It’s officially the holiday season.
For many folks, it’s a time for slowing down, celebrating with loved ones, and reflecting on the year that was.
That means taxes are probably the last thing on your mind right now.
However, there are a handful of steps you should consider taking before year-end to potentially save yourself some money (and stress!) during the 2023 tax season. And fortunately, most of them are relatively straightforward.
1. Take required minimum distributions (RMDs) if applicable.
Investors over the age of 72 are required to make a minimum withdrawal – known as an RMD – from tax-deferred retirement accounts like 401(k)s before Dec. 31 this year. (Though folks who just turned 72 this year have until April 1 next year to take their first RMD.)
If you fail to take an RMD before the deadline, you could be subject to a 50% penalty on the required sum. And because RMDs currently start at 3.66% of an account’s prior year-end value and increase with age, this can represent a significant (yet easily avoidable) expense.
Most folks take RMDs in cash. However, depending on your account type and the investments you hold, you may be able to take an “in-kind” distribution, where you simply transfer the required value of assets from your retirement account to a taxable account.
This strategy can allow you to take an RMD without selling those assets. However, you will then be required to pay taxes on the value of those assets, so be sure to check with a tax adviser before doing so.
2. Maximize your 401(k) contributions.
Another simple way to reduce your 2023 tax bill is maxing out your traditional 401(k) contributions if you haven’t already done so.
In 2022, investors can contribute up to $20,500 to 401(k)s and similar plans. (Those age 50 or older can contribute up to $27,000.) And every dollar you contribute to these plans represents one less dollar of income that the government can tax this year.
If you’re looking for more guidance on getting the most out of your 401(k), be sure to check out the short series I shared earlier this year:
3. Convert a traditional IRA to a Roth IRA.
This step won’t reduce your tax bill for 2022, but it could save you a fortune in taxes down the road.
Unlike a traditional, tax-deferred IRA (individual retirement account), a Roth IRA allows you to enjoy tax-free withdrawals in retirement. Unfortunately, many folks can’t contribute to these accounts due to income limits.
If you’re among them, year-end is also a good time to consider converting some or all of a traditional IRA into a Roth.
That’s because converted assets qualify as ordinary income, which can potentially push you into a higher tax bracket. Making this move near year-end will allow you to transfer as much value as possible while also ensuring you don’t have to pay a higher tax rate than necessary.
4. Make a charitable donation.
Donating to qualified charities is a great way to embrace the holiday spirit and potentially reduce your tax bill at the same time. The IRS generally allows you to deduct the value of cash donations up to 60% of your adjusted gross income.
This step can be handy for folks whose incomes are near the lower boundary of a given tax bracket and who have already maximized their tax-deferred retirement contributions.
Charitable donations can also help folks meet their RMD requirements as well. Specifically, those 70 1/2 or older can donate up to $100,000 to a charity directly from their IRA using a qualified charitable distribution (QCD).
QCDs don’t qualify for a tax deduction like other donations. However, they can be a helpful way to fulfill some or all of your RMD without increasing your taxable income.
Finally, it won’t necessarily help your tax bill, but this is also a good time to make any monetary gifts to friends or loved ones. This year, you can give away up to $16,000 (or $32,000 for married couples) to an unlimited number of individuals without triggering the federal gift tax or impacting your lifetime estate and gift tax exemption.
5. ‘Harvest’ some investment losses.
The last money-saving step to consider is “tax-loss harvesting.”
This strategy simply involves selling losing investments. That creates a “realized capital loss” in tax-speak, which can then offset an equal amount of realized capital gains (profits) in other assets that year.
Capital losses can also offset up to $3,000 in ordinary income each year. And any unused losses can be rolled forward to future years indefinitely.
As a simple example, suppose you sold your position in stock ABC earlier this year for a $10,000 profit, and you will owe $3,000 (30%) in taxes on that gain at your current tax rate.
However, suppose you also own stock XYZ, which is currently showing a loss of $15,000.
If you sell your position in XYZ, that $15,000 loss will completely offset the $10,000 gain in ABC and eliminate that entire $3,000 from your tax bill. You could then apply the remaining $5,000 loss to offset up to $3,000 in ordinary income, reducing your tax bill by another $900 (30% of $3,000).
With this one move, you’ve deferred nearly $4,000 in taxes this year and can “carry over” the remaining $2,000 to offset additional gains or income in future years.
As you can see, this strategy can be a powerful way to lower your tax bill, especially in difficult years like this one when you may still be holding on to some investments that have fallen significantly below your cost basis.
Taking advantage of tax losses is simple in principle. However, there are some tricks and potential pitfalls you should know about before using this strategy for yourself. So next week, we’ll take a closer look at the ins and outs of effective tax-loss harvesting.