Too often, we don’t think about how to lower our income tax burden until we’re getting our documents together for tax season. We suddenly realize how much we paid in taxes and worry about what we may still owe. While it is generally too late to do anything about last year, we can take steps to reduce our taxes this year. Consider these three income tax planning strategies:
1. Defer/Accelerate Income and Expenses
In some instances, you can time when you recognize income to save money on taxes. The first step is to figure out what tax bracket you’ll be in for this year and next. This can help you decide if you should defer or accelerate income this year.
The more well-known strategy is to defer income. Deferring income is the best option if you think you’ll maintain your current tax bracket or could move to a lower one. When you postpone income to the next year, you won’t owe taxes on that income until that year, since income is generally taxable the year you receive it. If you end up being in the lower tax bracket, you’ll pay less in taxes! That means more money in your pocket, and who doesn’t want that?
If your analysis shows you’ll likely move to a higher tax bracket in the next year—and, therefore, owe more in taxes—it might be a good strategy for you to accelerate your income. When you collect all the income you can before December 31st (even potential income you expect for the new year), you will be able to take advantage of your lower tax rate this year.
You may also be able to time your expenses. Another reason why knowing your tax bracket for the coming year is essential is because you can decide to pay bills early (even if they aren’t due yet). Are you wondering why you’d ever want to pay bills early?
If you are currently in a higher tax bracket than what you expect to be in next year, you can lower your tax bill by accelerating deductions this year. If you itemize, having tax planning strategies to prepay deductible expenses such as mortgage payments, state taxes, tuition, medical bills, and more can reduce your tax burden. On the flip side, if you expect to be in a higher tax bracket next year, defer those payments so you can increase your deductible expenses and therefore lower taxes.
Higher bracket this year / lower next year = defer income, prepay bills, accelerate deductions
Lower bracket this year / higher next year = accelerate income, defer bills, defer deductions
2. Consider Bunching Tax Deductions
Did you know that you can bunch deductions for multiple years into one year? Bunching deductions can help people who might fall short of being able to itemize or can do so only marginally. It can also help you take advantage of favorable tax laws.
For example, for the 2022 tax year, cash donations to public charities are deductible to 60% of AGI. When you choose to bunch, it can maximize your itemized deductions in one year, and then you take the standard deduction the following year. Another candidate for bunching is property taxes. Some local governments will allow homeowners to prepay property taxes, which then facilitates bunching. However, because of the SALT cap of $10,000, this option is better suited for people in lower tax areas.
Your decision to bunch or not is based on what you expect your tax bracket to be. If you’re in a higher tax bracket this year, it might make sense for you to bunch your deductions this year. But if you think you will have a higher tax bracket next year, take the standard deduction this year and bunch next year.
3. Don’t Miss Critical Tax Deadlines!
Mark your calendar now so you never miss a critical deadline. Here are a few to consider:
Traditional defined contribution plan
Every year, you can contribute a certain amount pretax (and therefore reduce your taxable income) to a traditional defined contribution plan for retirement. In 2022, if you’re under 50 years old, you can contribute up to $6,000 to a traditional or Roth individual retirement account (IRA). Those 50 and over can add in another $1,000 each year. When you maximize your contribution, you not only boost your retirement savings, but you may reduce current year tax liability. You have until April 15th of this year to contribute and count the contributions against last year’s taxes.
Employer-sponsored retirement plans
These plans, including 401(k), 403(b), SIMPLE IRAs and the like, are typically pretax) and also have contribution limits per calendar year. Individuals under 50 can contribute up to $20,500 per year, and those 50 and over can add an additional $6,500 per calendar year as catch-up contributions.
Health Savings Account (HSA)
If you have an HSA, you can set aside money pretax to pay for qualified medical expenses. The IRS has maximum contribution limits each calendar year. In 2022, an individual covered under a qualified high-deductible health plan (HDHP) can contribute up to $3,650 while families can contribute up to $7,300. Those 55 or older can catch up with another $1,000 a year in deposits. The beauty of an HSA is there is no “use it or lose it” provision. Unused balances carry over from one year to the next which makes this a popular place to save for medical expenses for those covered by an HDHP. And your contributions may help lower your tax bill.
Whether you donate cash, stocks, or property, you can not only do good with your donations and support causes important to you, but your generosity can also reduce your tax burden. You must make those donations before year-end to qualify for deductions. Don’t forget to get a written acknowledgment from the organization if you’re claiming a contribution of $250 or more.
Of course, everyone’s financial and tax situations are different, but our expert advisors can help determine the best strategies for your unique situation. Curious about other strategic wealth and estate management solutions that might work for you? Schedule an appointment today by calling 203-489-5362 or contacting us online. We look forward to sharing more smart solutions with you.