Top 10 Mid-Year Tax Planning Tips

In the 1980’s, David Letterman made top 10 lists a reason to stay up after the evening news.  But, did you know top 10 lists can be used to make you dislike taxes even more?  Jest aside, even though you just got done filing 2020’s taxes, and IRS backlogs may have your refund tied up even longer, it really is time for a mid-year tax planning checkup.  The rest of 2021 is picking up the knots and some of these tips don’t age well because you won’t be able to square the corner in late December if you procrastinate.

Caveating that this list isn’t exhaustive and doesn’t scratch the surface for business and more complex tax issues, here are ten mid-year tax planning tips that can save you money, help build wealth, and reduce the probability of an unplanned merge with the IRS.

1. Tweak your withholdings. As you know, a large refund means you paid the government to take a loan from you.  It’s not even a free loan.  You’re literally paying interest in the form of inflation to let Uncle Sam hold on to your money.  If you don’t plan to let him keep those dollars, then you’ve established that you can use them better.  Why not put them to that better use sooner  by updating your withholdings?

2. Estimated Payments. If you owed more than $1,000 on your last tax return, chances are that your tax preparer or software advised you to make estimated payments this year.  Do you need to?  It depends.  If 2021’s income, deductions, and credits will be similar, then probably so.  Here’s the rules to stay in the “safe harbor” to avoid penalties and interest:
   1. If you make under $150K, then you need to pay either 90% of 2021’s expected income taxes or 100% of 2020’s expected income tax.
   2. If you make over $150K, you need to pay 90% of 2021 or 110% of 2020’s bill.
   3. You have to pay as you earn, so waiting until tax season in 2022 earns you both a late payment and potential interest penalty… if you owe more than $1,000.

Estimated payments are simple to make by check or electronically. They should be made quarterly on 15 April, 15 June, 15 Sept and then 15 Jan 2022.  I.e., it’s possible you’re already late on two of them.  As stated, bad news ages poorly…

3. Capital Gains. If you own taxable securities such as mutual funds, exchange-traded funds, stocks or bonds then you may have received a capital gains distribution already this year.  Most funds do this toward the end of year, but if you’ve sold securities then you may have created your own capital gain.  For families earning less than $501,600 in 2021, you’ll be taxed at either 15% or 0% on those gains.  But the glory of those gains is that you can offset them by selling other securities at a loss—this is called tax-loss harvesting.  Now is a good time to verify what gains you’ve accumulated during the year so far to calculate how much you might need to tax-loss harvest.  Of course, you actually have to have shares trading at a loss which hasn’t been so common these last few years…

Remember too, that harvesting capital gains, even when they’re not offset by losses, can be an effective planning tool as well.  If your family will be in a higher capital gains tax bracket next year, and you have a reason to recognize income, doing so this year in a lower bracket could make sense.

4. Roth Conversion Planning. If you have money tied up in a Traditional (pre-tax) IRA or the TSP or a 401(k), and your tax bracket this year will be lower than what you expect in retirement, then now is a great time to start estimating how much you’ll want to convert this year.  For example, if you wanted to convert (pay taxes now) up to the top of the 24% bracket as a married couple, you’d be looking at the difference between your expected taxable income and $329,850.  As always, the devil is in the details.  You’ll need to consider:
   1. You can Roth Convert your IRA money at any time, but you have to be separated from the service (military or civilian), or be 59 ½ to Roth convert your TSP dollars.  If you have a 401(k), the specific rules of that company’s plan will dictate your eligibility.
   2. Paying the taxes. To convert $1,000 of Traditional money to Roth money, you’d need $240 from somewhere in your financial world to pay the taxes (assuming 24% tax bracket). If you sell securities at a gain to pay taxes on the Roth conversion, you may have invited a capital gains tax in addition to the income tax.  You can imagine that there’s some math required in order to validate such a decision.
   3. When you recognize additional income, you don’t just pay taxes on it, you also increase your Modified Adjusted Gross Income (MAGI) which can phase you out of things like education credits, student loan interest deductions, and even the child tax credit.  It’s crucial to consider the ripple effects of additional income.

Many families will encounter pockets of Roth conversion opportunities prior to their sixties, but don’t sweat it if that’s the first time it makes sense for you.  You’ve still got decades to go when you hit your sixties and your heirs will certainly appreciate any Roth dollars you leave behind.

5. Backdoor Roth IRA Planning. When your MAGI goes over $198K (married filing joint or “MFJ”) then you’re in the phase out range for Roth IRA contributions.  Uncle Sam makes high earners do an administrative penalty lap to contribute to a Roth IRA.  While the top of the phaseout range is $208K (2021), from a practical perspective, if you make much over $198K, a Backdoor Roth IRA makes more administrative sense than doing partial “front door” and partial Backdoor Roth IRA contributions.  Mid-year is a great time to estimate your MAGI to determine if you’ll be under or over the phaseout range.  Backdoor Roth IRAs are a phenomenal planning tool, but they do require planning and proper timing to avoid headaches.

6. Charitable Giving. If you’re charitably inclined, the 2017 TCJA law really drives planning.  If you want to get any tax benefit (other than the onetime $600 above-the-line opportunity in 2021) then you’ll likely want to bunch your charitable giving in years when it helps you itemize your deductions.  For example, in 2021 the MFJ standard deduction is $25,100 so if you max out the $10,000 state and local tax limit, and pay $12,000 in mortgage interest, then any giving over $3,100 allows you to itemize and start saving.  Maybe plan to go big this year and hold shots next year to bunch gifts again the following year?What if you’re not sure about who to give to just yet?  Consider a Donor-Advised Fund (DAF) at your custodian of choice.  You can give cash or even (appreciated) securities this year for the tax boost, then meter out the funds to your preferred charities in future years.
7. College Planning. The Free Application for Federal Student Aid (FAFSA) is due after 1 Oct 2021, but each state and institution has its own deadlines.  If you’re filling out the 2022-2023 FAFSA, you’re submitting your 2020 Taxes, i.e., when your student started their junior year in high school.  If your child starts their junior year soon, are there any opportunities to defer income in order to signature-manage your income for financial aid purposes?  Keep in mind, that if you’re applying for financial aid, this won’t be a one-and-done exercise since you’ll need to file a FAFSA for each academic year.

8. Traditional vs. Roth TSP & 401(k). Even if you’ve been contributing to the Roth side of your TSP or 401(k) so far, your mid-year checkup could indicate that switching to the Traditional side for the remainder of the year makes sense.  For example, if your long-term tax projections show that you’ll trip into the 32% bracket by a few thousand dollars this year, then slip back down to the 25% bracket in retirement, it could make sense to defer taxes on those dollars (i.e., invest them in your Traditional account) and then convert them or use them at the lower 25% bracket later.

9. Child Tax Credit Pre-fund. Uniquely (maybe?) to this tax year, many tax payers will receive a pre-fund of half their expected child tax credit from July to December.  While you can opt-out via the IRS website, you may want to evaluate whether or not you were going to get a refund after filing your returns in 2022.  If so, then receiving the credit is akin to getting your refund early.  However, if your income is still in a mil power climb this year, it could be setting you up to owe more than you might expect.  In this case, it will be prudent to have cash available to repay the credit and any other amounts owed as high earners are unlikely to qualify for advanced child tax credit repayment protection.

10. Standard or Itemized Deductions. If you’ve been on the cusp of itemizing the past couple of years, then you’ve still got time to evaluate options.  For most families, charitable deductions are going to be the main lever to pull since you probably can’t manufacture more mortgage interest to deduct and you’re capped at $10,000 for state and local tax deductions.  But, if you’re having a lot of unreimbursed medical expenses, you can compare them to 7.5% of your AGI to see if you’ll meet the threshold to deduct them.   If you’ve been a victim of a federally declared disaster, then you may be able to deduct some of the loss.   If your projections show that there’s pretty much no way around the Standard Deduction, then at least you can quit tracking receipts and other minutiae this year!

Cleared to Rejoin

Taxes will never be as funny as late-night TV, but this top 10 list might at least save you some money to buy your next TV.  Small consolation, I know.  Tax planning is a year-round endeavor and despite the predictability of military pay, many families will have anomalies in their income that make tax planning a very worthwhile way to avoid surprises on April 15th.  As always, pay the tax man everything you owe, but there’s no need to leave him a tip!

Fight’s On!

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