A day that no one looks forward to is upon us—tax day. Whether you did your 2021 taxes in February or are scrambling to complete them now, finishing is a relief. But that can quickly turn to frustration when you discover how much you owe the IRS—especially if you're trying to save for retirement.
With a tax code that grows increasingly complex every year, it takes careful planning to make sure you’re maximizing your deductions and credits. There are a few last-minute ways to save on taxes (such as retirement plan contributions) but for the most part, an effective tax strategy requires year-round preparation.
If you feel like you paid too much in taxes this year, or if you just want to minimize your tax bill so you can maximize your retirement nest egg, here are some key tips to consider now and throughout 2022.
Take Stock of Major Life Changes
A big tax bill at the end of the year is a double whammy. Not only do you owe the IRS a chunk of money, but you might also face underpayment penalties on top of it. Paying taxes is inevitable, but there are two strategies to avoid an unexpected tax burden and the associated penalties:
- Estimated quarterly taxes - The IRS requires that anyone who expects to owe $1,000 or more in taxes make quarterly estimated payments. This commonly applies to self-employed individuals, landlords, and real estate investors. However, anyone with significant taxable investments can fall into this group as well.
- Withholding adjustments - If you’re a salaried employee, you can file a new W-4 with your employer to change how much they hold from each paycheck for taxes. Seeing a smaller number every two weeks is frustrating, but it’s better than owing the IRS hefty fees at the end of the year.
When calculating estimated taxes or withholding adjustments, you’ll want to consider any major changes to your income or finances. This can mean a variety of situations, but there are a few common life events to keep in mind:
- Changing jobs - Whether you took a promotion, accepted a new job, or started your own company, a change in income means a change in taxes. Make sure you’re setting aside enough of your check to avoid an unpleasant year-end surprise.
- Receiving a lump sum - A lump sum can boost your retirement savings if you handle it properly. But it can also increase your tax burden. Before you do anything with a sudden windfall, consider the tax implications of spending or investing it.
- Buying a house - Not all life events lead to higher taxes. Buying a new home opens up a world of possible credits and deductions, and might make itemizing worthwhile if you’ve always taken the standard deduction.
Maximize Your Retirement Contributions
Contributing to retirement plans is key to setting yourself up for a secure financial future. It can also reduce your tax burden, thanks to tax-deferred accounts like 401(k)s and traditional IRAs.
For 2022, the IRS increased the contribution limit for 401(k)s to $20,500, which doesn’t include any employer matching. Additionally, anyone 50 or older can make “catch-up” contributions of up to $6,500. IRA limits are still $6,000, although people 50 and over can contribute an extra $1,000 on top of that.
Depending on your finances, you might also want to consider a Roth IRA Conversion. Moving savings from a traditional IRA into a Roth IRA might increase your tax bill in the short term, but the long-term tax savings can be substantial.
Double-check Your Deductions
There’s a multitude of credits and tax deductions, from child care to state sales tax to homeownership. In fact, deductions are one of the major sources of the growing tax-code complexity we mentioned. While a tax professional can identify all of the credits that apply to your situation, there are a couple of commonly overlooked or misunderstood deductions to plan for.
Most of us know that donations can be tax-deductible, but there are some key points that many people are unaware of:
- If you're over 70 1/2 years old, you might be able to use funds from your IRA to make Qualified Charitable Distributions. Rather than take a taxable distribution, you can pay the money directly to a qualified charity.
- You have to itemize your deductions to derive tax benefits from most charitable contributions. If you don't donate enough to justify itemizing every year, consider bunching your contributions every other year to hit deduction thresholds.
- Even if you don't itemize, you can take a yearly tax credit for charitable giving. In 2021, that credit changed from $300 per tax return to $300 per person, doubling the benefit for married couples.
- If you give your time rather than make cash donations, you can deduct any associated costs such as mileage or materials you provide while volunteering.
Self-employed Home Office
If you’re one of the many who left a corporate job to start your own company from home, you might be entitled to tax savings. The IRS has clear regulations on home office deductions, but you can also include monthly costs like your internet and phone bills.
Start Planning Now to Save on Next Year’s Tax Returns
Much like preparing for retirement, the best way to lower your tax bill is through careful planning. Avoiding taxes entirely is impossible—the IRS will always get their cut—but saving for retirement and reducing your tax bill go hand-in-hand. Contributions to 401(k)s and IRAs, strategic deductions, and keeping tabs on your tax situation throughout the year are all key to avoiding a nasty surprise.
If you find yourself confused by the tax implications of financial decisions, a fiduciary advisor can help. A fiduciary financial advisor is legally bound to always act in their clients’ best interests. So you can trust them to explain the consequences of any given choice and how it fits into your long-term financial plans.
Interested in more tips to minimize your tax burden and maximize your nest egg? Download our Essential Retirement Guide today and make sure you're on the road to a secure and comfortable retirement.
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