How often do you plan for your taxes?
When we say plan, we mean: think about how you can structure your finances in a way to minimize your taxes, both in general and as tax laws and IRS guidelines change from year-to-year.
Do you think about that other than when it’s time to file your tax return?
If the answer is “not really,” you’re not alone.
With a new year comes new opportunities, and now is the perfect time to set a goal to pay closer attention to your taxes with some general tax planning – which could result in more dollars in your wallet in the future. Monitoring your tax situation more regularly can help ensure you’re on the right track and can help you avoid any surprises when it finally comes time to file your tax return.
See below for some considerations to help you plan and strategize for the upcoming year.
Increased Limitations & Deductions for 2022
High inflation isn’t all that bad. Every year, the tax code requires the Internal Revenue Service (IRS) to adjust dozens of tax provisions for inflation, benefitting millions of taxpayers. Some of these inflation-based adjustments affect income thresholds for individual tax brackets, as well as the standard deduction. As we are currently experiencing higher-than-normal inflation, there were several notable increases to be aware of for 2022, including:
- 401(k) contributions increased to $20,500
- Health Savings Account contributions increased to $3,650 for individual plans and $7,300 for family plans
- Flexible Spending Account contributions increased to $2,850
- The estate tax exemption increased to $12,060,000
- The annual gift tax exclusion increased to $16,000
These increased thresholds can help you save more and better plan for your future with this general tax planning. As it’s still early in the year, now is the perfect time to make sure that you are taking advantage of these new limitations.
Current Tax Law Changes
The past couple of years have brought an onslaught of changes to our lives, including significant changes to the tax code. As a result of the pandemic, Congress implemented several tax laws to assist with the economic recovery. Many taxpayers who benefitted from these provisions will need to be prepared for the upcoming year as many of these temporary tax laws have since expired. Some of the tax provisions that expired at the end of 2021 include the advance child tax credit, the expanded earned income tax credit and the expanded dependent care credit. There were even special allowances for certain charitable contributions that are no longer available, including the additional $300 charitable deduction for taxpayers who claim the standard deduction
Even though you are now establishing a plan for 2022 and what lies ahead, it’s always a good idea to look back to analyze what changes you may be facing this year. It’s important to think about the tax laws that expired in 2021, as you may no longer be able to take advantage of certain deductions and credits that you recently relied on.
Future Tax Law Changes
With the Democrats in complete control of Congress, it is likely we are going to see even more tax law changes this year. The Democrats have been pushing for a social spending package called the Build Back Better Act (H.R. 5376) that would have included numerous tax law changes impacting retirement accounts, surtaxes for high-earners and expanded tax credits. While the bill successfully passed the House of Representatives, it failed to advance in the Senate. Even though the bill has since stalled, the Democrats have continued to advocate for tax reform and the members of the Senate are still expected to draft their own legislation.
This tax bill might include similar provisions to those included in the Build Back Better Act, and similarly, could become effective at any time during the year. So be sure to stay current on this legislation as it may have a significant impact on your 2022 tax return.
Roth IRA Conversions
A Roth IRA conversion allows you to transfer (‘convert’) before-tax dollars from your traditional IRA to an after-tax Roth IRA. A Roth IRA has certain benefits over a traditional IRA in that it allows you to eliminate all income taxes on both earnings and future distributions. Unlike a traditional IRA, there are no required minimum distributions with a Roth IRA, and you are even able to pass it on to your heirs free of income tax. While the conversion will likely result in an immediate tax liability, it can be an advantageous move in the long run. As we are currently experiencing historically low tax rates; recognizing the income now can potentially help you pay less in taxes on your retirement distributions.
Another conversion strategy to consider is the backdoor Roth IRA. This strategy allows taxpayers to fund a Roth IRA even if their income is too high and would otherwise be disqualified from making a direct Roth contribution. To complete a backdoor Roth conversion, you would first make a non-deductible IRA contribution to a traditional IRA. Once the traditional IRA is funded, you can transfer those funds over to a Roth IRA. While there is no time limit as to when you must convert the funds, it is recommended that they be transferred as soon as possible to avoid any unintended tax consequences. In addition, there is one caveat with this strategy to be aware of. If you have any pre-tax dollars in a traditional IRA (meaning you received an income tax deduction when the IRA contribution was made), the backdoor Roth IRA will likely result in a tax liability as there is a rule that requires the converted amount include a portion of your pre- and post-tax dollars.
The latest tax proposal by Congress included a provision that would prohibit the backdoor Roth IRA, so this could be the last year that this strategy is allowed for general tax planning. Depending on the situation, a Roth conversion could result in adverse consequences, so it is important to consult with a financial planner to ensure this is the right move for you.
If you make charitable donations every year, consider bunching your contributions for some general tax planning. Bunching involves consolidating your charitable contributions that would typically be made over multiple years, into a single tax year. With the standard deduction at an all-time high, many taxpayers who make charitable donations won’t see a tax benefit as they no longer itemize deductions. Bunching your donations can help you exceed the standard deduction threshold and therefore receive a larger tax benefit for your charitable contributions.
If you are considering bunching your contributions, but still want to support a charity each year, look into contributing to a donor-advised fund. A donor-advised fund is essentially a charitable investment account where contributions made are generally eligible for an immediate tax deduction. The donor can then recommend grants be made from the donor-advised funds to charities over several years. Funding a donor-advised fund with highly appreciated stock can also provide additional tax benefits aside from just a charitable deduction. With the stock market near its all-time high, a gift of appreciated stock not only can give you the benefit of a charitable deduction but can also allow you to avoid paying capital gains taxes on any appreciation.
The tax code also has a special allowance for charitable contributions for individuals with a traditional IRA who are over age 70.5. These contributions are known as Qualified Charitable Distributions (QCDs) and are made directly out of your IRA account. While you don’t get to claim an itemized deduction for these donations, they can still be quite advantageous. For instance, when you reach age 72 you can satisfy your required minimum distributions by distributing those amounts directly to charity, avoiding any income tax on the withdrawals.
Planning for the Year Ahead
As you work towards getting your tax return filed over these next few months, now is the perfect time to get started on general tax planning for the rest of the year. While everyone’s financial situation is unique, there is likely a tax strategy that could be beneficial for you. And if we’ve learned anything over the past few years, it’s that a lot can change in an instant, even the tax code. So, look to get yourself as prepared as possible and get ahead of tax planning to ensure you are taking advantage of every opportunity available to you.
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