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6 Questions to Consider when Prepping for Tax Season

Tax filing season may be months away, but it’s never too early to think about implementing a tax strategy that could save you money. Before the year passes you by, consider the following questions to help ensure you’re not missing out on potential tax benefits.

Questions about taxes that could save you money

  1. What are my withholdings and estimated tax payments?

  2. Have I maximized my retirement account contributions?

  3. Do I need RMDs?
  4. What is the cost basis of my investments?
  5. Are my investments tax-efficient?
  6. Have I maximized my charitable contributions?

Verify withholdings and estimated tax payments

Double-check your withholding and estimated tax payments. After the tax law changes from the Tax Cuts and Jobs Act (TCJA), it’s more important than ever to review your withholding and estimated tax payments.

Many people think getting a big tax refund is a good thing. Unfortunately, the IRS does not pay you interest on the refund it sends you. Having too much money withheld from your paycheck—or overpaying your quarterly estimated tax payments—means you’re forgoing the potential interest or returns that money could have generated.

On the other hand, withholding too little can lead to a large bill at tax time, an unpleasant surprise if you haven’t planned for it. Avoid both scenarios by checking that your withholding is appropriate.

Make early retirement contributions

Be sure to maximize your contributions to tax advantaged accounts and consider making your 2020 contributions sooner rather than later. Even though you have until year-end to make contributions to your 401(k) or Tax Day for your traditional or Roth IRA, making early contributions to your retirement accounts will give your money more time to benefit from potential long-term compound growth.

Consider required minimum distributions (RMDs)

It’s important to note that for 2020, all RMDs have been waived by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Though RMDs aren’t an issue this year, be aware that this change is likely to be a one-time deal and you will need to take RMDs in 2021.

In a normal year, when the CARES Act does not apply, if you’re 72 (or turned 70½ before January 1, 2020) or older and have to take RMDs from your retirement accounts, you must do so before the end of the year. Otherwise, you may have to pay a 50% excise tax on the amount not distributed.

Though there are no RMDs for 2020, you can still make a qualified charitable distribution (QCD) from your retirement account directly to your favorite charity. As long as you’re over age 70.5, you can use a QCD to donate up to $100,000 a year and it won’t be included in your income. 

Understand cost basis

Know your costs before you sell. Savvy investors know that managing cost basis can help them save on taxes. Your cost basis is essentially what you paid for an investment, including brokerage fees and any other trading costs. Your capital gain (or loss) will be the difference between the cost basis of the asset and the price at which you sell it. In a simple transaction, the cost basis should be easy to calculate.

However, if you buy the same investment over time—such as through a dividend reinvestment plan—each block of shares purchased is likely to have a different cost and holding period. In these situations you can pick which shares to sell, giving you the ability to sell the ones that will have the least tax impact.

Alternatively, you can go with the default method, which generally requires less effort on your part—but could cost you more in taxes.

Invest tax-efficiently

Make sure your assets are located in the most tax-efficient investment accounts. For example, it makes sense to hold long-term investments in a taxable account, because any gains will be taxed at the lower capital gains rate. The same is true for tax-efficient investments, such as stocks or funds that pay qualified dividends, municipal bonds, and most index funds and ETFs.

On the other hand, you’re better off keeping investments you’ve held for less than a year in tax-advantaged accounts, such as a 401(k) or IRA. Remember, gains on short-term investments are taxed as ordinary income, which is subject to a higher tax rate than capital gains. The same is true for actively managed mutual funds that may generate significant short-term capital gains or the interest income on corporate bonds.

Qualified withdrawals from Roth IRAs and Roth 401(k)s are tax-free,1 so it usually makes sense to use these accounts for assets that you expect will appreciate the most. Of course, tax-efficient placement presumes you have different account types. If most or all of your portfolio is in tax-deferred accounts, you’ll want to focus on your asset allocation strategy.

Maximize your charitable donations

If the changes within the Tax Cuts and Jobs Act (TCJA) made the standard deduction the best option for you, consider concentrating your donations into a single year. By giving more in one year, there’s the potential to maximize your itemized deduction for that year. The next year, you can switch and take the standard deduction, which could increase your overall deductions for that two-year period, resulting in a large tax benefit.

In addition, if you were planning on selling a significant amount of long-term appreciated stock—which will generate a large taxable gain—consider donating a portion of those assets directly to a charity. Subject to certain income limitations, you could get a tax deduction for the full fair market value of the donated stock and you won’t have to pay taxes on the gain for those shares.

Many charities are unable to accept gifts of appreciated assets, like stocks, but you can use a donor-advised fund, which is another great tax tool to facilitate the donation process. When you place assets in a donor-advised fund, you get the full deduction for the charitable gift that year. Then, you can grant those assets to your favorite charity over time.

Bottom line

These are just a few of the steps you can take to prepare for tax season and potentially minimize your tax bill. A qualified tax professional can help you find other effective ways to navigate tax season and answer specific tax questions based on your personal situation.

After you decide what to do this year, resolve to make financial planning a year-round exercise. By looking ahead, you’ll find it easier to check your progress, update your plan and, if necessary, take action long before the tax-filing deadline.

1. Qualified distributions are tax-free for those 59 ½ or older with accounts that have been open for five years or more.

What you can do next

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Withdrawals of any earnings from your Roth IRA investments are tax- and penalty-free if you have satisfied the five-year holding period and you are over age 59½. If you have met the five-year holding period but you are not yet 59½ years old, you will be subject to a 10% early withdrawal penalty.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.

Investing involves risk including loss of principal.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

A donor’s ability to claim itemized deductions is subject to a variety of limitations depending on the donor’s specific tax situation. Consult your tax advisor for more information.

Contributions of securities held for longer than one year are generally deductible at fair market value (FMV); securities held for one year or less have the same AGI limits as cash contributions (60%), but the valuation is based on the lesser of the cost basis or FMV. Contributions that exceed AGI limitations may be carried forward and deducted for five years. An account holder’s ability to claim itemized deductions may be subject to further limitations depending upon the donor’s specific tax situation and account holders should consult their tax advisors


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