As the calendar year winds down, it’s a good time to check for steps you can take to improve your 2021 financial outcome.
Year-end is a time to look at what your tax liability is likely to be for 2021. “Take a look at your tax situation, what your tax picture looks like for the year,” says Roger Young, senior retirement insights manager at T. Rowe Price. What is your taxable income likely to be?
Even if you’ve done some planning throughout the year there are still ways to save money on your 2021 taxes. Yet, in some cases, you must act by Dec. 31.
“Year-end is a good opportunity to take stock,” says Rob Williams, managing director of financial planning and retirement income, Schwab Center for Financial Research. What you decide to do “will vary a little bit if you are still employed.”
Here are some steps to take before Dec. 31.
If you are still working, max out your contributions to an employer-sponsored 401(k) plan. The 401(k) contribution limit is $19,500 for 2021. If you are 50 or older, you can also make an annual catch-up contribution of up to $6,500 before Dec. 31. Some employers allow you to put some or all of a year-end or holiday bonus into your 401 (k) so ask your company benefits manager if that is permitted, says Greg McBride, senior vice president, chief financial analyst, for Bankrate.com, a personal financial website.
Take your required minimum distribution (RMD). If you have reached age 70 ½ in 2020 or later, you must take your first RMD by April 1 of the year after you reach 72, according to the Internal Revenue Service. Generally, you have to begin withdrawing funds from your traditional IRA, SEP IRA, SIMPLE IRA, or retirement plan account. Otherwise, RMDs begin at age 70 ½. The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) changed the age from 70 ½ to 72. You can plan or take the withdrawals before the end of 2021. The penalty for not taking your RMDs in time is steep: 50% of the amount not taken on time.
Consider a Roth conversion. Converting a traditional IRA to a Roth IRA must be completed by Dec. 31. “You can’t reverse it once you execute the conversion,” Schwab’s Williams says. If you are not yet taking RMDs, consider converting a traditional IRA to a Roth. “A Roth conversion is most beneficial if you expect that your requirements on distributions in retirement (RMDs) might be in a higher tax bracket than your current bracket,” says economist Wade Pfau, author of “Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success.” “RMDs can bump you into a higher tax bracket.” The Roth conversion can reduce the amount of RMDs in the higher bracket later, Pfau says.
In general, if you are in a relatively low tax bracket this year because you are in phased retirement or working a part-time job, and haven’t yet claimed your Social Security retirement benefits, it can be time to consider converting a traditional IRA to a Roth IRA as well.
Check your capital gains (and losses) for 2021. “In a year like this when markets have done very well,” you may not have losses, says T. Rowe Price’s Young. “You might have some gains, and it might be harder to find those losses. Tax-loss harvesting might be hard to do,” he says. Yet, this might be a time to sell securities at a profit. “If you haven’t taken your Social Security, before Dec. 31, 2021, look at what your (income) tax bracket is or might be” for 2021, says Schwab’s Williams. Ask yourself, “How much room do I have before I hit the next tax bracket?”
If your earned income is lower than it might be in the future, this can be a “prime opportunity to take some of those earnings,” Williams says. “People don’t like to pay tax before they have to, but sometimes it’s advantageous. If you have lower taxable income, pay tax now to give yourself the flexibility of not having to pay any (tax) or paying more tax later.”
For long-term capital gains, generally you will be in a 0%, 15% or 20% tax bracket, depending on your earned income. For a single tax filer, earning $40,400 or less or for married joint tax filers earning $80,800, or less you’ll be in the 0% tax bracket for long-term capital gains. (Long-term capital gains are investments you’ve held for more than a year.)
Speak to a tax adviser before Dec. 31. “Be tax aware,” says Williams. “We can’t predict markets but we do have some control over planning for taxes. Don’t wait until the year is over to speak to a tax adviser. You have to make these sales before the year ends.” If you sell equities within a retirement account and leave the funds in the account, it’s not a “taxable event,” he says. However, within a brokerage account, if you want to lower your concentration of a particular stock, and you sell a stock such as Tesla or Amazon, you may have to pay capital-gains tax on the earnings. It will depend on your earned income level. “If you’re in a lower tax bracket than you might be later, you could sell and pay some tax on it,” Williams says. “Don’t let paying taxes stop you from doing it.” You can reinvest the money. If you have some losses, you can do what is called tax-loss harvesting. You can sell a stock at a loss and another for a gain to offset the loss as a way to reduce your tax liability. You can use the loss to reduce your capital gains. In addition, if your capital losses are greater than your capital gains, you can sometimes offset up to $3,000 of ordinary income. Check with your tax adviser. Also, see the IRS Topic No. 409.
Harriet Edleson is author of the book, “12 Ways to Retire on Less: Planning an Affordable Future” (Rowman & Littlefield). A former staff writer/editor/producer for AARP, she writes for The Washington Post Real Estate section.