Year-end Tax Planning Strategies for Individuals

With the end of the year fast approaching, now is the time to start thinking about tax planning strategies that could reduce your tax bill for 2022.

Let’s take a look. We’ll cover investments, year-end bonuses, charitable deductions, medical expenses, and more.

General Tax Planning Strategies

General tax planning strategies for individuals include accelerating or deferring income and deductions and carefully considering timing-related tax planning strategies concerning investments, charitable gifts, and retirement planning. For example, taxpayers might consider using one or more of the following strategies:

Investments. Selling any investments on which you have a gain (or loss) this year. See Investment Gains and Losses below for more on this.

Year-end bonus. If you anticipate an increase in taxable income in 2022, and are expecting a bonus at year-end, try to get it before December 31.

Contractual bonuses are different in that they are typically not paid out until the first quarter of the following year. Therefore, any taxes owed on a contractual bonus would not be due until you file your 2023 tax return in 2024. Please call the office if you have any questions about this.

Charitable deductions. Bunching charitable deductions every other year is also a good strategy if it enables the taxpayer to get over the higher standard deduction threshold under the Tax Cuts and Jobs Act of 2017 (TCJA). Another option is to put money into a donor-advised fund that enables donors to make a charitable contribution and receive an immediate tax deduction. A public charity manages the fund on behalf of the donor and, in turn, recommends how to distribute the money over time. Don’t hesitate to call if you want more information about donor-advised funds.

Medical expenses. Medical expenses are deductible only to the extent they exceed a certain percentage of adjusted gross income (AGI); therefore, you might pay medical bills in whichever year they would do you the most tax good. In 2022, these medical and dental expenses must exceed 7.5 percent of AGI. By bunching medical expenses into one year rather than spreading them out over two years, you have a better chance of exceeding the thresholds, thereby maximizing the deduction.

Deductible expenses such as medical expenses and charitable contributions can be prepaid this year using a credit card or check. You can only deduct the medical and dental expenses you paid this year – not payments for medical or dental care you will receive in the future. For example, suppose you charge a medical expense in December but pay the bill in January. Assuming it’s an eligible medical expense, you can take the deduction on your 2022 tax return.

Stock options. If your company grants stock options, you may want to exercise the option or sell stock acquired by exercising an option this year. Use this strategy if you think your tax bracket will increase in 2023. Generally, exercising this option is a taxable event; the sale of the stock is almost always a taxable event.

Invoices. If you’re self-employed, send invoices or bills to clients or customers this year to be paid in full by the end of December; however, make sure you keep an eye on estimated tax requirements. Conversely, if you anticipate a lower income next year, consider deferring sending invoices to next year.

Withholding. If you know you have a set amount of income coming in this year that is not covered by withholding taxes, there is still time to increase your withholding before year-end and avoid or reduce any estimated tax penalty that might otherwise be due.

Avoid the penalty by covering the extra tax in your final estimated tax payment and computing the penalty using the annualized income method.

Accelerating or Deferring Income and Deductions

Strategies commonly used to help taxpayers minimize their tax liability include accelerating or deferring income and deductions. Which strategy you use depends on your current tax situation.

Most taxpayers anticipate increased earnings from a job or investments from year to year, so this strategy works well. On the flip side, if you are retiring and anticipate a lower income next year or you know you will have significant medical bills, you might want to consider deferring income and expenses to the following year.

In cases where tax benefits are phased out over a certain adjusted gross income (AGI) amount, a strategy of accelerating income and deductions might allow you to claim larger deductions, credits, and other tax breaks for 2022, depending on your situation. These types of tax benefits include Roth IRA contributions, child tax credits, higher education tax credits, and deductions for student loan interest.

Accelerating income into 2022 is also a good idea if you anticipate being in a higher tax bracket next year. It is especially true for taxpayers whose earnings are close to threshold amounts, making them liable for the Additional Medicare Tax or Net Investment Income Tax ($200,000 for single filers and $250,000 for married filing jointly). See more about these two topics below.

Taxpayers close to threshold amounts for the Net Investment Income Tax (3.8 percent of net investment income) should pay close attention to “one-time” income spikes such as those associated with Roth conversions, sale of a home or any other large asset that may be subject to tax.

Examples of accelerating deductions include:

  • Paying an estimated state tax installment in December instead of at the January due date. However, make sure the payment is based on a reasonable estimate of your state tax.
  • Paying your entire property tax bill, including installments due in 2023, by year-end. This does not apply to mortgage escrow accounts. A prepayment of anticipated real property taxes that have not been assessed prior to 2023 is not deductible in 2022. Under the TCJA, the deduction for state and local taxes (SALT) was capped at $10,000. Once a taxpayer reaches this limit, the two strategies above are not effective for federal returns.
  • Paying 2023 tuition in 2022 to take full advantage of the American Opportunity Tax Credit, an above-the-line tax credit worth up to $2,500 per student that helps cover the cost of tuition, fees and course materials paid during the taxable year. Forty percent of the credit (up to $1,000) is refundable, which means you can get it even if you owe no tax.

Additional Medicare Tax

Taxpayers whose income exceeds certain threshold amounts ($200,000 single filers and $250,000 married filing jointly) are liable for an additional Medicare tax of 0.9 percent on their tax returns. They may, however, request that their employers withhold additional income tax from their pay to be applied against their tax liability when filing their 2022 tax return next April.

High net-worth individuals should consider contributing to Roth IRAs and 401(k) because distributions are not subject to the Medicare Tax. Also, if you’re a taxpayer who is close to the threshold for the Medicare Tax, it might make sense to switch Roth retirement contributions to a traditional IRA plan, thereby avoiding the 3.8 percent Net Investment Income Tax (NIIT) as well (more about the NIIT below).

Alternative Minimum Tax

The alternative minimum tax (AMT) applies to high-income taxpayers that take advantage of deductions and credits to reduce their taxable income. The AMT ensures that those taxpayers pay at least a minimum amount of tax. In 2022, the phaseout threshold increased to $539,900 ($1,079,800 for married filing jointly). Both the exemption and threshold amounts are indexed for inflation.

AMT exemption amounts for 2022 are as follows:

  • $75,900 for single and head of household filers,
  • $118,100 for married people filing jointly and for qualifying widows or widowers,
  • $59,050 for married people filing separately.

Charitable Contributions

Property, as well as money, can be donated to a charity. You can generally take a deduction for the property’s fair market value; however, for certain property, the deduction is limited to your cost basis. While you can also donate your services to charity, you may not deduct the value of these services. You may also be able to deduct charity-related travel expenses and some out-of-pocket expenses.

Contributions of appreciated property (i.e., stock) provide an additional benefit because you avoid paying capital gains on any profit.

Keep in mind that you must itemize for 2022 (unlike 2021 and 2020) to take advantage of the charitable deduction. You must also keep a written record of your charitable contributions, including travel expenses such as mileage. A donor may not claim a deduction for any cash contribution, check, or other monetary gifts unless the donor maintains a record of the contribution. A canceled check or written receipt from the charity showing the name of the charity, the date of the contribution, and the amount of the contribution is usually sufficient.

Qualified Charitable Distributions (QCDs). Taxpayers who are age 70 1/2 and older can reduce income tax owed on required minimum distributions (RMDs) from IRA accounts by donating them to a charitable organization(s) instead. Of note is that there is an annual maximum amount of $100,000 for single filers and $200,000 for married couples.

Starting in 2020, taxpayers required to take required minimum distributions from IRAs, SIMPLE IRAs, SEP IRAs, or other retirement plan accounts can wait until age 72. In prior years, the age was 70 1/2.

Investment Gains and Losses

Investment decisions are often more about managing capital gains than minimizing taxes. For example, taxpayers below threshold amounts in 2022 might want to take profits, whereas taxpayers above threshold amounts might want to take losses. Tax-loss harvesting – offsetting capital gains with losses – may be an excellent strategy to use if you have significant losses this year or an unusually high income.

Fluctuations in the stock market are commonplace; don’t assume that a down market means investment losses. If you’ve held the stock for a long time, your cost basis may be low.

Minimize taxes on investments by judicious matching of gains and losses. Where appropriate, try to avoid short-term capital gains, which are taxed as ordinary income (i.e., the rate is the same as your tax bracket).

In 2022, tax rates on capital gains and dividends remain the same as 2021 rates (0%, 15%, and a top rate of 20%); however, threshold amounts have been adjusted for inflation:

  • 0% – Maximum capital gains tax rate for taxpayers with income up to $41,675 for single filers, $83,350 for married filing jointly;
  • 15% – Capital gains tax rate for taxpayers with income of $41,675 to $459,750 for single filers and $83,350 to $517,200 for married filing jointly;
  • 20% – Capital gains tax rate for taxpayers with income above $459,750 for single filers, $517,200 for married filing jointly.

Where feasible, reduce all capital gains and generate short-term capital losses up to $3,000. As a general rule, if you have a significant capital gain this year, consider selling an investment on which you have an accumulated loss. You can claim capital losses up to the amount of your capital gains plus $3,000 per year ($1,500 if married filing separately) as a deduction against income.

Wash Sale Rule. After selling a securities investment to generate a capital loss, you can repurchase it after 30 days. This is known as the “Wash Rule Sale.” The loss will be disallowed if you repurchase it within 30 days. Or you can immediately repurchase a similar (but not the same) investment, e.g., an ETF or another mutual fund with the same objectives as the one you sold.

The wash sale rule only applies to stocks and securities. It does not currently apply to cryptocurrencies such as Bitcoin, which means you can sell Bitcoin and immediately buy it back.

If you have losses, you might consider selling securities at a gain and then immediately repurchasing them since the 30-day rule does not apply to gains. That way, your gain will be tax-free, your original investment will be restored, and you will have a higher cost basis for your new investment (i.e., any future gain will be lower).

Net Investment Income Tax (NIIT)

The Net Investment Income Tax (NIIT) is a 3.8 percent tax applied to investment income such as long-term capital gains for earners above a certain threshold amount ($200,000 for single filers and $250,000 for married taxpayers filing jointly). It is not indexed for inflation.

Short-term capital gains are subject to ordinary income tax rates and the 3.8 percent NIIT. This information is something to think about as you plan your long-term investments. Business income is not subject to the NIIT, provided the individual business owner materially participates in the business.

Mutual Fund Investments

Before investing in a mutual fund, ask whether a dividend is paid at the end of the year or whether it will be paid early in the following year but be deemed paid this year. The year-end dividend could make a substantial difference in the tax you pay.

Action: You invest $20,000 in a mutual fund in 2022. You opt for automatic reinvestment of dividends, and in late December of 2022, the fund pays a $1,000 dividend on the shares you bought. The $1,000 is automatically reinvested.

Result: You must pay tax on the $1,000 dividend. You will have to take funds from another source to pay that tax because of the automatic reinvestment feature. The mutual fund’s long-term capital gains pass through to you as capital gains dividends taxed at long-term rates, however long or short your holding period.

The mutual fund’s distributions to you of dividends it receives generally qualify for the same tax relief as long-term capital gains. If the mutual fund passes through its short-term capital gains, these are reported to you as “ordinary dividends” that don’t qualify for relief.

Depending on your financial circumstances, it may or may not be a good idea to buy shares right before the fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax consequences. Or the market could be moving up, with share prices expected to be higher after the ex-dividend date. To find out a fund’s ex-dividend date, call the fund directly.

Questions?

If you’d like more information on how dividends paid out by mutual funds affect your taxes this year and next, contact us at the office of Lahrmer & Company LLC at (866) 474-1238 or office@lahrmercpa.com

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