Tax Planning for a New Year-Are You Prepared?
January 6, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial
A new year has arrived, and with it comes the opportunity for new starts, accompanied by lots of resolutions about what’s going to change…this time. We can’t help you with your resolution to go to the gym more, lose weight, swear off sugar, quit smoking, or drink less, other than to offer a heartfelt “Good luck.” However, as your 2019 income taxes take shape, you may find yourself suffering some financial regret. If so, take heart: When it comes to taxes, the new year truly does give you a chance to start fresh. That means now is the time to tackle your 2020 tax planning.
To Itemize or Not to Itemize
As you may know, the Tax Cuts and Jobs Act of 2017 (TCJA) reduced or eliminated quite a few common deductions but raised the standard deduction in addition to modifying the tax brackets. For 2019, the standard deduction is $12,200 for single filers and $24,400 for joint filers; in 2020, those amounts will increase to $12,400 and $24,800 respectively. Married taxpayers who are blind or age 65 and up gain an additional $1,300 deduction, and if both joint filers meet one of those conditions, the total is $2,600. For single taxpayers, the additional deduction is $1,650.
Alternatively, if you have deductions available that are greater than the standard deduction, you will benefit from itemizing. However, between the doubling of the standard deduction and the aforementioned reductions and eliminations of deductions, an even greater number of taxpayers will benefit more from the standard deduction. Keep in mind that, for example, the state and local tax deduction is now limited to $10,000, the casualty and theft loss deduction has been eliminated (with certain exceptions), and the deductibility threshold for medical and dental expenses is now back at 10% of adjusted gross income (AGI).
The most important factor with deductible expenses is documentation. This is especially true for charitable donations; you are now required to have a receipt from the recipient organization for any donation over $250. Good records are also advisable if you have sufficient medical expenses to itemize.
If you use some type of personal financial software and are disciplined about staying current and making accurate entries, chances are good that you can estimate your 2019 tax liability (or refund — let’s stay positive here!) as soon as the year ends. In all likelihood, that estimate will be a worst case, as your tax professional is likely to find ways to reduce your taxable income. The main benefit is that you will be able to tell whether you are even close to the threshold for itemizing deductions. If the answer is yes, you can start getting your records together long before your first visit to your tax preparer.
Maximize Your Tax Deferrals
Part of the reason the U.S. tax code is so byzantine is that the federal government loves to use taxes as a policy tool. Congress thinks home ownership is a good thing? We’ll make mortgage interest deductible. We should encourage people to seek higher education? We’ll make student loan interest deductible. You get the idea. Still, a great benefit of this taxation-as-policy is the various tax-deferred vehicles that were created to encourage retirement savings as defined-benefit plans began disappearing, the main ones being the 401(k) and IRA, and the HSA that was created to help with rising health insurance deductibles.
If you have access to a 401(k) (or one of its cousins, the 403(b) and 457 plans), it should be your first choice for retirement savings. There are two main reasons. First, the deduction limits are higher than with IRAs: $19,000 in 2019 and $19,500 in 2020, with additional “catch-up” limits for those 50 and older of $6,000 in 2019 and $6,500 in 2020. Second, most plans offer an employer match, and who doesn’t love free money?
Some younger people find it tough to max out 401(k) contributions early in their careers thanks to lower salaries combined with student loan payments and the costs of starting a family or just plain getting going in the adult world. That’s understandable, but you should always contribute enough to your 401(k) to receive the maximum employer match. For example, many plans feature a maximum 3% employer match against a 6% employee contribution.
If you don’t have access to a 401(k), open an IRA. Unfortunately, the contribution limits for both traditional and Roth IRAs will remain at their 2019 level of $6,000 in 2020 (plus an extra $1,000 catch-up allowance as with 401(k) plans). Roth IRA contribution limits phase out for high-income taxpayers (in 2020, an AGI of $124,000 for single filers and $196,000 for joint filers). However, there is a tax planning technique sometimes called the “backdoor Roth” that uses after-tax dollars to make a nondeductible contribution to a traditional IRA, which is then converted to a Roth. (This is one of those things that requires an individual discussion with your financial or tax advisor.)
Know The Benefits of a Health Savings Account and Flexible Spending Account
While not everyone is a fan of the Affordable Care Act, or for that matter the current state of the health insurance market, the prevalence of high-deductible health plans means that you’re probably eligible to contribute to a Health Savings Account (HSA). For 2020, the contribution limits are $3,550 for those with individual health plans (up from $3,500 in 2019) and $7,100 (up from $7,000 in 2019) for those with family coverage.
If you’re more familiar with the original Flexible Spending Account (FSA), the HSA has multiple advantages. FSA funds have to be used by year-end, whereas your HSA balance can roll over to the following year. FSA contributions are fixed at the level you choose at the beginning of the year, but HSA contributions can change contribution amounts at any time during the year. HSA account funds can be invested; FSA balances cannot.
Most importantly, the employer owns an FSA, but you own your HSA, so it is fully portable if you change jobs. Also, while employers can contribute to your HSA, you keep those funds if you leave. At age 65, the account holder can withdraw funds for any purpose (although withdrawals that are not for medical expenses are taxable income), so in a way the HSA is like a mini-IRA.
The main requirement to contribute to an HSA is participation in a high-deductible health plan (HDHP); FSAs do not carry that requirement. If you change to a plan that does not qualify as an HDHP, you can keep your existing HSA, but you cannot contribute to the plan during any period when you are not covered by an HDHP.
These are some of the common tax planning strategies that affect a large percentage of taxpayers. If you are in a less common category, such being as a high-income earner or having a large amount of non-wage income, there are many nuances in the tax code that can affect your tax situation. Regardless of your category, you should speak to a financial or tax advisor to determine what changes you can make in 2020 to optimize your tax liability.
To learn more about year end tax planning read this post.