No matter your income level or age, it's always a good idea to keep your tax bill to a minimum and stay on top of tax-related matters. Here are a few smart tax strategies to incorporate in the course of 2021.
1. Max out your retirement plan contributions
Whether you're saving for the future in an employer-sponsored 401(k) or an IRA, the more money you put into your plan, the less tax you're likely to pay. Now this does assume that you're saving in a traditional 401(k) or IRA, not a Roth. Roth accounts offer numerous tax benefits, but contributions aren't tax-free. But with a traditional 401(k) or IRA, the money you put in is income the IRS won't tax you on.
The contribution limits for 2021 are as follows:
- $6,000 in an IRA if you're under 50
- $7,000 in an IRA if you're 50 or older
- $19,500 in a 401(k) if you're under 50
- $26,000 in a 401(k) if you're 50 or older
Note that these limits did not increase from 2020.
2. Max out your health savings account
With a health savings account, or HSA, you can set aside funds for medical expenses that can be used immediately or invested and carried into the future. Like traditional IRAs and 401(k)s, HSA contributions are made with pre-tax dollars, so any money you put in is income the IRS won't be able to tax.
Eligibility for an HSA depends on your health insurance plan. If you have an annual deductible of $1,400 or more as an individual and an out-of-pocket maximum of $7,000 or less, you'll qualify for an HSA. If you're saving on behalf of a family, you'll need a deductible of $2,800 or more with an out-of-pocket maximum of $14,000.
Assuming you qualify, the 2021 HSA limits are:
- $3,600 for individuals under 50
- $7,200 for families when the plan participant is under 50
- $4,600 for individuals 55 and older
- $8,200 for families when the plan participant is 55 and older
3. Max out your flexible savings account
If you're not eligible for an HSA, a flexible spending account, or FSA, is your next best bet. With an FSA, you can allocate tax-free dollars to pay for both healthcare expenses for your family and dependent care for your children. The maximum contribution toward healthcare in 2021 is $2,750, while the maximum dependent care contribution is $5,000. These limits are actually unchanged from 2020.
One thing you should know is that FSA funds work on a use-it-or-lose-it basis. Unlike HSAs, you can't carry funds into the future, so you'll need to do a good job of estimating your 2021 expenses in time for your employer's enrollment deadline. Also, you can only use your healthcare FSA for medical expenses, and your dependent care FSA for day care, summer camp, or other child care costs. You can't, for example, use your dependent care FSA to cover a prescription copay.
4. Sign up for commuter benefits
If you commute to work, you can allocate pre-tax dollars to pay for that expense. It's a workplace perk known as commuter benefits, and it's effectively a transit FSA. In 2021, you can designate up to $270 per month for transit, such as a bus or train pass, and up to $270 a month for parking fees. These numbers are unchanged from 2020.
5. Hold investments at least a year and a day before selling at a profit
When you sell investments for more than what you paid for them, you're subject to taxes on your capital gains. But the amount of tax you'll pay will depend on how long you hold your investments before taking in that profit.
If you hold your investments for a year or less, you'll face short-term capital gains taxes, and the rate you'll pay is the same as your ordinary income tax rate. On the other hand, if you hold your investments for at least a year and a day before selling, you'll bump yourself into the much lower long-term capital gains category, where the tax rate you'll pay could be as low as 0% and will max out at 20%. Most people, however, pay only 15% on long-term capital gains.
Here's how this benefits you. Say you're single and earn $100,000 a year. If you sell investments that are subject to short-term capital gains, your tax rate will be 24%. If you sell investments that are subject to long-term gains, you'll pay just 15%.
Even if you're a higher earner who's subject to the 3.8% net investment income tax, you'll still fare a lot better paying long-term capital gains than short-term gains. In that scenario, your total capital gains tax rate could be 23.8% (20% plus 3.8%) versus 40.8% (the top marginal tax rate of 37% for single tax filers plus 3.8%).
6. Harvest losses from underperforming investments
If you have investments in your portfolio that have been down for quite some time and aren't likely to recover, selling them at a loss could benefit you tax-wise. You can use capital losses to offset capital gains, and if your losses exceed your gains, you can use up to $3,000 in losses to offset ordinary income (in other words, the IRS won't tax up to $3,000 of your earnings). Furthermore, capital losses can be carried from year to year, so if you have a remaining loss once you've offset your gains and $3,000 of income, you can use the remainder to lower your 2022 taxes.
7. Donate money to charity
If you itemize on your tax return, donating money to a registered charity will give you a higher deduction to claim. Be sure to retain receipts and track your contributions accurately. You can also donate stocks to charity and get a tax write-off that way. Not only will you get to deduct the fair market value of those stocks, provided you've held them for over a year, but you'll also avoid paying capital gains taxes if those stocks have appreciated since you first bought them.
8. Donate goods to charity
It's not just cash donations that can serve as a tax break. If you donate goods to a registered charity, you can deduct their fair market value (the amount they'd sell for at present, not their original value) on your taxes as well if you itemize. Just be sure to keep copies of all donation receipts. Incidentally, if you have a vehicle you no longer use, you can donate it to charity as well.
9. Invest in municipal bonds
Municipal bonds are a good way to generate semiannual income via interest payments without taking on the same risks you'll face when you buy stocks. Furthermore, like corporate bond interest, municipal bond interest is always exempt from federal taxes, and if you buy bonds issued by your state of residence, you won't pay state or local tax on that interest income either.
10. Invest in an opportunity zone (please seek professional investment advice)
The Tax Cuts and Jobs Act of 2018 created opportunity zones, a program that allows you to invest in low-income areas that can benefit from economic development. Among other tax breaks, these special zones allow for a multi-year deferral of capital gains taxes. Specifically, capital gains aren't taxed until the end of 2026, so if you're willing to dabble in real estate investing, opportunity zones could be a good choice.
11. Fund a 529 college savings plan
If you have children who you'll eventually want to send to college, or who attend or will attend private school, then it pays to open a 529 savings plan. With a 529, you can invest your money for added growth, and you won't pay taxes on your gains or withdrawals provided you use that money for qualified education expenses. While 529 plan contributions aren't tax-free at the federal level, some states offer individual tax incentives for funding a 529.
12. Get a good accountant
You don't need to be rich to benefit from the advice of a seasoned, savvy tax professional. If your tax situation is at all complex, it pays to find an accountant who can review your finances with you and help you make smart choices that lower your tax burden. But don't wait until tax season to get an accountant. Rather, get the ball rolling as early in the year as you can.
13. Put estimated quarterly tax payments on your calendar
If you're self-employed, you'll need to pay the IRS taxes in quarterly installments to avoid penalties down the line. It pays to keep those deadlines in mind so you can plan for them ahead of time.
Estimated quarterly taxes in 2021 will be due as follows:
- March 15: first payment
- June 15: second payment
- September 15: third payment
- January 15, 2022: fourth payment
14. Adjust your tax withholding
If you typically get a large tax refund from the IRS, then it could pay to adjust your withholding to have less tax taken out of your paychecks month to month. The more allowances you claim on your W-4, the less tax your employer will withhold. Of course, if your last tax return resulted in a huge underpayment on your part, then it could pay to claim fewer allowances on your W-4 so that more tax is withheld during the year. Ultimately, your goal should be to break even, or get as close to it as possible, so that you don't get a huge refund but also don't owe the IRS a ton of money when you file your taxes.
15. Make an early mortgage payment
If you're planning to itemize on your 2021 taxes, there's a good chance your mortgage interest deduction will be one of your most substantial write-offs. And you can maximize that benefit by making your last mortgage payment of the year a bit early. Generally, your December mortgage payment will be due the following Jan. 1. But if you make that payment on Dec. 31, it'll count for 2021, which means you'll have more interest to write off.
16. Bunch deductions for a higher tax benefit
If you're on the fence between itemizing on your 2021 tax return or claiming the standard deduction, it pays to consider bunching your deductions – cramming more deductions into 2021 and then taking fewer deductions the year after and not itemizing then. For example, if you typically give $5,000 to charity each year, you might consider donating $10,000 in 2021 and itemizing that year, and then giving nothing in 2022 when you take the standard deduction.
In 2021, the standard deduction is as follows:
- $12,550 for single taxpayers and married individuals filing separately
- $18,800 for heads of household
- $25,100 for married couples filing jointly
Be as tax-savvy as you can
The more strategic you are on the tax front, the less money you'll need to pay the IRS in 2021, and the less financial stress you'll have. It pays to incorporate these moves into your 2021 tax plans, whether you're a higher earner with multiple income streams or an average earner who's keen on reaping as much savings as possible.
Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
This Week’s Author, Mark Bradstreet, CPA