Towards the end of the year, a flurry of activity begins—and not just in the nation’s kitchens. With just a few months left in 2015, people are starting to think about 2016—and the tax bill that will be due in April.
You probably know that it is a good idea to do some year-end tax planning to try to reduce your 2015 tax bill. However what actually works, and what exactly should you do? Donate to charity? Sell some losing stocks? Pay January’s mortgage bill now?
The answer, of course, depends on your individual circumstances. While a certified financial planner or other professional can help you make a customized plan, here are some rules of thumb for when to try some common tax-reducing strategies—and when to skip them:
1) If your income fluctuates a lot from year to year, take a look at whether you can accelerate or defer some of that income. This strategy often works best for people who are self-employed, like small business owners, freelancers, and some doctors and dentists, or those who work on commission, like real estate brokers or other salespeople. If you are having a particularly good year, you could hold off on sending out a couple of end-of-year bills to push some of that income to next year. If it is a bad year—if you have just started a business or spent a lot on business expenses and your profits are low—see if you can pull some January income into December, in the hopes that your tax bracket will be lower this year than next.
For most people with traditional full-time jobs, accelerating or deferring income will not make a big difference. “When you have changes in income, that is a place where a lot of opportunities come in,” says John Scherer, a certified financial planner with Trinity Financial Planning.
2) If you are in a low tax bracket, you should consider tax-gain harvesting, Scherer says. This strategy works well for retirees who do not have a lot of income coming in, or for people with fluctuating income who are in a lean year, for example.
Most people know about tax loss harvesting, and for many investors, that is worth doing most years. “It is sort of like free money,” Scherer notes. But “tax gain harvesting, people do not talk a lot about,” Scherer says. Anyone who is in the 15% tax bracket (singles earning up to $37,450, or married couples filing jointly earning up to $74,900) will not have to pay capital gains tax, Scherer says. So any year you are going to end up in that lower tax bracket, you can lower your future tax bills by taking gains now, he says.
Here is how this works: You will sell some investments that have appreciated, and you will not pay any capital gains tax on them. You then immediately buy them again at today’s higher price—so you keep your investment portfolio the same, but later, when you need to sell those investments for income, your cost basis will be higher, and your tax bill will be lower.
3) If your deductions are close to the standard deduction amount, consider bunching your deductions. Generally, you should itemize if your itemized deductions will be greater than the amount of the standard deduction, which this year is $6,300 for single people. But if your itemized deductions are not adding up to much more than that standard deduction, you can bunch your deductions into on and off years and reduce your total tax bill, Scherer says.
Basically, you would pull as many deductions into this year as possible—pre-pay your January mortgage, property tax, or tuition bills, make 2016’s charitable contributions in December, and so on. You would itemize your deductions this year and take as many deductions as you can. Then, next year, you would have fewer deductions and take the standard deduction. You could save yourself a few thousand dollars over the course of two years through this method, Scherer says.
4) If you are subject to the alternative minimum tax, most deductions will not help you—except for deductions for charitable donations, Scherer says. So if you are subject to AMT, make sure you get receipts for all your donations, including donations of goods. Most people do not keep track of the value of, say, old clothes they are donating to Goodwill, but those donations can add up, Scherer says.
Of course, donating to charity only saves you money if you were going to donate anyway, Scherer notes. If you donate $1,000 and it saves you $250, you are still out $750; so do not donate just for the tax deduction. “It is like buying something at the store that is on sale—you are still out the money,” Scherer says.
Make sure all your tricks and tips are really worth it to your personal bottom line. Look for strategies that make sense for your personal situation, and do not spend money just to save money.
SigFig Wealth Management is not a tax advisor. All decisions regarding the tax implications of your investments should be made in consultation with your independent tax advisor. SigFig Wealth Management does not provide tax or legal advice. This material is not intended to replace the advice of a qualified tax advisor, attorney, accountant, or insurance advisor. Consultation with the appropriate professional should be done before any investment decisions are made. The material contained herein is for informational purposes only and does not constitute tax advice. Investors should consult with their own tax advisor or attorney with regard to their personal tax situation.
Sarah Morgan is a freelance writer and editor based in Brooklyn. Her work has appeared on SmartMoney.com and in the Wall Street Journal.