There is still time to potentially reduce your 2020 federal income taxes, but you'll need to act soon. There are several tax minimization strategies for individuals including timing your income and deductions, making the most of your retirement and health savings accounts, being smart about charitable donations, keeping taxes to a minimum on the investments in your taxable accounts, and minimizing taxes on your estate and inherited retirement accounts. Many of these strategies need to be completed by the end of the year to be effective, and not all of the strategies may be appropriate for you. Let’s review how to make the most of your retirement and health savings accounts.
Use Tax-Deferred Retirement Accounts to Shelter Income From Current Taxes
Contributing to a tax-deferred retirement plan at work is a great way to minimize your current taxes. The money you contribute reduces the amount of income you will be taxed on this year—and it helps pave the way to a financially secure retirement. For example, if you contribute $15,000 this year, you do not have to pay income tax on that $15,000 of income this year, and you are $15,000 closer to your retirement savings goal.
Contributing to a traditional IRA can also help minimize your current taxes as long as you are eligible to deduct your contributions. Your contributions will be tax deductible if you and your spouse (if you are married) are not covered by retirement plans at work. If either of you is covered, your income must be under certain limits for your contributions to be tax deductible.
Keep in mind that contributing to a tax-deferred retirement account minimizes your current taxes. You will eventually have to pay income tax on your pre-tax or deductible contributions, as well as your investment earnings, but not until they are withdrawn from the retirement account, which may be decades from now.
In certain situations, you may prefer to skip the current tax benefit and contribute instead to a Roth IRA or Roth retirement account so that your withdrawals will be tax-free in retirement. Your financial professional can help you determine which type of account—tax-deferred or Roth—may be more beneficial for you.
The Age Limit on Contributing to a Traditional IRA is Removed
Prior to 2020, individuals were not allowed to contribute to traditional IRAs if they were 70 ½ or order. The SECURE Act of 2019 removed the age limit, and you can now contribute at any age as long as you (or your spouse if filing jointly) earn taxable compensation, such as wages.
Business Owners: Start Your own Retirement Plan
If you are self-employed or own a business and want to contribute more to your retirement savings each year than the IRAs allow, consider starting a business retirement plan.
Business retirement plans typically allow you to contribute far more each year on a tax-deferred basis than a traditional IRA does. For example, one type of business retirement plan, the SEP IRA, allows you to contributed from 0% to 25% of your compensation every year, up to a maximum of $57,000 in 2020. In contrast, traditional and Roth IRA contributions are limited to $6,000 at most this year, or $7,000 if you are age 50 or older.
If you are interested in establishing a business retirement plan, please talk to your financial professional about it soon. Some plans must be established by the end of your business’s fiscal year (generally December 31) and others by the due date of your tax return, including extensions.
Use a Health Savings Account to Shelter Your Income from Taxes
Contributing to a health savings account (HSA) is a great way to shelter some income from taxes if you have a high-deductible health plan (HDHP). Money that you contribute to an HSA is either pre-tax or tax deductible, which lowers your taxable income and taxes for the current year. Plus, earnings grow tax-free and withdrawals for qualified medical expenses are tax-free.
For 2020, you may be able to contribute as much as $3,550 if you have self-only HDHP coverage or $7,100 if you have family HDHP coverage. $1,000 catch-up contributions can also be made for those age 55 or older.
If you have questions about this topic or any of the other tax planning topics in this series, please contact us. We’re happy to help.