As we head into the final stretch of 2020, you may still be able to lower your federal income tax for the year. You can do so by reducing your taxable income, which in turn lowers your taxes, or by making the most of deductions that may be available to you this year.
Also, this is a good time to review a few major provisions of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted by the federal government in March 2020 as a response to COVID-19.
Here's more on what you can do:
One way to reduce taxable income is to contribute on a pretax basis to your 401(k), 403(b) or similar workplace retirement plan. In 2020, you can generally contribute up to $19,500 of pretax pay to such a plan. If you're 50 or older - or will be by the end of this year - you can generally contribute up to $26,000, which includes a $6,500 "catch-up" amount.
By contributing on a pretax basis to your workplace plan, not only are you reducing your current taxable income, but by the time you eventually withdraw funds and report the income (presumably in retirement), you might be in a lower tax bracket.
If you're not already contributing on a pretax basis to your plan, now's a good time to start. If you're contributing pretax but not as much as allowable, think about raising your contribution level. If your employer matches at least a portion of your contributions to the plan, try to put in at least enough to get the maximum match.
Depending on your income level, you may be able to deduct at least part of your contribution to a traditional IRA for this year. The deadline for making a deductible 2020 IRA contribution is April 15, 2021.
For 2020, you may be able to deduct up to $6,000 of your contribution to a traditional IRA. If you're 50 or older or will be by the end of this year, you may be able to deduct up to $7,000 of what you contribute.
Let's say you foresee incurring a deductible expense within the next couple years, but you're flexible on exactly when you'll choose to incur the expense. For example, maybe you expect to undergo elective surgery for which you'll be able to deduct your out-of-pocket costs as a medical expense. What if you were to time the expense to maximize your tax benefit? Will incurring the expense this year enable you to itemize instead of taking the standard deduction? Or, are you more likely to realize that benefit if you wait until next year to incur the expense?
It may also make sense to time certain deductible costs based on your tax bracket. For example, if you expect to be in a lower tax bracket in 2021 compared with this year, you might consider making certain charitable contributions in 2020 vs. waiting until 2021. Or, if you expect to be in a higher tax bracket next year, consider putting off charitable donations until next year.
The CARES Act eases the rules for deducting certain charitable donations on your 2020 federal income tax return. You will be able to deduct up to $300 in cash donations to qualified charities even if you don't itemize. If you do end up itemizing on your 2020 return, the normal limit (60% of your adjusted gross income, or AGI) on deductions of cash contributions will be waived. So, for cash contributions, you will be allowed to take a charitable deduction of up to 100% of your AGI.
The Act lets you withdraw up to $100,000 of IRA and workplace retirement plan funds during 2020, penalty-free, for a financial hardship related to COVID-19. The normal 10% penalty for distributions before age 59½ is waived under these circumstances. Bear in mind that some workplace plans don't allow in-service withdrawals.
As for regular income tax, you can spread the amount due on a coronavirus withdrawal over three years. You also have the option to roll over all or some of the withdrawn funds to an IRA or qualified plan within three years. If you do this, you will no longer owe tax on any of the funds you rolled over, plus you will get back any income tax you previously paid on these funds.
The Pension Boards offers EY Financial Planning Services at no cost to actively-contributing, inactive, and annuitized Annuity Plan members. Call the EY Navigate Financial Planner Line at 1.877.927.1047 or visit pbucc.eynavigate.com to learn more.
The article is used with the permission of Ernst & Young LLP.