This article also appeared in Forbes.
The holidays are a perfect time for a financial check-up.
Here are seven must make financial moves before year end to save you money and lower your tax bill:
1. Defer your income
If you have a choice between receiving income in 2016 or 2017, you should opt for 2017 to defer the income taxes associated with that income. Why? Income tax is due in the year in which it is incurred. Therefore, if you receive income after January 1, then it will be taxed as 2017 income and you can defer the tax liability.
If you are self-employed or a consultant, you have more control over when you bill customers and therefore can defer income more easily than if you are an hourly or salaried employee. However, you may be able to defer your bonus to next year if your company offers this option.
This strategy only makes sense if you expect to be in the same or lower tax bracket in 2017. If you expect to be in a higher tax bracket in 2017, then you may be better off receiving the income in 2016 and paying income tax in the lower tax bracket.
2. Sell Portfolio Losers
Tax loss harvesting, or selling stock that has declined in value to realize a tax loss, is an optimal strategy at year end. Why? Tax loss harvesting enables you to offset all investment losses against your investment gains, thereby lowering your tax bill.
For example, let’s say you recently sold 100 shares of Company ABC stock and made a $1,000 profit. If you owned the stock for more than one year, you would pay long-term capital gains tax on your profit. However, there is a way to offset your stock gain and not pay capital gains tax.
Let’s say that you bought 100 shares of Company XYZ for $100 per share for a total cost of $10,000. Unfortunately, the share price of Company ABC declined and its current share price is $90. On paper, you lost $1,000 ($10,000 – $9,000). If you sell all your shares of Company ABC today, you can recognize that $1,000 loss on your income taxes. Your gain on Company ABC and loss on Company XYZ offset each other, and there is no capital gains tax liability.
There are two main limitations on the above example. First, the “wash sale” rule prohibits you from selling your Company XYZ shares, harvesting the tax loss and then repurchasing Company XYZ stock (or a stock substantially identical to Company XYZ) within 30 days. Therefore, if you sold Company XYZ at $90 per share and then decide you want to purchase more shares of Company XYZ at $85, for example, you would need to wait 30 days from the date of sale if you want to claim the tax loss. Second, after offsetting your investment losses, if you are single or a married couple, you can use $3,000 of capital losses each year to offset ordinary income (and $1,500 if married filing separately). For example, if you have $9,000 of capital losses and no capital gains in the current tax year, you can use $3,000 to offset ordinary income this year, and $3,000 in each of the next two years to offset ordinary income in those years.
3. Never buy a mutual fund in December
If you’re looking to buy a mutual fund now, wait until the new year. Each December, many mutual funds pay out dividends and capital gains that have accrued during the year. It may be tempting to buy the mutual fund right before the mutual fund makes such a distribution. However, while you would receive the distribution for each share you own, you must pay tax on the distribution. This is called “buying the dividend” and is a poor investment strategy.
For example, let’s assume Company ABC declared a $1 per share dividend and will pay investors on December 20. On December 15, in anticipation of receiving this dividend, you decide to buy 100 shares of Company ABC at $10 per share. Therefore, you are entitled to $100 in distributions (100 shares multiplied by $1 dividend per share). Typically, all else equal, the price of the underlying stock will fall by the amount of the dividend. In this example, Company ABC should trade at $9 per share ($10 – $1). That means you not only have a lower share price, but also a tax liability.
The smarter move is to wait until after the dividend is paid to purchase the mutual fund. You can contact the mutual fund company and ask them when the next dividend distribution will be made so you don’t buy the dividend (and the tax liability).
4. Max out your 401(k) contributions
Due to the power of compounding, tax-deferred retirement accounts are an optimal strategy to grow your wealth. If your company matches a portion of your 401(k) contributions, then even better.
Make sure that you contribute the maximum amount each year to your 401(k). In 2016, you can contribute $18,000 (or $24,000 if you are over 50). At a minimum, try to contribute as much as you can to qualify for an employer match.
5. Convert to a Roth IRA
A Roth IRA is a retirement account that allows you to contribute after-tax earnings now and keep all the appreciation tax-free. That means when you retire and start permitted withdrawals from your Roth IRA, the funds will not be taxed.
For example, if you put $10,000 of after-tax earnings into a Roth IRA at age 30, you would have $106,766 at age 75 (assuming a 7% annual return and no further contributions). If you are a millennial, a Roth IRA makes good financial sense because you are relatively early in your career and can generally expect your income and tax bracket to increase over time.
If you have a Traditional IRA, you may want to consider converting to a Roth IRA. If you choose to convert to a Roth IRA, you will owe taxes on the current balance of your Traditional IRA. One major factor that may drive your decision is your expected tax rate in retirement. If you expect your tax rate to increase in retirement, then it may be better to pay taxes now on the existing balance in your Traditional IRA and convert to a Roth IRA. If you expect your tax rate to decrease in retirement, then keeping your Traditional IRA may be the better decision. Another advantageous time to convert is a tax year in which you have low income because you will be in a lower tax bracket.
With tax rates likely to fall next year, waiting until the start of 2017 might be the optimal time for a Roth IRA conversion. Why? Once you convert to a Roth IRA, you have until the last date, including extensions, for filing your prior-year tax return, which is typically on or about October 15, to change your mind and undo (or “recharacterize”) your Roth IRA conversion. Therefore, during this period, you can monitor the stock performance of your converted holdings and decide to recharacterize your Roth IRA to a Traditional IRA if the value of your stock portfolio declines.
6. Make charitable contributions
The holiday season is a good time to give back to those less fortunate. In addition to making a positive difference, you can deduct the amount of your charitable contribution on your income taxes. While cash is the traditional currency for charitable giving, you can also donate stock that has appreciated in value. Rather than sell the stock and donate the after-tax proceeds, you can gift the stock to the public charity of your choice and take a tax deduction on the full fair market value of the stock (if you owned the stock for at least one year). You can deduct up to 30% of your adjusted gross income. Plus, when you donate appreciated stock, you will not owe any capital gains taxes.
7. Use your flex spending
Flexible spending accounts are pre-tax accounts offered by many employers. If you have health insurance through your employer, you can use your flexible spending account to pay medical and dental co-payments, deductibles, medicine and other health care costs. You can contribute up to $2,550 per year per employer. If you are married, your spouse can also contribute $2,550.
A dependent care flexible spending account allows you to use pretax dollars to pay for eligible expenses related to care for your child or other dependents up to $5,000 per year for individuals or married couples filing jointly (or $2,500 if you are married filing separately).
The good news is that you do not pay taxes on any contributions to your flexible spending account.
Make sure to use all your flexible spending benefits because the remaining funds in your account are forfeited when the plan year ends. If December 31 marks the end of your plan year, then now is not too late to visit a doctor, refill a prescription or buy a pair of new glasses.