Editors' pick: Originally published Nov. 11.
This late in the year, you should be hunting down tax deductions like a kid searches for hidden holiday gifts.
We're just weeks away from the end of 2016 and its tax year, but both ignorance and terrible record keeping may be preventing you from minimizing your tax hit. According certified financial planner Melinda Kibler of Palisades Hudson Financial Group in Fort Lauderdale, Fla., lost deductions can be the result of simple procrastination.
Take your charitable deductions, for example. Most people who itemize deductions underreport their charitable contributions, because they don't keep records throughout the year. Even though some of your deductions may seem small, they can add up to a big tax savings.
"If you dropped off a bag of clothing at a local charity or gave them $5 at the cash register of your grocery store, make sure to track these contributions so you get the highest tax benefit possible," she says.
The Internal Revenue Service allows taxpayers to deduct donations up to 50% of their adjusted gross income when those gifts are given to public charities or certain private foundations. Even for gifts to family or other non-qualifying foundations, the deduction can be as large as 30% of all adjusted gross income.
Of course, the more you have to give, the greater the tax benefit. For example, an individual in the 28% federal income tax bracket that makes a $500 charitable donation, will see their tax liability decline by $140 (28% of their tax bill). For wealthy individuals subject to either federal or state estate tax, the assets they give to qualified charities will escape the tax. With a top federal tax rate of 40%, $4 out of every $10 in assets subject to the tax will go to the government instead of to family members and other loved ones. Not only is the family losing that money, but it's losing a valuable opportunity to learn about how to manage whatever wealth remains.
"For those individuals with donative intent, donating assets to charity may not only reduce their estate tax exposure, it can also be used as an opportunity to teach their beneficiaries about thinking less about themselves and doing more for those less fortunate," says Shomari Hearn, certified financial planner and vice president of Palisades Hudson Financial Group in Fort Lauderdale, Fla. "In fact, by informing loved ones of their philanthropic objectives, donors can get their family involved in the process by holding family meetings to discuss giving goals, selecting the charitable organization(s) that will receive their donations, establishing a vehicle (like a donor-advised-fund) through which to donate , and evaluating the impact of the donations that have been made."
Donations to eligible nonprofits, religious organizations, and government organizations (such as a school or public library) are deductible: Especially if you give cash or goods, get receipts from the organization. Kibler suggests using software such as Quicken to log donations, but also notes that those donations are only part of your charitable deductions. For example, you can use a standard mileage rate of 14 cents a mile to figure your vehicle deduction for miles driven in service to a charitable organization. If you drive to to a shelter to serve meals to the homeless, for instance, you can deduct the mileage, tolls and parking fees as well.
If you're in a real bind, there's a chance you can donate some of your investments, too. Highly appreciated stocks or mutual funds you've owned for more than one year can go directly to a charity. If if you've purchased shares for $1,000 and they are now worth $10,000, giving those share to a qualified charity would give someone in the 28% tax bracket a $2,800 tax deduction, based on the current market value of the donated shares. You're doing a good deed, you won't be hit with the capital gains tax and you'll get the deduction. However, you only get the benefits of a deduction if you contribute the security to the charity directly.
"Never sell a security, pay tax on the capital gain, and then donate the proceeds," Kibler says.
Similarly, if you sold your home this year and made a whole lot of money off of it, you can deduct up to $250,000 of the gain if you're single or $500,000 if married filing jointly. However, it gets a bit complicated. The home must have been your primary residence during at least two of the last five years. You also have to calculate the gain on your home by subtracting the basis from the proceeds of the sale. Your basis includes the original price of your home, the costs of any improvements you made (additions, renovations and even fencing or insulation), the agent's commission and some other, smaller items.
"You can also add to the basis the agent's sales commission and some settlement fees and closing costs such as legal fees, recording fees, and survey fees," Kibler says. "Keep clear records to substantiate your basis in case the IRS ever audits you."
Your investments are also a rich source of deductions. Whenever you reinvest a dividend in a stock or a fund, make sure to add this amount to your base cost of the security. Brokerage firms will do this for you automatically, but if you own stock directly, you'll have to do it yourself. By tracking the that base cost, you can reduce your capital gains tax if you sell the security at a higher price later.
Further, investment management fees for taxable investments are deductible when they exceed 2% of your adjusted gross income. To deduct investment-management fees on your retirement accounts, you must pay them with non-retirement assets. If your advisor automatically debits your IRA for their fee, it's not deductible. But if your advisor bills you, and you mail a check, it's deductible. Finally, if you have a tax-exempt retirement investment like a Roth IRA, management fees aren't deductible.
"I usually recommend paying investment management fees for retirement assets separately," Kiblers says. "You get a double benefit: Your plan grows faster, and you get a deduction."
If some of your investments have taken a beating, those losses are deductible as well. While losses on your retirement accounts aren't deductible, losses on non-retirement accounts can be used to offset gains. he best part is that you can carry those tax losses forward indefinitely. If you don't need those losses to offset capital gains right away, you can use the excess loss to offset gains in a future year. That's particularly helpful since net capital losses (capital losses minus capital gains) can only be deducted up to a maximum of $3,000 in a given tax year. Any losses beyond $3,000 must be carried over, which also makes it worth your while to consider putting off selling some of your 'winners' until next year."
When selecting investments to sell for tax-loss purposes, consider investments that no longer fit your strategy or can be easily replaced by other investments that fill a similar, but not identical role, Kibler says. However, whatever you do, don't buy back into your original investment or an identical investment 30 days after the sale date or less. That triggers a "wash sale," which means you can't deduct the loss on your investment.
"It's usually easiest to just to replace the investment you sold with a similar one," Kibler says. "However, the definition of 'substantially identical' can be tricky."
Even if you've exhausted the deductibles on your investments, there are other ways to reduce the tax hit on them. Bankrate's Kay Bell notes that boosting your retirement savings can be particularly helpful. If you haven't made your maximum $18,000 401(k) contribution ($24,000 for people age 50 or older) or $5,500 contribution for an IRA ($6,500 for people age 50+), now is the time. If you've contributed little or nothing this year, you can contribute a lump sum from you paycheck by December 31 to catch up.
"If your employer permits you to make extra contributions to your 401(k), put in as much as you can afford," says Bill Ringham, vice president and senior wealth strategist at RBC Wealth Management. "You typically contribute pretax dollars, so the more you invest, the lower your taxable income. Your earnings also grow on a tax-deferred basis."
If your modified adjusted gross income is less than $71,000 for singles or $118,000 for married taxpayers filing jointly, Kibler says you can receive a full deduction for your contribution. You have until April 17, 2017, to make 2016 contributions on certain retirement accounts.
Ringham also notes that 529 plan contributions are tax deductible in several states, so contributing to your kid's college fund will allow your earnings grow tax-free, provided they are used for qualified higher education expenses. Just make sure it's going toward college, however, as distributions not used for qualified expenses may be subject to income tax and a 10% penalty.
Beyond that, there are myriad other deductions you can make just by going through your records and getting actives. If you were out of work this year, expenses including the costs of a job-placement agency, the costs of preparing or mailing resumes and travel expenses (including mileage costs of 54 cents per mile if you're traveling for a job hunt) are all deductible.
In some cases you can deduct your state and local sales tax instead of state and local income tax, which comes in especially handy in areas that don't tax income. Meanwhile, Bankrate's Bell suggests homeowners submit January mortgage payment and property taxes by December 31 so they can deduct the interest in 2015. Also, if you haven't taken advantage of your flexible spending account for health care, now is a great time to schedule doctor's appointments or buy eligible supplies ranging from glasses to knee braces to cold medicine. Palisades Hudson certified financial planner Rebecca Pavese, meanwhile, suggests filing a new W-4 form with your employer and adjusting your December tax withholding just to keep from running afoul of penalties and interest.
Just about anything you can do to lower your adjusted gross income is helpful. Lowering income can also lower deduction hurdles that are calculated as a percentage of that income. For example, unreimbursed medical expenses can only be deducted if they exceed 10% of adjusted gross income, and investment expenses must exceed 2%.
"Lowering your income has many potential benefits," she says. "If you can lower your taxable income to below $74,900 for a married couple filing jointly or $37,450 for a single filer, you will pay 0% federal tax on sales of assets you've held longer than one year and 0% on dividends. Even if you can't get your taxable income quite so low, you may be able to lower it enough to step down to the next lowest capital gains tax rate."