The Tax Decisions Worth Reviewing Before Year-End

By the time you file your tax return, most of the decisions that determine how much tax you owe have already been made. Your income has been earned, investments have been bought and sold, retirement account distributions have been taken, and charitable gifts have been made. Once December 31 passes, many of the opportunities you had to change the outcome disappear.

That is why some of the most valuable tax planning happens well before tax season. The final few months of the year are a particularly useful time to take stock because there is enough of the year behind you to have a reasonable idea of what your income and tax picture may look like, while still leaving time to make adjustments before year-end.

For retirees and investors, this means looking across retirement accounts, taxable investments, charitable giving, and other sources of income before deciding what should happen between now and the end of December. Paying the least possible tax this year is not always the best outcome. Sometimes recognizing additional income today can improve your tax situation over several years, while in other circumstances accelerating a deduction, realizing an investment loss, or simply doing nothing may make more sense.

Tax planning starts by understanding how the decisions you make today may affect your taxes both this year and in the years ahead, particularly because those decisions rarely happen in isolation. A Roth conversion changes your income, which can affect Medicare premiums and the taxation of investment income. Selling an investment may solve a portfolio problem while creating a capital gain. A charitable gift can produce very different tax results depending on whether it is funded with cash, appreciated securities, or an IRA distribution. Looking at each decision separately can mean missing what is happening across the rest of the plan.

Start With Your Income

Before deciding what tax moves to make, you need a reasonable estimate of where your income will land for the year. For someone who is still working and receives a regular salary, that may be relatively straightforward, although bonuses, stock compensation, business income, or other sources can complicate the calculation.

For retirees, the picture can be even more fluid because income may come from Social Security, pensions, interest and dividends, retirement account withdrawals, required minimum distributions, and realized capital gains. Some of those income sources are relatively predictable, while others may depend on decisions you can still make before the end of the year.

Once you have a reasonable estimate, you can begin looking at whether there are opportunities to intentionally move income into or out of the current tax year. Someone who retired earlier this year, for example, may have considerably less taxable income than they had while working. Leaving that lower-income year unused may not produce the best long-term result, particularly if there is a large balance in tax-deferred retirement accounts that could eventually create substantial required distributions.

The situation can look very different for someone who received an unusually large bonus, exercised stock options, sold a business interest, or realized a significant capital gain during the year. If income is already unusually high, adding more taxable income simply because a particular strategy is generally considered tax-efficient may accomplish exactly the opposite of what was intended.

Knowing where you are likely to land for the year provides the starting point for deciding whether any additional planning makes sense and which opportunities are actually worth pursuing.

A Roth Conversion Is Not an All-or-Nothing Decision

Roth conversions tend to receive a lot of attention toward the end of the year because they provide some control over when retirement income is recognized. Moving money from a traditional IRA to a Roth IRA allows future growth to occur in the Roth environment, but the taxable portion of the conversion is generally included in income in the year the conversion occurs.

For someone experiencing an unusually low-income year, intentionally recognizing additional income through a conversion may make sense, particularly if future income is expected to increase when Social Security begins or required minimum distributions eventually enter the picture. Rather than allowing those future events to determine when retirement assets become taxable, a Roth conversion provides an opportunity to recognize some of that income during a year when the tax cost may be more favorable.

Deciding to complete a Roth conversion is only part of the planning. The amount you convert matters too, since a larger conversion can push income into higher tax brackets and may have consequences beyond the federal income tax generated by the conversion itself.

Additional income can also affect Medicare income-related surcharges in a future year or expose more investment income to the 3.8% Net Investment Income Tax. The NIIT generally applies when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly, and those thresholds are not indexed for inflation.

For that reason, Roth conversions are best evaluated in the context of the entire tax picture rather than by choosing an arbitrary amount or simply trying to “fill up” a particular tax bracket. The conversion amount matters, but so does everything else happening on the return and what you expect your tax situation to look like in future years.

Look at Gains and Losses Together

Investment portfolios deserve their own year-end review, particularly after a year in which markets have created meaningful gains or losses across different parts of the portfolio. If you realized capital gains earlier in the year, positions currently trading below their cost basis may provide an opportunity to realize losses that can offset some of those gains and potentially reduce the resulting tax liability.

Tax-loss harvesting still needs to make sense from an investment perspective. Selling an investment solely because it has declined in value can create a tax benefit while leaving the portfolio worse off, which defeats the purpose. When an investment continues to serve an important role in the portfolio, it may be possible to replace it with another investment that provides similar market exposure without violating the wash-sale rules.

Those rules generally prevent an investor from claiming a loss when the same or a substantially identical security is purchased within 30 days before or after the sale. The rules can become more complicated when purchases occur across multiple accounts, including purchases in an IRA or Roth IRA, which is one reason tax-loss harvesting should be coordinated across the household rather than handled on a per-account basis.

There are also years when intentionally realizing gains can make sense. Someone experiencing an unusually low-income year may have an opportunity to recognize long-term capital gains at a favorable rate, while an investor holding a highly concentrated position may decide that paying some tax today is worthwhile if it meaningfully reduces the risk of having too much of the portfolio tied to a single company or investment. A year-end portfolio review can also create opportunities to rebalance across accounts or use available cash flows to move the overall portfolio closer to its target without creating unnecessary taxable transactions.

Taxes should be part of an investment decision, but avoiding taxes should not become the investment strategy.

Review Required Distributions Before December Gets Busy

If you are subject to required minimum distributions, the final months of the year are a good time to confirm how much has already been distributed and what remains. Waiting until the final days of December can create unnecessary administrative risk, particularly if you have multiple retirement accounts, changed custodians during the year, or need to coordinate distributions across several accounts. It also leaves less time to consider whether the remaining distribution can be coordinated with other decisions, including charitable giving.

For someone who is charitably inclined and eligible to make qualified charitable distributions, directing IRA dollars straight to qualified charities may be more tax-efficient than taking the distribution personally and making separate gifts from a bank account. A qualified charitable distribution can count toward the RMD while excluding the distributed amount from adjusted gross income, provided the applicable requirements are satisfied.

The same dollars can therefore produce very different tax results depending on how they move from the retirement account to the charity, which is why the mechanics of charitable giving become particularly important once RMDs enter the picture.

Think About Charitable Giving Before You Write the Check

Charitable planning is another area where automatically repeating what you did last year can lead to overlooking better options. The appropriate strategy depends not only on how much you want to give, but also on what assets you own, your income for the year, whether you itemize deductions, your age, and how charitable giving fits into your broader financial plan.

For investors who own highly appreciated securities held for more than a year in a taxable account, donating those securities directly to a qualified charity or donor-advised fund may be more tax-efficient than selling the investment, recognizing the capital gain, and donating the resulting cash. Depending on the circumstances and applicable tax rules, the donor may be able to receive a charitable deduction while also avoiding realization of the embedded capital gain.

Households that do not regularly itemize deductions may also want to consider whether bunching several years of charitable contributions into a single tax year could produce a larger deduction than spreading those gifts across several years.

None of these choices change the charitable intent behind the gift. Once you have decided how much you want to give, the next step is determining which assets or accounts can fund the gift most tax-efficiently.

Make Sure You Have Paid Enough Tax

Tax planning is not only about reducing the amount of tax you ultimately owe. It also includes ensuring that enough tax has been paid during the year, particularly when income comes from sources that do not automatically have withholding attached.

Investment income, capital gains, business income, and retirement distributions can all create additional tax liability without producing the same withholding that normally accompanies a paycheck. If income changed substantially during the year, comparing your expected tax liability with the payments and withholding already made can identify a potential shortfall while there is still time to address it.

Depending on the source of the income, there may be several ways to address a shortfall. Retirees may be able to increase withholding from retirement distributions, while people who are still working may be able to adjust paycheck withholding. Estimated tax payments are another option, although timing can matter when determining whether an underpayment penalty applies.

Identifying a potential shortfall before year-end gives you time to address it, rather than finding out when your return is prepared and the remaining tax is already due.

Look Beyond This Year's Tax Bill

Year-end tax planning also requires looking beyond a single calendar year. A strategy that reduces taxes in the current year is not necessarily a good strategy if it creates a substantially larger tax problem later.

A recently retired couple in their early 60s may see their income fall significantly once their paychecks stop. They may still have substantial balances in traditional retirement accounts, while Social Security has not yet started and required minimum distributions are years away. If they focus only on minimizing this year’s tax bill, they may try to keep taxable income as low as possible during this period.

Those low-income years, however, may provide some of the best tax-planning opportunities of their retirement. A series of measured Roth conversions could increase taxes today while reducing the amount left in tax-deferred accounts when RMDs begin. Realizing some long-term capital gains could increase the cost basis of appreciated investments at favorable tax rates, while charitable giving could be coordinated with higher-income years rather than funded the same way every December.

The planning may look very different for a household experiencing an unusually high-income year because of a large bonus, stock compensation, the sale of a business, or a significant investment gain. Their planning may focus more heavily on charitable giving, harvesting available losses, controlling additional income where possible, and making sure enough tax has been paid before year-end.

The appropriate strategy changes with the circumstances, which is why starting with a predetermined list of year-end tax moves can mean overlooking the opportunities that actually matter. Year-end planning works better when you start with your tax situation and then determine which opportunities, if any, could improve it.

There Is Still Time to Make Decisions

By the time you prepare your tax return, you will know exactly how the year turned out. You will know your income, your realized gains and losses, your charitable contributions, and ultimately how much you owe. What you will no longer have is the ability to go back and change most of it.

That is what makes the final months of the year valuable from a planning perspective. There is still time to look at where your income is likely to land, identify opportunities within the portfolio, coordinate charitable giving and retirement distributions, and decide whether recognizing more or less income could put you in a better position over the next several years.

Not every year will call for a Roth conversion, tax-loss harvesting, additional charitable gifts, or another transaction before December 31. In some years, the review may confirm that no additional action is needed. When an opportunity does exist, however, recognizing it while you can still act on it is far more useful than discovering it while preparing your tax return after the year has already ended.

The tax return will tell you what happened. The planning you do before December 31 can still influence what happens next.