The end of the year often serves as a reminder to evaluate our lives and set goals for the future (even if we don’t call them resolutions). For many, this includes putting a magnifying glass to their finances.
There is no better time to think about your investments and budgets and to make a plan for the upcoming 365 days. One thing that is often left out of this plan however, is how taxes will play into the equation.
Tax season might still be several months away, but now is actually the best time to begin preparing for April 15th, because you can still make moves to lower your 2014 taxes and can make plans to keep your taxes down next year.
(MORE: 7 Key Changes to the 1040 Tax Form)
Here are seven steps to do this. They go beyond simply updating your tax software and gathering your W2s. The goal: to make sure you’re kicking off 2015 as financially fit and tax-ready as possible.
1. Find last minute deductions for 2014. There are a number of different ways to reduce your taxable income for 2014 before the end of the year.
First, consider putting more money into a pre-tax retirement savings account, such as a 401(k) or traditional IRA. Just remember not to exceed the 2014 contribution limits: $5,500 for an IRA if you’re under 50 ($6,500 for people 50 and up) and $17,500 for 401(k)s ($24,000 if you’re 50 or older).
Donating to charity in November or December lowers your taxable income, too, and gives you a tax deduction. Check with your tax adviser first to determine the maximum amount you can deduct based on your income.
(MORE: Why Begin Year-End Retirement Planning Now)
2. Take a financial inventory. This will help you position your investments properly for 2015. Determine how much money you have in your pre-tax and after-tax 401(k)s and IRAs. This will help you understand what taxes are going to be deducted from your current year’s income and what will be taxed in retirement.
Sit down with your financial and tax planners to help make a more informed action plan for your year-end retirement and tax planning. It could save you money in taxes this year and in retirement.
3. Know your effective tax rate. You’re probably familiar with your tax bracket but you might not know your effective tax rate — that’s the percentage of your total income that you pay in taxes every year. For example, if your net income is $90,000 and you file as single, you’re in the 25 percent bracket for taxes of $18,300. However, after deductions, your total taxable income might drop to $80,000. So your effective tax rate — your total taxes actually paid divided by your taxable income — is slightly lower: 22 percent.
Why is this important to understand now?
Knowing your effective rate can help you determine whether to allocate money before the end of the year in a traditional pre-tax 401(k) or use an after-tax Roth account instead.
If you believe your effective rate is likely to be lower now than when you retire (either because you will be making more money or because you expect taxes to increase), you may want to have your money taxed now by putting it into a Roth savings option before year-end.
(MORE: 7 Ways to Avoid an Audit)
4. Make conversions count. Once you understand the impact of your effective tax rate on retirement planning, go back to your inventory. Ask yourself: Do you have more retirement funds in pre-tax money than in other categories? If the answer is “yes” (which it is for many people, thanks to 401(k) plans) and you think your effective tax rate will increase in retirement, you may want to consider a series of Roth conversions which must be done by December 31st to count for this year’s taxes. (Either a financial adviser or your investment company can set up a Roth conversion account.)
Roth conversions let you move money in small increments into a taxable retirement vehicle like a Roth IRA. Since this conversion is a taxable event, you would be paying taxes on the money now.
Doing conversions year over year, a little at a time and ideally with the guidance of your financial and tax advisers, can help minimize taxes in retirement.
5. Address any 2015 withholding issues. Are you afraid you'll owe taxes next year? Rather than waiting to see if you have an issue, run the numbers now — with your tax professional or tax software. Then, make any necessary adjustments to your withholdings before the New Year to help avoid a tax bill next year. Conversely, if you expect to get a refund, lowering your 2015 tax withholdings can give you more disposable income every month next year.
6. Make the most of your 2014 investment losses. This has generally been a good year for investors. Still, you may have had some paper losses, particularly if you owned retail stocks. If so, you may want to sell those investments and incur those losses this year, allowing you to can write off some of them when you file your taxes in April — especially if you do not think the investments are going to recover.
Just remember that the amount of investment losses that you can write off is limited tp $3,000 per year. You’ll need to talk with your tax professional and financial adviser to assess whether selling the losses makes sense.
7. Leverage your resources. If you have taken advantage of a Flexible Spending Account (FSA) this year to lower your taxable income, check to see how much money is left in your account. If you don’t spend the money you put away by December 31, you will lose it. (A Health Savings Account (HSA) also lets you lower your taxable income, but it allows you to roll over your account balance year to year.) Should you have any FSA money remaining, try to use it up by taking care of doctor appointments, flu shots and other medical expenses.
Too many of us wait until we file our taxes in the spring to learn what we should have done to create a better tax picture for the year. Take time now and be proactive; it’ll help you go into 2015 wiser about your tax situation.
Voya Retirement Coach Holly Kylen is a financial adviser with Voya Financial Advisors, the broker-dealer of Voya Financial. She is an author of a Retirement Planning for Women seminar and serves on Voya’s Women Advisors Network Board. Securities and Investment advisory services offered through Voya Financial Advisors, Inc., (member SIPC). Neither Voya Financial Advisors nor any of its agents or representatives provides legal or tax advice. For complete details, consult with your tax adviser or attorney.
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