If the economic slowdown from the measures in place to fight the coronavirus pandemic has taught us anything, it's that we all need to make the most of whatever money we have available. That makes tax planning an even bigger deal than it normally is, since every dollar you hold onto is another dollar that helps you get through this mess.
Unfortunately, tax mistakes are often hard to spot in advance, and many of them, once they take place, can't be readily reversed. For the most part, though, individuals' tax situations largely reset each year, making few errors truly permanent problems. That makes now a great time to figure out how to get ahead of these particular costly tax mistakes and potentially eliminate them before 2021.
No. 1: Over- or under-withholding
You are not required to have your taxes perfectly paid in full until the filing deadline for each year. Of course, the IRS does require you to get it close throughout the year, but it's OK to owe money before filing as long as your withholdings allow you to fall within one of the safe harbor guidelines.
In general, as long as you meet one of these three tests, you're covered:
- You owe less than $1,000 after considering withholdings throughout the year.
- Your withholdings covered at least 90% of what you owe for the year.
- Your withholdings covered at least 100% of what you owed for the previous year (110% if you're considered a high earner).
Getting close to what you owe is a much better option than either over- or under-withholding, If you under-withhold, you will likely owe the IRS penalties on top of your taxes due. That's extra money you otherwise wouldn't have to pay. If you over-withhold, all you're really doing is giving the government an interest-free loan on your money that you don't get back until you finally do file and true things up. In the coronavirus economy, do you really want to be loaning out your money for free like that?
No. 2: Early withdrawals from your 401(k), IRA, or other qualified retirement account
Ordinarily, you need to be either at least 59 1/2 or 55 or older in the year you separate from service from the company that sponsors it to withdraw money from your retirement accounts without penalty. Due to the economic slowdown from the coronavirus pandemic, Congress is allowing people affected by the virus to take early withdrawals in 2020 without facing that penalty.
That penalty waiver is only good through the end of this year, though, so if you need to tap your plan to cover your costs, recognize that the penalty is scheduled to come back next year. That penalty amounts to 10% of any withdrawals you take, so it's worth trying to avoid it if you can.
In addition to the penalty, remember that money you take out of your retirement plan early to cover your costs today is money that no longer compounds on your behalf for your retirement. That can have serious consequences down the road above and beyond the impact from the penalties themselves. As a result, if you can make ends meet without taking early withdrawals from your retirement plans, you should avoid the temptation to take the money out early.
No. 3: Letting the tax tail wag the investing dog
When you invest, you make a trade-off between cash in your pocket today and the potential for more cash in your pocket at some point in the future from investing. The problem with that, though, is that if you start thinking only in terms of the tax costs of making a move, you risk losing sight of the net benefits of that move. That can cause you to miss out on making a great financial move.
For instance, if you're approaching or in retirement, a smart asset allocation plan may have recommended you move some money from stocks to bonds after the market's massive run-up last year. After that large run-up, the taxes to make that move would probably have reduced your net worth on paper, but it would have also protected you against part of the coronavirus-related crash.
You never know when the next crash will happen, and paying taxes on your gains beats losing those gains in the next downturn. As a decent rule of thumb, try to keep, after taxes and commissions, at least as much money from any stock sale as you think the underlying company is really worth. In a valuation model like that, you'll never get it perfect, but it will at least help you avoid the problem of keeping investments that may no longer make sense to hold just to avoid the taxes.
Who knows what 2021 will bring?
The tax landscape may change in 2021 depending on who wins the upcoming election and how the economy looks as 2020 draws to a close. Regardless of what comes to pass, though, taking care of these three potentially costly tax mistakes now will help set you up for a better chance of success then.