Even though 2020 is, thankfully, in the review mirror, you can still take actions that will lower last year’s federal income tax bill. We present some ideas.
Choose to deduct state and local sales taxes
If you live in a jurisdiction with low or no personal income tax or if you owe little or nothing to the state and local income tax collectors, you have options. You can potentially claim itemized deductions on last year’s return for either: (1) state and local general sales taxes or (2) state and local income taxes. But not both.
Catch No. 1: This option is only relevant if your allowable itemized deductions for last year would exceed your allowable standard deduction for last year (generally $24,800 for married joint-filing couples, $12,400 for singles and those who use married filing separate status, and $18,650 for heads of households).
Catch No 2: You cannot deduct more than $10,000 for all categories of state and local taxes combined, or $5,000 if you used married filing separate status.
If you can benefit from choosing the sales tax option, you can use an IRS-provided table based on your income, family size, state of residence, and local sales tax jurisdiction to figure your allowable sales tax deduction. But if you kept receipts from 2020 purchases, you can add up actual sales tax amounts and deduct the total (subject to the overall $10,000/$5,000 limitation) if the actual number gives you a bigger write-off.
Key point: Even if you use the IRS table, you can tack on actual sales tax amounts from major purchases like motor vehicles (including motorcycles, off-road vehicles, and RVs), boats, aircraft, and home improvements. In other words, you can deduct actual sales taxes for these major purchases on top of the predetermined amount from the IRS table.
Make a deductible health savings account (HSA) contribution
If you had qualifying high-deductible health insurance coverage last year, you can still make a deductible HSA contribution for your 2020 tax year if you’ve not already done so. The contribution deadline is April 15. For the 2020 tax year, the maximum deductible HSA contribution is $3,550 for self-only coverage or $7,100 for family coverage (anything other than self-only coverage). More specifically, if you’re eligible to make an HSA contribution for last year because you had qualifying high-deductible health coverage, you have until April 15 to establish an account and make your rightful deductible contribution.
Key point: The write-off for HSA contributions is an above-the-line deduction. That means you can take the write-off even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. Even billionaires can contribute if they have qualifying high-deductible health insurance coverage and meet the other eligibility requirements. If you are interested, your tax pro can supply full details. For details on how HSAs work, see my earlier column.
Compile your health insurance premiums and medical expenses
If you will itemize deductions on your 2020 Form 1040, you can potentially claim a deduction for qualifying medical expenses that you paid last year, including premiums for private health insurance coverage and premiums for Medicare health insurance. Specifically, you can claim an itemized medical expense deduction to the extent your total qualifying expenses exceed 7.5% of your adjusted gross income (AGI) for the year. Since the TCJA greatly increased the standard deduction amounts for 2018-2025, fewer individuals will be itemizing on their 2020 returns. But having significant medical expenses may allow you to itemize and collect some tax savings.
Key point: If you are self-employed or an S corporation shareholder-employee, you can probably claim an above-the-line deduction for your health insurance premiums — including Medicare premiums. And you don’t need to itemize to get the tax-saving benefit. Ask your tax advisor for details.
Make deductible traditional IRA contribution
If you’ve not yet made a deductible traditional IRA contribution for the 2020 tax year, you can still do so between now and the April 15 Form 1040 filing deadline. Then you can claim the resulting write-off on your 2020 return, assuming last year’s income was not high to qualify.
If your 2020 income was not too high to qualify, you can potentially make a deductible contribution of up to $6,000 or up to $7,000 if you were age 50 or older as of 12/31/20. Ditto for your spouse if you’re married. Thanks to a change included in the 2019 SECURE Act, you now make traditional IRA contributions regardless of your age. Before the SECURE Act, you lost the right to make traditional IRA contributions after reaching age 70½. Thankfully, that restriction is now gone, and we won’t miss it.
Catch No. 1: You must have enough 2020 earned income — from jobs, self-employment, or taxable alimony received — to equal or exceed your IRA contribution for the year. If you’re married, either you or your spouse, or both, can supply the necessary earned income.
Catch No. 2: Deductible IRA contributions are phased out (reduced or eliminated) if last year’s income was too high and you and/or your spouse participated in a tax-favored retirement plan last year.
- If you are unmarried and in 2020 participated in a tax-favored retirement plan (an employer-sponsored plan or a self-employed plan like a SEP or SIMPLE-IRA), your eligibility to make a deductible IRA contribution the 2020 tax year is phased out between adjusted gross income (AGI) of $65,000 and $75,000. AGI includes all taxable income items and certain deductions such as the aforementioned write-offs for self-employed health insurance premiums and HSA contributions.
- If you are married and both you and your spouse participated in retirement plans in 2020, your eligibility to make a deductible contribution for last year is phased out between joint AGI of $104,000 and $124,000. Ditto for your spouse’s ability to make a deductible contribution.
- If you are married and only one spouse participated in a plan in 2020, the participating spouse’s eligibility to make a deductible contribution for last year is phased out between joint AGI of $104,000 and $124,000. The non-participating spouse’s eligibility is phased out between joint AGI of $196,000 and $206,000.
- If you are unmarried and did not participate in a plan last year, you can make a fully deductible contribution for the 2020 tax year, assuming you had enough earned income last year to cover it. In this scenario, high AGI does not limit your right to make a deductible IRA contribution for your 2020 tax year.
- If you are married and neither you nor your spouse participated in a plan last year, you can both make fully deductible contributions for the 2020 tax year, assuming you had enough earned income to cover them and assuming you both have IRAs set up in your respective names. In this scenario, high AGI does not limit your right to make a deductible IRA contribution for the 2020 tax year.
Small-business owners can establish SEPs for major tax savings
If you work for your own small business and have not yet set up a tax-favored retirement plan for yourself, you can establish a simplified employee pension (SEP). Unlike other types of small business retirement plans, a SEP can be created this year and still generate a deduction on last year’s return. In fact, if you are self-employed and extend your 2020 Form 1040 to October 15, 2021, you’ll have until then to establish a SEP and make a deductible contribution for last year. The deductible pay-in can be up to 20% of your 2020 self-employment income or up to 25% of your 2020 salary if you work for your own corporation. The absolute maximum amount you can contribute for the 2020 tax year is $57,000. So, we can be talking major bucks here, and major tax savings too. However, you might not want a SEP if your business has employees, because you might have to cover them and make contributions to their accounts. That could be too expensive. Bottom line: if you have employees, don’t start up a SEP without consulting your tax pro.
Small-business owners can take advantage of COVID-19 tax relief
Several COVID-19 federal tax relief measures are potentially available to eligible individuals who own unincorporated businesses (sole proprietorships, single-member LLCs treated as sole proprietorships for tax purposes, partnerships, and multi-member LLCs treated as partnerships for tax purposes) and S corporations. These relief provisions can significantly improve your personal tax situation. For example, you can carry back a 2020 business net operating loss (NOL) for up to five years and recover some or all of the personal federal income tax paid for the carryback year(s). Talk to your tax pro about available COVID-19 tax relief provisions that could be claimed on your 2020 Form 1040 with tax-saving results.