior to selling investments in your brokerage account(s).  Savvy investors know that managing their cost basis can help save on taxes.  Your cost basis is essentially what you paid for an investment, including brokerage fees and any other trading costs.  Your capital gain (or loss) will be the difference between the cost basis of the asset and the price at which you sell it.  In a simple transaction, the cost basis should be easy to calculate.

However, if you buy the same investment over time – such as through a dividend reinvestment plan or via dollar cost averaging – each block of shares purchased is likely to have a different cost and holding period.  In these situations, you can pick which shares to sell, giving you the ability to better manage the tax implication.

Alternatively, you can go with the default average cost method, which requires zero effort or calculation on your part – but could cost you more in taxes.

Invest tax-efficiently

Make sure your assets are located in the most tax-efficient investment accounts (often called “asset location”).  For example, it makes sense to hold long-term investments in a taxable account, because any gains will be taxed at the lower capital gains rate.  The same is true for tax-efficient investments, such as stocks or funds that pay qualified dividends, municipal bonds, and most index funds and ETFs.

On the other hand, you’re better off keeping investments you’ve held for less than a year in tax-advantaged accounts, such as a 401(k) or IRA.  Remember, gains on short-term investments are taxed as ordinary income, which is subject to a higher tax rate than capital gains.  The same is true for actively managed mutual funds that may generate significant short-term capital gains or the interest income on bonds.

Qualified withdrawals from Roth IRAs and Roth 401(k)s are tax-free, so it usually makes sense to use these accounts for assets that you expect will appreciate the most.  Of course, tax-efficient placement presumes you have different account types.  If most or all of your portfolio is in tax-deferred accounts, you’ll need to focus primarily on your asset allocation strategy.

Maximize your charitable donations

If the recent changes to the tax law make the standard deduction the best option for you, consider concentrating your donations into a single year. By giving more in one year, there’s the potential to maximize your itemized deduction for that year.  The next year, you can switch and take the standard deduction, which could increase your overall deductions for that two-year period, resulting in a large tax benefit.

In addition, if you were planning on selling a significant amount of appreciated stock which will generate a large taxable gain, consider donating a portion of those assets directly to a charity.  Subject to certain income limitations, you could get a tax deduction for the full fair market value of the donated stock and you won’t have to pay taxes on the gain for those shares.

Many charities are unable to accept gifts of appreciated assets, like stocks, but you can use a donor-advised fund, which is another great tax tool to facilitate the donation process.  When you place assets in a donor-advised fund, you get the full deduction for the charitable gift that year.  Then, you can grant those assets to your favorite charity over time.

Bottom line

These are just a few of the steps you can take to prepare for tax season and potentially manage and minimize your tax bill.  A qualified tax professional can help you find other effective ways to navigate tax season and answer specific tax questions based on your personal situation.

After you decide what to do this year, resolve to make financial planning a year-round exercise.  By looking ahead, you’ll find it easier to check your progress, update your plan and, if necessary, take action long before the tax-filing deadline.