7 Important Year-End Tax Planning Moves to Make Before the New Year

Most taxpayers think of January 1 through April 15 as tax season. They may not even spend much time contemplating their income tax situation before the new year starts. But December is actually one of the most important months in the tax year. During December you have an opportunity to make last-minute maneuvers that can save you hundreds or even thousands of dollars on your income tax. You could owe less. Or get a bigger refund.

If you're self-employed, December is even more important. It gives you a last-minute opportunity to create additional end-of-year business tax deductions. You can generally take advantage of those deductions as late as December 31.

Keep in mind that the IRS extended the deadline to file your 2020 taxes to May 17, 2021, which gives you an extra month.

Here are some year-end tax planning strategies to consider by December 31.

1. Schedule a Meeting With Your Tax Advisor to Discuss End-of-year Business Tax Deductions

If you have a business, you should be consulting with your tax advisor throughout the year. But it's especially important to have a face-to-face meeting in the closing weeks and days of the current tax year. Your tax advisor can often generate tax projections based on your year-to-date income and expenses.

So provide your advisor with a profit-and-loss statement for your business through November 30. Then he or she can recommend certain tax minimization strategies based on your business and expected net income.

Some of those strategies may be performed in 2021. But some you must complete by December 31 to improve your tax situation for this year.

2. Make or Maximize Retirement Contributions

401(k) Plans

If you participate in an employer-sponsored retirement plan, maximize your contribution for 2020 by December 31. These plans include 401(k), 403(b), 457 and TSP. Under IRS rules, you can make contributions to any of these plans with up to 100% of your earned income, up to a maximum of $19,500 or $26,000 if you're 50 or older. By contrast, traditional and Roth IRA contributions can be made until April 15 and still be deductible for 2020.

If you're self-employed, follow the same strategy if you have a solo 401(k) plan. Under that plan, you can make similar “employee” contributions. But make them by December 31. Employer matching contributions on a solo 401(k) plan can be made by the tax filing deadline next year. And you can make both contributions because you're both the employee and employer in the plan.

You can contribute up to 25% of your net business income to a solo 401(k) as an employer contribution, up to a combined maximum of $57,000 for 2020. But note that amount must be reduced by the employee contribution you make to the plan. Calculating the employer contribution to a solo 401(k) is quite complicated and yet another topic you should discuss with your tax advisor.

Other Options

Other retirement plans for the self-employed include a SIMPLE IRA and SEP IRA. Both allow you to make higher contributions than to traditional or Roth IRAs.

For example, you can contribute up to $13,500 per year to a SIMPLE IRA or $16,500 if you are 50 or older. SIMPLE IRA plans also allow you to make a small employer contribution. Again, discuss this with your tax advisor for proper calculation. You must make the employee contribution by January 30, 2021, for a 2020 deduction. But you have until April 15 to make the employer contribution to the plan.

You can contribute up to 25% of your net business income to a SEP IRA, up to a maximum of $57,000 for 2020. Once again, huddle with your tax advisor to determine your net business income for 2020, as well as the exact calculation for your SEP IRA contribution. You must make the SEP IRA contribution no later than the date you file your tax return for 2020, which will be April 15, 2021, or October 15 if you file for an extension.

3. Open an HSA and Maximize Your Contributions

Whether you're self-employed or a W-2 employee, opening a health savings account (HSA) is one of the best tax moves you can make. That's especially true now that out-of-pocket costs on health insurance plans typically run into many thousands of dollars.

As well, if you're self-employed, it's likely your health insurance has been purchased from the health insurance exchanges. These typically include policies with high out-of-pocket maximums.

An HSA helps you cover those high out-of-pocket costs. And you get a tax deduction in the process. And you can take that tax deduction even if you don't itemize.

HSAs are designed to work in conjunction with a high deductible health plan (HDHP). That's defined as a health insurance plan that has a minimum annual deductible for 2020 of $1,400 for an individual and $2,800 for a family. (If you have a family plan, ensure that both the individual and family deductions meet the minimums.) There's also an out-of-pocket maximum, which is $6,900 for individual plans and $13,800 for families.

If your plan meets the eligibility requirements for an HSA, you can open an account with a bank, credit union, or even an HSA dedicate broker. You can contribute up to $3,550 for a single plan or $7,100 for a family plan.

Contributions to an HSA are tax-deductible and withdrawals from the plan made to pay for approved out-of-pocket medical expenses are tax-free. This means that when you use the funds to pay for expenses, you still do not have to pay any tax on them.

Use Your HSA for Retirement

Any money not withdrawn from the plan can be carried forward, similar to an IRA. You can even invest the funds in the HSA and earn interest, dividends, and capital gains. That income is not taxable, which lets you to build a very large HSA. You can participate right up until age 65, after which HSAs are no longer permitted. Read more about this option here.

4. Make Major Business Purchases Before Year's End

If you've been contemplating purchasing major business equipment in the near future, make the purchase by December 31. The IRS has a very generous provision for major equipment and asset purchases referred to as Section 179 depreciation.

Business property and equipment has traditionally been required to be depreciated over several years. But Section 179 allows you to fully expense purchases of up to $1 million in the year it's purchased.

That one deduction could eliminate all taxable net profit from your business for 2020. And if the Section 179 deduction exceeds your taxable income, the balance can be carried forward into the 2021 tax year and written off against your net income for that year.

There are limitations on Section 179 deductions for certain assets, like motor vehicles. So discuss this with your tax preparer.

If you're a cash-basis taxpayer — meaning you deduct expenses in the year you pay them — pay as many expenses as possible before year's end. That can include prepaying January rent and other expenses that may not be due until after the end of the current year. Then deduct those expenses for this year since you actually paid them in 2020.

5. Offset Capital Gains and Create Capital Losses

December is the preferred time of the year to engage in some tax-loss harvesting. That's where you sell losing investment positions to generate losses that will offset gains from winning investments. If you have substantial taxable capital gains for 2020, sell off losing positions to cancel out the tax liability created by those gains.

You can repurchase in 2021 the investments you sell during December. Just wait at least 31 days after the sale to avoid the IRS “wash sale” rule.

Even if you don't have capital gains to offset, consider selling investments that can create a tax loss, since you can apply that against other income. Under IRS rules, you can apply up to $3,000 in capital losses against other income (or $1,500 if you're married filing separately). And the other income doesn't need to be investment income. It can be earned income, pension income or any other income from sources that are taxable.

If you're in a 22% marginal federal income tax bracket, a $3,000 capital loss saves you $660 on your 2020 tax bill.

6. Do a Roth IRA Conversion by December 31 if You Expect to Be in a Higher Tax Bracket in 2021

If you've been doing annual Roth IRA conversions, consider converting a larger amount by December 31 if you believe you'll be in a higher tax bracket in 2021. Discuss this topic with your tax advisor before the year ends.

To summarize, in a Roth IRA conversion, you convert retirement funds from other plans into a Roth IRA to gain tax-free income in retirement. Other funds to consider include a traditional IRA and 401(k) plan from a previous employer, among others.

Contributions made to other retirement plans are generally tax-deductible and the investment income earned on those funds is only tax-deferred, not tax-free. So you must pay the income tax for the distribution from those plans in the year they're converted to a Roth IRA.

For example, say you're in the 12% federal tax bracket for 2020 but expect to be in the 22% bracket in 2021. You save as much as 10% tax of the amount converted by completing the conversion by the end of 2020.

7. Make Year-end Charitable Contributions

The standard deduction has roughly doubled since 2017. So, fewer taxpayers need to itemize deductions like charitable contributions. For 2020, the standard deduction is $12,400 if you're filing single or $24,800 if you're married filing jointly.

But if you have enough deductions to itemize, don't forget charitable contributions. Any contributions you make through December 31 will be deductible on your 2020 income tax return. If there are any charities you've been thinking about contributing to — perhaps in the new year — contribute to them in 2020. Then deduct that from your taxes for this year.

Start Thinking About Your Taxes Now

Yes, time is getting short for making year-end tax planning moves and business deductions. But there are some tax strategies you'll need to carry out by December 31 or lose them until the 2021 tax year.

Review last year's income tax return for clues about extra deductions you can take this year. Or discuss year-end tax strategies with your tax advisor.