Tax Planning Earlier Saved us $5,800 – Here’s How to Lower Your Taxable Income

You may already know that doing a little tax planning can save you a lot of money on your taxes. However, are you aware you could be missing out on savings if you save your tax planning for year end?

Here’s how doing our tax planning earlier in the year saved us an extra $5,800 on our taxes. Plus, 6 ways you can lower your taxable income in 2021.

We almost missed out on an extra $5,800 this year!

Although we briefly consider tax planning for the upcoming year during our year-end financial review process, we haven’t historically performed our formal tax planning until mid-year. The primary reason for this is laziness. Although we also don’t know what our annual pay raises and variable compensation will be until a few months into the year.

Ideally, tax planning is an iterative process that you perform early in the year and continuously reevaluate. So this year, I finally moved our tax planning earlier. I prepared the analysis in April, after bonuses were paid and we finally had all the information needed to properly plan.

This year was a bit different from a tax planning perspective: We’re expecting our lowest income ever as a couple, since I quit my job in March 2020, and the pandemic put a serious dent in Mr. RFL’s annual bonus.

In prior years, we had to withhold extra money from each paycheck so that we didn’t owe too much at tax time. We always aim for owing a small amount or $0. No need to give the government an interest-free loan!  I wanted to make sure we adjusted withholdings, as needed.

However, by performing our tax planning analysis earlier in the year, I was able to do more than just adjust withholdings. I found some extra savings.

How tax planning earlier in the year saved us from missing out on extra savings

Prior to performing the full tax planning analysis, our 2021 tax strategy was to take advantage of our lower tax rate this year by doing the following:

• Max out contributions to Mr. RFL’s 401k retirement plan and Health Savings Account (“HSA”)
• Make pre-tax contributions for the full cost of preschool to Mr. RFL’s Dependent Care Flexible Spending account (“FSA”).
• Max out both Roth IRAs – In recent years we’ve only been able to make non-deductible contributions to our Traditional IRAs.
• Exercise as many of Mr. RFL’s stock options as we could, up to the 2021 income limit for contributing to a Roth IRA.

When I projected out the “taxable income” using Mr. RFL’s paychecks and bonus, I realized that our taxable income would be even lower than I’d expected.

I’m estimating taxable income of around $155,000 after adding in expected dividends, interest, and other income. If we exercised stock options, like we were about to do just before I did this planning, we’d come in higher than this. Most likely between $165,000 – $175,000.

What does this mean? That there’s a silver lining to having abnormally lower income this year.

With a little tax planning, we’ll qualify for $5,800 in stimulus money

We didn’t receive any federal stimulus money in 2020. We had dual incomes for part of the year which pushed us over the limits. Additionally, when the income limits were lowered in 2021, I assumed we wouldn’t qualify for any this year either.

And indeed, if we continue with our plan of exercising stock options and contributing to our Roth IRAs, we’d be over the limits to receive these benefits.

Luckily, we caught the opportunity early enough and were able to make some changes in our tax planning strategy to capture these savings.

Are you getting all your stimulus money?

The American Rescue Plan Act of 2021 (the “Act”) provides for stimulus checks of $1,400 per person, including children, for married couples filing jointly with an Adjusted Gross Income (“AGI”) below $150,000. For individuals, the limit is $75,000. These amounts quickly phase out, completely disappearing once AGI surpasses $160,000 for joint filers or $80,000 for individuals.

The Act also increased the child tax credit from $2,000 to $3,600 per child under 6, and $3,000 for other children. The original $2,000 credit is available for all families making under $400,000. However, the extra credit is phased out or eliminated using the same income levels as the stimulus payments.

For our family of 3, these extra credits come to a total of $5,800. However, they are only available to us IF we can reduce our taxable income to below the $150,000 limit… which we’ll do with a little tax planning. While we didn’t receive checks due to our higher income last year, we will be eligible to take a credit on our 2021 tax return.

How we’ll change our plan to maximize tax stimulus:

If you recall from above, our original plans would have resulted in a taxable income of between $165,000 and $175,000. This would make us ineligible for any additional stimulus money.

Instead, we’ll make the following two changes to our tax plan:

1. I will make deductible contributions to my Traditional IRA instead of my Roth IRA in order to lower our taxable income.  

I’ve already contributed some money to a Roth IRA this year. However, we’ve since halted contributions. Later in the year, I’ll contribute the remainder of my $6,000 to a Traditional IRA and take the tax deduction instead.

Because Mr. RFL has access to a 401k plan at work, his contributions are not deductible. As such, he’ll still contribute the full $6,000 to his Roth IRA. 

You are allowed to recharacterize contributions made during the year between a Roth and Traditional IRA. So it is possible to adjust strategies prior to the tax deadline, if needed. We’re close enough that I may need to recharacterize the contributions I made earlier this year to stay under $150,000. But we’ll assess that at year-end.

2. Wait until year-end to exercise stock options (if any), and limit amount exercised to stay below the $150,000 AGI cap.

Unfortunately, unless I recharacterize the Roth contributions already made, I don’t think we’ll be able to exercise any options this year. We’ll make the final decision on this at the end of the year

Even though we’ll be in a lower tax bracket this year, the benefit of receiving the tax stimulus credit is far greater than any savings we’d get from exercising options and shifting more income to this year. To illustrate, at a 22% marginal tax rate, a tax credit of $5,800 is equivalent to earning an extra $26,000 in income! Needless to say, we’ll be doing everything we can to stay under that limit this year.

Here are 6 simple ways to lower your taxable income in 2021

1. Contribute more to your tax-deferred retirement accounts.

Making pre-tax contributions to your retirement accounts is a great way to reduce your taxable income for the year.

If you have a 401k plan through work, you can contribute up to $19,500 in 2021. Any matching contributions made by your employer do not count towards this limit. Contributions from each paycheck are excluded from W-2 wages at year end, so there is nothing you need to do at tax time. If you don’t have access to a 401k plan through work, you may be eligible for other types of retirement plans. Many of these offer similar benefits and some have higher contribution limits.  

Another popular option available to most earners is a Traditional Individual Retirement Account (“Traditional IRA”). In 2021, you can contribute up to $6,000 per person into a Traditional IRA. While contributions to a Roth IRA are made on an after-tax basis, those made to a Traditional IRA may be deductible for tax purposes.  Whether and how much you can deduct depends on your modified Adjusted Gross Income and whether or not you or your spouse has access to a 401k or other retirement plan at work.

If you choose to contribute to tax-deferred investments, it’s important to remember that you will be responsible for paying taxes on the entire amount, plus any gains, when you take that money out. As such, it’s important to have a plan for withdrawal to minimize taxes on the backend. It can be worth kicking that can down the road if you’re in a high tax bracket or need to lower your taxable income for a specific deduction or benefit (like us). However, if you’re fresh out of college or in a low-income tax bracket, a Roth IRA or Roth 401k may make more sense.

2. Open and contribute to an HSA if you’re on a high-deductible health plan.

If you have a high deductible health insurance plan, I highly recommend looking into a Heath Savings Account (HSA).

Your employer may offer one or you can open an account on your own. Generally, you should go through your employer if you have that option, as contributions are deducted from your paycheck before income and other payroll taxes. Many employers also offer incentives, such as a match for healthy behaviors or participation. 

For 2021, individuals and families can contribute up to $3,600 and $7,200, respectively. In addition to lowering your taxable income, the balance (including any growth) never expires. You can withdraw the money TAX FREE at any time if it’s used to pay for qualified medical expenses. HSAs are one of my favorite retirement savings vehicles.

3. Take full advantage of pretax flexible spending accounts.

Many employers now offer flexible spending accounts (FSAs), which allow you to contribute pre-tax dollars from each paycheck. Although you must spend this money for specific things, contributing will reduce your taxable income, thus allowing you to pay for these expenses with pre-tax dollars.

The most common FSAs are for medical expenses (cannot be used with an HSA) and dependent care/childcare.  For 2021, the limits for a dependent care FSA and medical FSA were $5,000 and $2,750, respectively.

Unfortunately, FSAs are linked to your employer and operate on a “use it or lose it” basis each year. Although there is usually a short grace period for submitting expenses for reimbursement after year end.

4. Don’t miss out on any deductions if you’re self-employed or have a side hustle.

There are a number of deductions you can take to lower your taxable income if you operate a small business. For example, you can deduct a portion of your home office, self-employment taxes, and health insurance expenses. You can also time certain business expenditures to shift expenses into the current (or following) year, as needed. If you run a business, do your research.

5. Donate more to charity.

While this won’t save you money overall, charity is a good thing. Generally, you can only deduct charitable contributions if you itemize your tax return. However, the IRS recently revised these rules. In 2021, you can deduct cash charitable contributions up to $300 for individuals, and $600 for joint filers. Even though it’s not much, this deduction is made before determining AGI, so can help you qualify for additional tax credits and deductions if you are on the cusp of a phase out. If you itemize, additional charitable contributions will further lower your taxable income.

6. Sell your losers to harvest capital losses.

You can use the capital losses from selling losing investments to offset any capital gains you may have incurred during the year. Additionally, you can go negative and deduct additional losses up $3,000 ($1,500 if Married Filing Separately).

I prefer a buy and hold strategy, so I’m not a big fan of this approach. However, it’s a useful tool if you’re close to phasing out, have bad investments you want to unload, or are currently withdrawing from your investment portfolio anyways.

Your turn – What are you doing to lower your taxes this year?

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