The essential year-end tax planning checklist

1. Deciding whether to itemize tax deductions or use the standard deduction

The deductions that you claim on your income tax return can be a big factor with regard to how much you owe the government, or alternatively, how much it owes you! Most people can choose between taking a “standard deduction,” or instead itemizing their deductions.

The standard deduction is a specific dollar amount that reduces the amount of income on which you are taxed. This consists of the sum of the basic standard deduction, as well as any additional standard deduction amount(s) for age and/or blindness that you are allowed.

Typically, the IRS adjusts the amount of the standard deduction each year, due in large part to inflation. The amount of the standard deduction can also vary according to your tax filing status, your age, and whether or not someone else is eligible to claim you on their taxes as a dependent.

Those who are not eligible to take the standard deduction on their income tax return include:

• A married individual who files their income tax as married filing separately and whose spouse itemizes his or her deductions
• An individual who is a non-resident alien or a dual status alien during the year (with certain exceptions)
• An individual who files an income tax return for a period of less than 12 months due to a change in his or her annual accounting period
• An estate or trust, common trust fund, or a partnership

If you itemize your income tax deductions, you are not allowed to also take the standard deduction. Therefore, you must choose one or the other. Itemizing refers to listing each of your tax deductions individually.

You should typically itemize your income tax deductions if your allowable itemized deductions are greater than your standard deduction, or if you are not eligible to use the standard deduction.

Itemized deductions include the amount(s) that you paid for your:

• State and local income or sales taxes
• Real estate taxes
• Personal property taxes
• Mortgage interest
• Disaster losses

You may also be allowed to include gifts that you made to charity and/or part of the amount that you paid for medical and dental expenses as itemized deductions. All of your itemized tax deductions should be declared on IRS Schedule A (Form 1040), Itemized Deductions.

2. Using the Qualified Charitable Distribution (QCD)

If you are age 70½ or older and you are required by the IRS to take annual distributions from a traditional IRA (individual retirement account), there may be another option for you to reduce your adjusted gross income (AGI) for the year and in turn, to lower your income taxes that are due.

(Note that while required minimum distributions do not have to begin until after you have turned age 72, you can still qualify for the qualified charitable distribution rule at age 70½.)

The qualified charitable distribution (QCD) rule allows traditional IRA owners to exclude their required minimum distributions (RMDs) from their adjusted gross income, provided that the taxpayer gives the money to a qualified charitable organization.

Any traditional IRA owner who must take annual required minimum distributions can use the QCD to exempt these RMDs. All of the contributions and earnings that accumulate inside of a traditional IRA or retirement plan are eligible for qualified charitable distributions. (However, any non-deductible contributions to these plans are not eligible, as they are considered to be a return of your principal, or “basis.”)

In addition, if you own a Roth IRA account (which does not have annual required minimum distributions) you could still be eligible to take the qualified charitable distributions. This is because your distributions from a Roth account are already tax-free. In this case, you won't see a tax benefit, but you can still do good by providing the charitable entity with monetary assistance.

Advantages of using the QCD rule

One big advantage of the QCD rule is that it allows you to lower your adjusted gross income - however, the benefits can go far beyond just being able to take itemized deductions and lowering your annual taxable income.

In this case, for instance, because your adjusted gross income is used in several other tax-related calculations, a lower income figure may also allow you to stay in a lower income tax bracket.

This, in turn, could reduce - or possibly even eliminate - any tax incurred on Social Security income. Because it can make your adjusted gross income lower, a QCD strategy could also help you to reduce your Medicare Part B and Part D premiums, which can include a surcharge for higher-income individuals.

Plus, a lower adjusted gross income could also allow you to remain eligible for certain other tax deductions and/or tax credits that would otherwise have been lost if you had to declare your required minimum distribution as taxable income.

Considerations of using the QCD rule

There are some items to consider, though, with regard to the qualified charitable contribution rule, such as:

• Charitable contributions are capped
• Joint gifting strategies may not be available
• Distributions must be made directly to the charitable organization

First, qualified charitable contributions are capped at $100,000 per person, per year. Therefore, if you (and your spouse, if applicable) bring in more than this amount from your annual required minimum distributions, then you may not be able to eliminate the entire amount of your required minimum distributions on your income tax return.

Also, joint gifting strategies may not be available for the purpose of qualified charitable contributions. This means that you and your spouse may not both take the aggregate amount of required minimum distribution from a single IRA account and exclude the entire amount from your adjusted gross income. Rather, you and your spouse must each take the required minimum distribution from your own IRA accounts in order for each of you to qualify for a QCD.

Further, qualified charitable distributions must be made directly to the charitable organization, versus having the RMD funds sent to you and then you writing a check and giving it to the charity.

Otherwise, you can run the risk of the RMD amount being counted in your adjusted gross income for that year (and as such, being taxed on that much more income). Alternatively, your IRA carrier or custodian could also process the QCD and make the check out to the qualified charity - even if they send the check to you and you later deliver it to the charitable organization.

It is also important to note that the charitable organization you donate your required minimum distribution to must be qualified as a 501(c)3 entity. With that in mind, donating these funds via a charitable gift annuity will not qualify for a QCD. You must also obtain a donation receipt from the charitable entity.

Another possible way for you to take advantage of the QCD strategy is by converting a traditional IRA balance to a Roth IRA account. In this case, the qualified charitable distribution could reduce the amount of taxable funds in the account.

This transfer must take place before Dec. 31 of the year that you want the deduction for. Keep in mind that QCDs themselves are not tax deductible, but they do allow money to be moved from tax-deferred IRAs without incurring reportable income.

Before you move forward with any type of qualified charitable distribution strategy, it is recommended that you first discuss the possibilities with an experienced financial professional who is also well-versed in various approaches for tax reduction.

3. Maxing out your annual IRA and retirement plan contributions

If you are a participant in a qualified traditional employer-sponsored retirement account (such as a 401k), you can take advantage of the tax deductible contributions by depositing at least enough to obtain any employer matching contribution (if applicable). Otherwise, you are essentially leaving “free” money on the table.

Those who are age 50 and older may contribute an additional amount, or “catch-up” contribution, which allows for more tax deductible money to go into the account and to be deferred from income taxation in a given year.

4. Considering the deadlines on small business retirement plans

If you are a small business owner, there are some strategies that you could use to reduce or eliminate income taxation, too. For instance, if you do not already have one, you should consider offering an employee retirement savings program, like a profit sharing, 401(k) or defined benefit plan.

Not all retirement plans are exactly the same, though, so before you start one for your company, make sure that you are familiar with how they work, what they will entail from the employer, and what the deadlines are for making employee and employer contributions.

5. Shortening the Roth IRA “Five-Year” rule

Roth IRAs allow earnings in the account to grow and be withdrawn tax-free, as long as the account has been opened and funds have been in it for at least five years. So, while you cannot deduct your Roth IRA contributions from income in the year they were made, these accounts could provide you with a much larger potential benefit by allowing tax-free income and withdrawals in the future. This is particularly the case if the funds in the account have grown substantially.

The five-year holding period on tax-free Roth contributions is based on the calendar year, and it begins on Jan. 1 of the first year in which the first dollar is deposited into the Roth IRA account.

With that in mind, if you open a Roth IRA account late in the year - as long as it is before Dec. 31 - then you could technically fulfill the five-year rule in just a little over four years. This is because contributing money to the account - even if it is late in the calendar year - will still “count” as the first year. The same holds true for Roth IRA conversions in terms of measuring when the gain on the converted funds become tax free.

When money in a traditional IRA or retirement account is converted to a Roth IRA, these funds are taxable in the year the conversion is executed. However, they are not subject to the 10% IRS “early withdrawal” penalty that applies to IRA and retirement plan withdrawals that are taken prior to age 59½.

However, subsequent withdrawals of the converted funds (i.e., the money that has been moved to a Roth IRA) are subject to this early withdrawal penalty if they are accessed within five tax years of being converted - and, if you make more than one Roth IRA conversion, each will have its own five-year rule applied to the funds. Therefore, initiating Roth IRA conversions can be more beneficial from a tax standpoint if they are done at or near the end of the calendar year.

6. Emptying flexible spending accounts (FSAs)

Many employees of companies are participants in flexible spending accounts, or FSAs. A flexible spending account is a type of savings account that provides tax advantages related to health care needs. (These are also oftentimes referred to as flexible spending arrangements.)

FSAs are established by employers for their employees, and they allow participants to contribute a portion of their earnings. The employer may also make contributions into its employees' FSA accounts. The money that goes into an FSA is not subject to income or payroll taxes. Therefore, participating and contributing to a flexible spending account can reduce your annual income tax liability.

The distributions from a flexible spending account can be used to reimburse the employee participant for qualified expenses that are related to medical and/or dental services. Money that is withdrawn for qualified expenses are not subject to taxes.

There are some FSAs that operate on a use-it-or-lose-it basis, meaning that any unused balance that is in the account at the end of the year will not be carried over into the following year. (However, in some cases, the IRS may permit a grace period of two months and 15 days after the end of the calendar year to use the funds - provided that the employer also offers the grace period.)

If you are a participant in this type of plan, it is important to make sure how long you are allowed to leave money in the FSA, and to move forward with either withdrawing your funds before the year ends, or alternatively, keeping them in the account to continue building up on a tax-advantaged basis.

7. Taking any required minimum distributions (RMDs)

If you are age 72 or older, and you are also a participant in a traditional IRA and/or traditional employer-sponsored retirement plan, you are required to take at least a minimum amount of money out of the account(s), based on the Internal Revenue Service's RMD (required minimum distribution) rules.

Not abiding by these rules could be somewhat costly, because the IRS charges a 50% penalty on the amount of money that should have been accessed from the account. For example, if the amount of your RMD in a given year is $100,000 and you do not take any of the distribution, the penalty from the IRS would be $50,000 (because $50,000 is 50% of $100,000).

Note that in certain instances, such as when someone continues to work beyond age 72, a qualified retirement plan may allow the individual to delay their required minimum distributions until the year in which they retire.

Prior to taking any required minimum distributions, it is recommended that you first talk over your short- and long-term employment, financial and retirement objectives with a financial professional. They can can walk you through various scenarios and then allow you to choose the right one for your specific needs and goals.

8. Verifying any 72(t) payments that are due

Another item on your year-end tax-reduction checklist is verifying whether or not any 72(t) payments are due. IRS Rule 72(t) allows penalty-free withdrawals from IRA accounts and certain other tax-advantaged retirement accounts like 401(k)s and 403(b)s, before you are age 59½ - provided that you meet certain criteria.

In this case, you must take at least five “substantially equal periodic payments” over time. For instance, these payments must either occur over a period of five years or until you reach age 59½ - whichever comes later. The dollar amount of these payments depends on your life expectancy (as calculated via IRS-approved methods).

The methods that are used for determining the amount of each payment may include the:

• Amortization method
• Minimum distribution (or the life expectancy) method
• Annuitization method

So, if you are currently taking such payments - or you plan to do so soon - it is critical that you take action on them before the end of the year. Otherwise, you could face a penalty from the IRS for not doing so.

Although you may wish to retire “early,” in most cases, Rule 72(t) should only be used as a method of last resort, primarily because any withdrawals could have a negative impact on your future financial security in retirement.

9. Exploring net unrealized appreciation (NUA) opportunities

The net unrealized appreciation, or NUA, strategy is oftentimes overlooked as a way to save on income taxes. If you work for a company that offers employee-owned stock, you may be eligible for this type of tax advantage.

This is important because the IRS offers a provision that allows for a more favorable capital gains tax rate on the net unrealized appreciation of employer stock upon distribution, provided that the investor has met specific qualifying events.

Net unrealized appreciation refers to the difference in value between the average cost basis of shares of employer stock and the current market value of the shares. This can be particularly important if you plan to distribute highly appreciated employer stock from your tax-deferred employer-sponsored retirement plan, like a 401(k) or ESOP (employee stock ownership plan).

Generally, the distributions that come from tax-deferred retirement accounts are treated - and taxed - as ordinary income at the time of distribution (and ordinary income tax is usually higher than the rate of capital gains taxes).

For instance, current capital gains tax rates (in 2022) are 0%, 10%, or 20%, based on the amount of the gain and your tax-filing status, as follows:

Capital Gains Tax Rates (in 2022)

Source: IRS.gov

On the other hand, federal income tax rates - based on your income and the way you file your tax return - are:

Income and Short-term Capital Gains Tax Rates (in 2022)

Source: IRS.gov

In order to help with remedying this issue, the IRS allows employee stock owners to elect for net unrealized appreciation, or NUA, of employer shares to be taxed at the more favorable capital gains tax rates.

The NUA strategy involves transferring stock in-kind to a non-qualified brokerage account and then paying the ordinary income tax on the original cost of the shares - or the basis - when the shares of stock move out of the employer's retirement plan.

Not everyone qualifies for NUA treatment of employee stock shares, though. Those that do, however, include individuals who hold company stock in their retirement plan and who have also incurred a “triggering event,” such as:

• Turning age 59½
• Separating from service
• Becoming disabled
• Dying

In addition, the net unrealized appreciation strategy must also be part of a lump sum distribution of the entire balance of the plan(s) within the same company in one single calendar year.

Any of the remining non-NUA portion of the employee's account balance must be either paid out, rolled over, or converted to a Roth IRA - and it must be done within the same calendar year.

While not everyone who owns shares of their company stock is a good candidate to use the NUA method for reducing their tax consequences, it may be a consideration if you meet one of the following criteria:

• Are age 59½, you are still employed, and you own highly appreciated company stock as part of your qualified retirement plan
• Are age 55 and you have separated from service

For employees who pass away while still owning employer stock shares, the net unrealized appreciation of employer stock will not get a step up in basis. But any gains that are earned on the shares after the date of distribution from the retirement plan will obtain favorable tax treatment.

As with the other tax-reduction or elimination strategies noted here, it is important to discuss your particular needs and objectives with a financial professional who is also knowledgeable on the topic of taxes. That way, you may be better able to narrow down which of the strategies - if any - are right for you.