Strategies to help you keep more of what you earned in 2011—and plan for next year.
Although it’s been a volatile year for stock markets, it doesn’t mean your tax picture has to suffer. By taking advantage of some strategies before the end of the year, you could potentially find yourself with a smaller tax bill next April.
“Two words that summarize an effective tax strategy are ‘plan wisely,’” says Chris McDermott, CFP,® and senior vice president of retirement and financial planning at Fidelity Investments. “This can be true for everyone, but especially for investors who have the ability to choose tax-advantaged accounts and strategies aimed at minimizing their taxable income.”
Here are eight strategies that may potentially lower your tax bill and help improve your tax picture for future years.
1. Consider tax-loss harvesting
Tax-loss harvesting is the process of selling investments that have lost value in order to offset any capital gains you realized during the year. This may be a strategy to consider using this year due to the stock market’s turbulent performance. If you end up with more losses than gains, you can use the remaining losses to offset ordinary income up to $3,000. If you still have excess losses, you can carry them over to offset capital gains and ordinary income in future years.
Keep in mind that there’s much more to a systematic tax-loss harvesting plan than a one-time sale of a depreciated asset. This strategy requires careful tracking of your investments, including when you purchased each lot of stock or mutual fund shares and how much you paid (the cost basis).
Also, pay close attention to the types of assets you are selling to guard against inadvertently straying from your asset allocation strategy. You can replace the shares you sold with an investment in the same category, but beware of “wash sale” rules that negate the capital loss if you repurchase substantially identical securities within 30 days before or after the sale.
2. Max out your tax-advantaged retirement accounts
A simple yet potentially powerful way to lower your tax bill and save for retirement is to max out your tax-advantaged retirement accounts—such as a 401(k) plan, 403(b) plan, or IRA. Contributions generally are not included in your taxable income for the year, meaning that your tax liability could be reduced by your marginal tax rate, multiplied by the amount of your contributions—for example, 28 cents on the dollar if you’re in the 28% tax bracket.1
The 401(k) plan contribution limit for 2011 is $16,500, which could translate into a $4,620 current-year tax savings if you’re in the 28% bracket. And, if you reach age 50 before the end of the year, you can kick in another $5,500 as a “catch-up” contribution. The ability to contribute at this level depends on your income and plan contribution rules.
For IRAs, the contribution limit for the year is $5,000, or $6,000 if you’re 50 or older in 2011. You don’t have to make a contribution before the end of the calendar year, as you do with a workplace savings plan. You can contribute to an IRA for 2011 right up until the tax-filing deadline of Monday, April 16, 2012. Remember, there are income restrictions for deductible contributions into an IRA. The deduction phaseout starts at $90,000 of modified adjusted gross income (MAGI) for couples filing jointly and $56,000 for single filers. And don’t forget about low-cost, tax-deferred annuities as another option because, unlike an IRA or 401(k) plan, there are no annual contribution limits.2
Although you’ll have to pay taxes on your workplace savings plan, IRA, and annuity savings when you withdraw them, you’ll potentially have benefited from years of compounded growth.
3. Consider a Roth IRA conversion
There may be some good reasons to convert a traditional IRA to a Roth IRA. Among them: a Roth’s tax-free growth potential and the ability to take tax-free withdrawals in retirement.3
The income limits for eligibility to make contributions to a Roth IRA are higher than those for a traditional IRA, with phaseout beginning at $107,000 of MAGI for single filers and $169,000 for joint filers. However, you can convert all or a portion of your traditional IRA savings to a Roth IRA regardless of your income.
While you’ll have to pay tax in the near term on the amount you convert, you gain potential tax-free growth until you withdraw the money, tax free, in retirement and reduce the impact of potential tax rate increases in the future. If possible, consider covering your conversion expense with cash on hand or other savings held in nonretirement accounts, because tapping your IRA to pay the taxes will reduce the amount you would have available to grow tax free in your new Roth IRA. Additionally, if you are under age 59½, using funds from your IRA could result in a 10% tax penalty, which may reduce most or all of the benefit of a conversion.
The deadline to convert a traditional IRA to a Roth IRA for the 2011 tax year is December 31, 2011.
4. Consider itemizing deductions and delaying income
By bunching deductions in the current year and pushing income into next year, you may be able to lower your 2011 tax bill. Among the candidates for deduction bunching are charitable contributions (see Strategy 5), elective surgery, and unreimbursed work expenses, such as travel, professional education, or uniforms. Keep in mind that you can only deduct medical expenses that exceed 7.5% of your adjusted gross income (AGI), and miscellaneous expenses, as defined by the IRS in Publication 529, above 2% of AGI.
On the income side, you could consider delaying payment for freelance or self-employment work, or asking your company to defer any year-end bonus, until the new year begins.
To make this strategy work, you will need to itemize your deductions when filing taxes rather than take the standard deduction ($11,600 for joint filers and $5,800 for single filers). Keep in mind that this strategy may not be effective if you’re subject to the alternative minimum tax (AMT). And you may not want to pursue it if you expect Congress to increase tax rates for 2012, or if you think the additional income could push you into a higher tax bracket next year.
5. Consider contributing to charity
Contributions to public charities can be an attractive strategy for reducing taxes. The amount of your deduction for charitable contributions is limited to 50% of your AGI, and may be limited to 30% or 20% of your AGI, depending on the type of property you give and the type of organization you give it to.
Furthermore, contributing to a public charity with a donor-advised fund (DAF) program, like Fidelity CharitableSM , provides a structured and efficient approach to giving. With a DAF, you can take an immediate tax deduction for your charitable contributions, creating a ready reserve of funds earmarked for charity, and then take your time researching what types of charitable causes you’d like to support. This removes the need to rush the decision-making process at year-end so you can create a thoughtful giving strategy.
Long-term appreciated securities that have been held for more than one year and have increased in value may also be donated to any charity, whether a public charity or a private foundation. In this case, you are typically able to deduct the fair market value, and potentially eliminate capital gains tax on the appreciated value of the contribution.
6. Consider opening a 529 college savings plan
A 529 college savings plan is a tax-advantaged vehicle for putting aside money for the education of a child, grandchild, or loved one.
You can contribute up to $13,000 ($26,000 per married couple) per beneficiary, per year, without incurring federal gift tax, and the contributions are generally considered to be removed from your estate, even though you retain control over the distribution of the funds. For an accelerated transfer, you can contribute up to $65,000 ($130,000 per married couple).4
Any earnings are tax deferred, and withdrawals are tax free if they’re used to pay for qualified higher education expenses of the beneficiary.
7. Review your stock plan strategy
If you have stock options or restricted stock awards from your employer, you should carefully weigh your choices for how to handle them. For example, you might want to consider exercising option grants that are about to expire or for which the stock price is significantly above the grant price. But before you do, consider the timing. If you expect your marginal tax rate to be higher next year, then exercising the options this year may make sense. On the other hand, if your broader strategy is to push income into next year and minimize this year’s taxes, then waiting might be a better choice.
Also, keep in mind that if you had a restricted stock award that vested in 2011, you probably had federal income tax withheld at a flat rate of 25%. But if you’re in a high tax bracket, you could owe additional tax when you file. For example, you might have been required to make a quarterly estimated tax payment. Be sure to consult your tax adviser, so you can set aside funds or make a payment as necessary.
For people in incentive stock option plans, one strategy to consider is called “exercise and hold,” which is designed to result in favorable capital gains tax treatment but, in making this decision, you should be sure to consult with your tax adviser about whether you are subject to AMT. If you exercised and held incentive stock options earlier in 2011, and the value of your stock has subsequently dropped, you may want to consider selling your shares before the end of the year to create a “disqualifying disposition,” which in some cases may reduce your total tax bill. Be sure to consult your tax adviser for more information on these strategies.
8. Start preparing for the Medicare tax on investment income in 2013
Starting in 2013, couples filing jointly with more than $250,000 of MAGI ($200,000 for single filers) will owe 3.8% Medicare tax on the lesser of net investment income—including interest, dividends, capital gains, annuities, rents, and royalties—or MAGI over the threshold.
For example, if you and your spouse had a total MAGI of $275,000—with $225,000 coming from earned income and $50,000 from investment income—you would owe the Medicare tax on the amount of investment income equal to your MAGI over the $250,000 threshold, or $25,000. On the other hand, if your $275,000 in MAGI consisted of $260,000 in earned income and $15,000 of investment income, you would owe the 3.8% tax on just $15,000.
One strategy you may want to consider to help minimize your exposure to the new tax would be to hold your income-paying investments in tax-advantaged accounts, such as IRAs, 401(k) plans, or a tax-deferred annuity. Be aware that the income would be treated as taxable income when you withdraw it in retirement, but if you converted to a Roth IRA before withdrawal, you could avoid all tax on withdrawal, including the potential 3.8% Medicare tax, assuming it’s still in place and your income exceeds the thresholds.
Also keep in mind that a capital gain on the sale of your home is considered unearned income. However, the law excludes $500,000 in capital gains from the sale of a primary residence for a couple and $250,000 for a single filer.
Taking a tax-efficient approach to investing can be a smart move, but the real keys to potential success are staying disciplined and having a big-picture perspective. These are just some potential tax strategies to help you manage your financial life more efficiently. Depending on your individual situation, there may be other strategies to help provide even greater tax savings. Be sure to ask your tax professional for more information.