As 2023 comes to an end, it’s time to review your situation and take advantage of opportunities to reduce your tax bill. Whether you’re a high-income earner, self-employed, or a retiree, there are some moves you can make before December 31st to lower your tax bill. Let’s review them:
1. Max Out Your Retirement Savings
The easiest way to lower your taxable income and save for the future is to contribute as much as possible to your retirement accounts. Depending on your income and eligibility, consider the following:
- Maximize 401K contributions – $22,500 for most
- Mega Backdoor Roth if your 401K allows it. This allows you to get $66,000 overall into your 401K.
- IRA or Roth IRA contributions – $6,500
- If income is too high, consider a backdoor Roth contribution (watch out for the pro rata rule!).
2. Harvest your Tax Losses
Another way to save on taxes is to review your investment portfolio and sell any investments that have lost value since you bought them. This is called tax loss harvesting, and it can help you offset your capital gains and reduce your taxable income. Here’s how it works:
- Capital losses will first offset capital gains of the same type (short-term or long-term). Short-term capital gains are taxed at your ordinary income tax rate, while long-term capital gains are taxed at a lower rate (0%, 15%, or 20%, depending on your income).
- If you have more capital losses than capital gains, or if you have no capital gains at all, you can use up to $3,000 of your capital losses to offset your ordinary income.
- If you still have unused capital losses after offsetting your capital gains and ordinary income, you can carry them forward to future years and use them to offset future capital gains and $3,000 of ordinary income annually. There is no limit to how long you can carry forward your capital losses.
Tax loss harvesting can also help you rebalance your portfolio and align it with your investment goals and risk tolerance. However, beware of the Wash Sale rule. You cannot claim a tax loss if you buy the same investment within 30 days of the sale.
3. Make Estimated Tax Payments
If you’re self-employed, have large capital gains, or otherwise receive significant income without income taxes withheld, you may have to make estimated tax payments to avoid an underpayment penalty when you file your taxes. Estimated tax payments are due four times a year: April 15, June 15, September 15, and January 15 of the following year.
4. Take Required Minimum Distributions (RMDs)
If you are 73 or older, you have to take required minimum distributions (RMDs) from your qualified retirement accounts, such as 401(k)s, IRAs, and 403(b)s. RMDs are the minimum amount you have to withdraw from your accounts each year, based on your account balance and life expectancy.
If you fail to take your RMDs on time, you will face a stiff penalty from the IRS: 25% of the amount you should have withdrawn but didn’t. That’s one of the highest penalties in the tax code, so make sure you don’t miss the deadline.
5. Make a Qualified Charitable Distribution (QCD) from Your IRA
If you’re over 70 ½ and charitably minded, consider making a qualified charitable distribution (QCD) from your IRA to help lower your tax bill. A QCD is a direct transfer of money from your IRA to a qualified charity, up to $100,000 per year. The QCD counts as part of your RMD, but it’s not included in your taxable income.
To make a QCD, you have to follow some rules and requirements:
- You have to be at least 70 ½ years old at the time of the distribution.
- You have to transfer the money directly from your IRA to the charity. You can’t withdraw the money yourself and then donate it to the charity.
- You have to transfer the money to a qualified charity. A qualified charity is one that is eligible to receive tax-deductible donations, such as a 501©(3) organization. You can’t transfer the money to a donor-advised fund, a private foundation, or a supporting
6. Use your Flexible Spending Account (FSA) Balances
If you have a flexible savings account (FSA) through your employer, you can use it to pay for qualified medical expenses with pre-tax dollars. This can help you lower your taxable income and save on taxes. However, FSAs have a ‘use it or lose it’ rule, which means that you have to spend the money in your account by the end of the year, or you will forfeit it. Some employers may offer a grace period until mid-March of the following year.
If you have a health savings account (HSA), you don’t have to worry about the ‘use it or lose it’ rule, as you can carry over your balance indefinitely.
7. Estate Plan Gifting
If you have a large estate and you want to reduce your estate tax liability, you may want to consider gifting some of your assets to your heirs or beneficiaries. You can give up to $17,000 per person per year in 2023 without triggering any gift tax or using up any of your lifetime gift tax exemption. This is known as the annual gift tax exclusion, and it can help you transfer wealth to your loved ones without paying any taxes. You can give cash, stocks, bonds, real estate, or any other asset, as long as you don’t retain any control or interest in it. You can also give more than $17,000 per person per year, but you will have to file a gift tax return and use up some of your lifetime gift tax exemption
If you itemize rather than take a standard deduction on your taxes, consider bunching your deductions. This is a strategy where you try to concentrate your deductible expenses into one year, rather than spreading them over multiple years. This way, you can increase your itemized deductions and lower your taxable income in that year, and then take the standard deduction in the other years.
One of the most common expenses that can be bunched is charitable donations. If you are generous and donate to your favorite causes, you may want to make two years’ worth of donations in one year, and then skip the next year. This can help you boost your itemized deductions and save on taxes. However, you have to make sure that you have enough cash flow to make the larger donations, and that you don’t exceed the limit for charitable deductions, which is between 20-60% of your adjusted gross income depending on the type of donation and charity.
9. College Savings
If you have kids or grandkids, consider saving into an Educational Savings Account (ESA) or 529 plan. While contributions don’t reduce your federal taxable income, they grow tax-free as long as proceeds are used to pay for qualified educational expenses.
Additionally, some states give tax breaks for 529 plan contributions.
When you’re self-employed you may have some discretion over the timing of your business expenses. Obviously, they have to be legitimate expenses that the IRS would view as ordinary or necessary. But you might consider trying to time some of your bigger discretionary expenses to occur in a year in which you expect your income to be higher.
There are many ways you can save on taxes in 2023, but it’s important to act fast and plan ahead. Tax planning can be complex and confusing, and every situation is different. Therefore, you should consult a professional tax advisor before you make any decisions or take any actions. At Sophos Wealth Management, we can help you with your tax planning and wealth management needs. Contact us today to schedule a free consultation and see how we can help you achieve your financial goals.
Scott Caufield, CFA, CPA