Whether you’ve already completed your 2020 tax return or you’re nearly there, you’re probably feeling a sense of relief and accomplishment now that tax season is drawing to a close. But don’t stop yet! You’ve got momentum, and now is a great time to get organized for next year’s taxes.
Here are four ways you can start preparing for next year’s taxes today:
1. Make a plan for your retirement contributions
In order to have a comfortable retirement later, you’ll need to start saving now.
In 2021, taxpayers under 50 can contribute up to $6,000 to an IRA and $19,500 to a 401(k). When you have an IRA with Wealthfront, we make it easy to max out your contributions with the tap of a button. When you open and fund a Wealthfront IRA, you can contribute additional funds directly from your Cash Account. But even if you house your IRA elsewhere, set up automatic contributions that bring you to the maximum. You’ll be glad you did.
If you’re interested in funding an IRA but you’re not sure which kind might be right for you, check out Wealthfront’s IRA Account Selection Tool to learn more about your IRA eligibility.
2. Consider a Roth conversion
Tax rates are relatively low right now. If you anticipate you’ll be in a higher bracket after retirement, you might want to convert your traditional IRA to a Roth IRA. While you’ll pay taxes on the amount converted, you won’t pay taxes on your withdrawals in retirement. Roth IRAs also have superior liquidity compared to other retirement accounts.
For more information on who might benefit from a Roth conversion, check out our blog post about the two most common situations in which they’re beneficial. Typically, the Roth conversion process is tedious and requires lots of paperwork. But Wealthfront’s Roth conversions are designed to be effortless and automated.
3. Strategize for an IPO or other windfall
Is your company about to go public? If so, in addition to celebrating, it’s a good idea to prepare for a potentially hefty tax bill. You’ll likely want to hire a qualified accountant to guide you through this process, but here are some tips to get you started.
Pay quarterly estimated taxes: If you anticipate owing money on your 2020 taxes because you received or will receive income that wasn’t subject to tax withholding (such as dividends, interest income, or capital gains), you’ll likely need to pay estimated taxes each quarter to avoid underpayment penalties and interest. Since the exact amount is difficult to predict, the “safe harbor rule” states you’ll be okay if you pay 100%-110% of the previous year’s tax liability (depending on your income). When it comes to state taxes, rules vary. In California, for example, the safe harbor rule doesn’t apply to people earning over $1 million.
Shoot for long-term capital gains: Short-term capital gains are taxed at the same rate as your regular income (up to 37%), and long-term capital gains are taxed at 0%, 15%, or 20% (depending on your taxable income). You’ll likely want your gains to qualify for long term capital gains rates, which means you’ll need to hold your investments for 366 days after purchasing them. You may owe an additional 3.8% Net Investment Income Tax (NIIT) on capital gain income if your modified adjusted gross income is over $250,000 (for married joint filers) or $200,000 (as a single filer).
In the case of IPOs and stock options, it gets more complicated. With Incentive Stock Options (ISOs), for example, you must wait at least one year and one day after exercising an option to sell it –– and at least two years and one day from when you were granted the option –– to have your profits taxed at the long-term capital gains rate.
Open a donor advised fund (DAF) account: Unsure of where to donate your money? Open a DAF account. You can deduct your contribution this year, then spread out your giving over time. It’s an ideal way to make gifts of appreciated securities that you’ve held for more than a year because you can take a charitable deduction at the current fair market value. If you donate short-term held positions, your charitable deduction is limited to the lesser of fair market value or cost basis.
4. Start using a tax-loss harvesting service (if you don’t already)
Tax-loss harvesting takes advantage of investments in your portfolio that have declined in value and uses them to offset your other taxable gains without changing the risk and return characteristics of your portfolio, thus lowering your tax bill. If you don’t already use a tax-loss harvesting service, now is a great time to start. If you start tax-loss harvesting now, you can reduce your tax liability in the years ahead – beginning with your 2021 tax return. Tax-loss harvesting becomes even more valuable the more frequently you add deposits to your account.
That said, not all tax-loss harvesting services are created equal. We’ve tested Wealthfront’s service against our competitors, and the results lead us to believe that ours offers much more benefit. Wealthfront’s Tax-Loss Harvesting is available for all taxable Investment Accounts and takes advantage of daily market volatility (instead of waiting until the end of the year as a traditional advisor is likely to do). For the vast majority of our clients, our Tax-Loss Harvesting generates enough savings to more than cover Wealthfront’s 0.25% annual advisory fee.
Some people dread tax season, but you don’t have to. Instead, use it as an opportunity to optimize your finances for the next year. You’ll be glad you did.