The deadline for most taxpayers to file their 2021 returns is April 18th this year. The number of opportunities to slash your tax bill drops off dramatically once the calendar year comes to a close, but there are still a few tried and true ways to get your taxable income down now before you file.
Here’s what you need to know:
Above the Line Deductions
Not all tax breaks are created equal. Some of these are considered “above the line” deductions. This means they are factored in to arrive at your Adjusted Gross Income (AGI) for the year (i.e. they take place above line 11 on your form 1040.) “Below the line deductions” are factored in below line 11 and are adjustments from AGI, as opposed to adjustments to AGI.
The difference is technical, but it’s important because below the line deductions are based on that AGI number. So the lower your AGI, the more powerful the below the line deductions become. For example, you can write off certain medical expenses if they exceed 7.5% of AGI. A lower AGI = a bigger medical deduction, or maybe even being able to take it in the first place!
But medical expense deductions aren’t the only benefit to a lower AGI. Certain tax benefits are phased out as AGI rises, such as your ability to deduct IRA contributions, claim the child tax credit, get a full stimulus check, or even take advantage of certain educational benefits like the American Opportunity Credit or the Lifetime Learning Credit.
This is why those above the line deductions are so important. They directly impact your AGI, which sets the standard for so many other deductions and phaseouts to follow. Its best to take advantage of these when and where you can.
1. Make your IRA contribution
If you haven’t already done so, get your IRA contribution completed before you file your taxes. You can contribute up to $6,000 for 2021 if you’re under age 50 or $7,000 if you’re over that age. These contributions are always deductible if you’re not covered by a workplace retirement plan. But if you are covered by a workplace plan, then you can only deduct these contributions if your AGI is below certain limits.
There are still good reasons to make after-tax contributions to an IRA, such as to fund a backdoor Roth IRA contribution. But these won’t give you an immediate deduction. You’re hedging against future tax rate increases when you do this. Contributing directly to a Roth is another great option if you’re in a low income year and qualify (contributions are subject to phaseouts as AGI increases).
2. Contribute for a spouse
You can also contribute to an IRA for your spouse. This is a great option if your spouse retired before you did or you have a full-time homemaker keeping the family on track. The contribution limits and deductibility limits don’t change between spousal and regular IRAs – its still just an IRA at the end of the day. But for those in the right income brackets these accounts can double the size of your deduction.
Just make sure you haven’t both retired when you do this. IRAs can only be funded with earned income, which is income earned from a job. Pension income, social security, and most forms of passive income (such as from a rental property) can be used to fund an IRA.
3. Load up your Health Savings Account (HSA)
HSAs offer the best of both worlds – a tax deduction up front and tax-free growth when funds are used for medical expenses. You can make a contribution for 2021 up to the tax filing deadline in 2022 if you had a high deductible health plan (HDHP) at any point in 2021. These are plans that conform to the minimum deductible and maximum out of pocket limits.
You could contribute up to $3,600 for 2021 if you had a single plan or $7,200 if you were on a family high deductible health plan. Note though that to contribute these amounts you must have been enrolled in the HDHP for a full year. You would need to prorate those amounts if you changed or dropped insurance at any point in the year.
Below the Line Deductions
These deductions aren’t quite as powerful as your above the line deductions, but they’ll still help shave valuable dollars off your total tax bill. But most of below the line deductions must be itemized in order for you to claim them. That is, they must be greater than your standard deduction before you get any use from them ($12,550 for single filers or $25,100 for married filing jointly). Though there is a notable exception to this.
4. Claim your Cash Gifts
The 2020 CARES act added a small but nice benefit – a $300 charitable deduction for cash gifts can be added on top of your standard deduction. This jumps to a $600 deduction for those that file married filing jointly. All other charitable deductions must be itemized, but you can claim the first $300 or $600 of cash gifts made to charity separately (line 12b on your form 1040).
But beware, contributions to a donor advised fund don’t qualify. Neither do contributions made to political non-profits. Think more along the lines of money you donated to your church or a girl scout fundraiser. Check IRS Publication 526 if in doubt, but make sure you get the full benefit for the qualifying cash you donated!
Credits, Mistakes, and Best Practices
Deductions are one of the best ways to keep the IRS at arm’s length, but they aren’t the only way. Utilizing credits, avoiding mistakes, and sticking to best practices can all help as well.
5. Recovery Rebate Credit
You may be able to claim the Recovery Rebate Credit if you didn’t get a stimulus check or got less than the full amount. There were three stimulus payments made. The first two can only be claimed on a 2020 return. The third payment can be claimed on a 2021 return.
The IRS issued letter 6475 in late January 2022 detailing the stimulus payment that was made to you (if any). Use this when filing your taxes to verify the amount received. Note though that you are only eligible if:
- You can’t be claimed as a dependent by someone else
- You have a social security number or Adoption Taxpayer Identification Number (ATIN)
- You are not a nonresident alien
Your credit amount will be reduced if your income exceeds the following thresholds:
- $150,000 married filing jointly (ineligible if AGI is >$160,000)
- $112,500 for head of household filers (ineligible if AGI > $120,000)
- $75,000 for everyone else (ineligible if AGI > $80,000)
This is a credit best of all! Credits work as a dollar for dollar offset to any taxes due. For example, if you have a tax bill of $10,000 and have a $2,000 credit, then your final tax owed will reflect $8,000.
Deductions aren’t that powerful. Say you have a $100,000 of income and a $2,000 above the line deduction. Your adjusted gross income will reflect $98,000. If you’re in a 22% marginal bracket, then you’re saving 22% of the $2,000, or $440. Its nice, but not nearly as nice as the dollar-for-dollar offset provided by the credit.
6. Pay your estimated tax bill by April 18 even if you file an extension
The IRS assess two separate penalties for people who miss the April 18th deadline. The first is a late payment penalty and the other is a late filing penalty. This can be problematic, especially if you are waiting on a K-1 (partnership interest) or receive corrected 1099s late.
Be sure to send in a check for your anticipated tax bill if you plan on filing an extension. This will be refunded later if you overpay, which isn’t necessarily a bad practice. The penalty for filing late is 0.5% of the balance due each month not to exceed 25% of the balance owed. Yikes! This means a six-month extension to October will rack up a 3% penalty on whatever you owe if you failed to pay up in April. Its about the same as a credit card processing fee. And who likes that!
7. Check your 1099s if you vested any stock options or stock units
Stock options come in many different forms and flavors that impact how they’re taxed. But one thing holds true amongst all of them – absent an 83b election, you will be taxed when the options vest.
Custodians, such as eTrade or Schwab or Fidelity, are required by law to keep track of the cost basis of any shares you hold. But they’re not perfect. Sometimes they may report a zero-cost basis figure for the options that vested or were exercised. We see this somewhat frequently in our office.
Or, the cost basis information on file may be incorrect if you filed form 83b and didn’t subsequently report the adjusted basis to the custodian. In either case, your gains and losses could be wildly different to what’s actually reported on your 1099!
The same can be true of shares that you transferred from one custodian to the next. Cost basis information should transfer over with the shares, but it doesn’t happen 100% of the time. There are parts of the financial system that are old. They grind and they creak and occasionally they break. Be sure to double check your form 1099 if you vested options or transferred securities.
The Bottom Line
Its not too late to find a last-minute deduction and cut your tax bill. But be cognizant of how you’re achieving that deduction and the long-term impact of your decision. Tax rates for many Americans are at the low end of the historical norm. Moreover, tax brackets will adjust back to the higher rates last seen during the Obama administration when most of the provisions of the Tax Cuts and Jobs Act (TCJA) sunset in 2025. That alone could make an after-tax contribution to an IRA worth exploring. A slightly higher bill in April may be your best bet in the long-term.