2020 is nearly half done, but you still have time to make adjustments to help you reduce the total tax you owe when it comes time to true up next April. After all, when all is said and done, what matters more than what you make is what you're able to keep to invest or spend on your personal priorities.
You can use these four tax strategies to decrease what you ultimately owe for the year, keeping more of your money in your control.
1. Contribute to your traditional 401(k) or similar retirement plan
Every dollar you put toward your traditional 401(k) or other traditional-style employer-sponsored retirement plan up to the plan and legal limit brings with it a tax deduction based on your contribution. If you're in the 24% tax bracket, every $100 of contributions you make reduces your Federal income taxes by $24. If your state allows tax deductions for 401(k) contributions, too, then you will also reduce your state taxes based on whatever state tax bracket you're in.
For those under age 50, the contribution limit is $19,500, while those ages 50 and up can contribute as much $26,000. For both age ranges, however, your contribution may be more limited than that based on factors, like whether you're considered a highly compensated employee.
On top of deductions for contributing your money, once in the plan, your money grows tax-deferred between when you contribute it and when you withdraw it for retirement. Once you do withdraw it, you'll pay ordinary income taxes on that money, but you'll potentially have had decades of tax-advantaged compounding working in your favor along the way.
2. Sell enough losers to offset your gains
Even the best investors make mistakes. Just ask Warren Buffett about his investments in the airlines, for instance. If there's an upside to an investing mistake, it's that you can make use capital losses taken in ordinary investment accounts. You can offset up to 100% of your capital gains, deduct up to $3,000 in excess capital losses against ordinary income, and even carry over any additional net losses beyond that limit.
This can be helpful in controlling your taxes if you either choose to sell a winner or are forced to do so by some factor out of your control like an acquisition. Except in cases like a margin call, bankruptcy, or acquisition, when you sell is generally within your discretion, which means that leveraging your losses can be a powerful means of controlling your income. That can come in handy if you're close to an income limit, such as being at risk of losing an Obamacare subsidy due to having $1 too much income.
Be careful with this strategy, however. You can't claim your losses if you sell and buy back the same (or a substantially identical) security within 30 days before or after the sale. Doing so would trigger a "wash sale" and disallow your loss until you ultimately disposed of the investment.
In addition, you'll generally want to sell your losing investments where you recognize your investing thesis is broken, not just for the tax benefit of selling. After all, volatility happens in the stock market, and you'll kick yourself if you ended up selling for the tax benefit just before the market realized that the company you sold was really a bargain.
3. Try to hold your winners for at least a year and a day
If you sell a stock for more than you paid for it, you have a capital gain. In an ordinary investment account, those gains are subject to tax. How much tax you pay depends primarily on two factors, your total income level and how long you held the stock before you sold it. If you held the stock for a year or less, it's considered a short-term capital gain, but if you held it for more than a year -- even a year and a day -- it's considered a long-term capital gain.
Short-term capital gains are taxed at the same rates as your ordinary income, but long-term capital gains get a tax break, enabling you to keep more of your gains. Indeed, if your income is below $78,750, your long-term capital gains may even be free from Federal taxes entirely. Above that point, Federal tax rates on long-term capital gains are generally 15%, unless your income starts to get well above $400,000 ($244,425 if you're married filing separately).
As a result, tax law gives you a strong incentive to hold your winners for at least a year and a day. On the flip side, of course, if you have a compelling reason to sell earlier, you shouldn't let the tax tail wag the investing dog. After all, a more highly taxed gain you actually keep beats taking a loss because the market took away a limited-time opportunity. Those situations don't happen often, however, but in cases like a stock rising in speculation of a takeover deal, you may only have a limited time to act.
4. Reach a safe harbor from your withholdings
When it comes to taxes, you are not expected to get things perfect until the tax filing deadline for the year, but you are expected to get reasonably close. As long as you've had enough withheld (or paid through timely estimated payments) throughout the year to satisfy a "safe harbor" test, you can true up the rest of what you owe by that deadline. If you don't reach a safe harbor, however, the IRS will generally levy a penalty above and beyond what you owe in taxes.
There are three safe harbor tests, and you only need to meet one of them each year to be covered. For most people, they are:
- If you owe less than $1,000 after your withholdings, you're covered
- If you had at least 90% of your total taxes due for the year withheld, you're covered
- If you had at least 100% of your total taxes for the previous year withheld (110% if you're considered high income), you're covered
You've worked hard for your money. Keep more of it for yourself
As you work your financial plan throughout the year, recognize that taxes are a reality we all have to face. Planning for them appropriately can help you keep more of what you've earned while still keeping you in the good graces of the IRS. When all is said and done, that's a great path to take to help assure you're able to keep your money working effectively and efficiently for you.