As the year closes, many individuals look for ways to save on their taxes. I've learned through nearly two decades of experience that this process takes careful planning. Here are three tips for sneaking in some savings in before the year ends.
1. Switch from FSA to An HSA
Often used but not as "flexible" as the name implies, flexible spending accounts (FSAs) allow you to use pre-tax dollars on dependent and medical care. The major downfall is the funds don't roll over year to year. (For related reading, see: Year-End Tax Planning for Your Investments.)
However, did you realize that a health savings account (HSA) gives you more bang for your buck? The HSA is great way to save pre-tax dollars that grow tax free for future medical expenses. These accounts are usually available when you opt in to your employer's high deductible health plan, which may be restricted to certain enrollment periods unless you have a qualifying life event.
I like to call these plans “two-fers.” You not only get a current tax deduction (up to the amount of your contribution) but you get tax-free growth on qualified distributions. For young savers this can an excellent alternative to a long-term care plan that provides a lot more flexibility and no monthly premiums. For a couple over 55 years of age, they can reduce their taxable income by an additional $7,750 per year.
Expecting a big bonus? This is a great way to reduce your tax liability.
2. Contribute Beyond Employer Match
Regardless of your feelings, your 401(k) will likely be your largest wealth-building tool. Yet many individuals don’t contribute beyond the employer match. A 401(k) is an excellent tool because besides the creditor protection offered by ERISA law, it provides you with one of the largest tax breaks you can receive dollar-for-dollar. This is because pre-tax salary deferrals into an employer plan like a 401(k) act similar to an "above the line" deduction, thereby directly reducing the amount of taxes you owe.
The cap on your contribution for 2017 is $18,000 (not including what the employer matches or contributes through plan forfeitures, etc.). Most plans allow you to change your contribution during the year allowing for another excellent use of a big year-end bonus. (For related reading, see: 10 Money Saving Year-End Tax Tips.)
3. Tax Loss Harvesting
Had a pretty active year in your taxable brokerage account? Maybe your bitcoin exchange-traded funds (ETFs) are up but your Treasury bond ETFs are down. One strategy would be to sell some of each in the amount of the gain (or loss).
Let’s say Jim has an E*Trade brokerage account with the following:
- $10,000 in long-term realized gains
- $8,000 in long-term unrealized losses
Jim could “harvest” his investments in the loss position and offset his $10,000 of gains reducing them to $2,000 and thereby reducing the tax on his investment income.
If you know that your realized gains (short term or long term) will present a tax consequence for you, then offset them with realized losses. You can deduct up to $3,000 in net capital losses against your income. For now, keep these four rules in mind when you're thinking about netting your investment gains and losses:
- Long-term losses offset long-term gains.
- Short-term losses offset short-term gains.
- Long-term (investments held for more than a year).
- Short-term (investments held for less than a year). (For more from this author, see: Is It Possible to Create Tax-Free Income for Life?)