As Americans race to file their federal returns by April 18, many think there's nothing they can do right now to shrink what they'll owe Uncle Sam. A filing season covers income and expenses for the prior year, so most tax-reduction strategies, such as selling losing investments to offset the taxes owed on profits taken from winners, must be wrangled into place by the previous Dec. 31.
But there's one big exception to that reality, and it centers on contributions to certain retirement accounts. As long as the dollars are kicked in before a return is filed, they can lower the amount you'll shell out to the Treasury Department on your current return.
With some investors receiving unpleasant capital gains distributions from their mutual funds for last year — even as those funds lost money in 2022's horrible stock and bond markets — it's a particularly valuable last-minute strategy.
Investors "probably don't know about this as much as they should," said Timothy Steffen, the director of advanced planning and a managing director at Baird Private Wealth Management in Milwaukee.
The giving that keeps on giving
With individual retirement accounts, taxpayers who file by April 18 for an extension to Oct. 16
Dollars put into 401(k)s are due by Dec. 31 of the prior year. How much a taxpayer can contribute to a 401(k) or IRA in exchange for a deduction that lowers his overall taxable income depends on several factors. And different retirement plans have different contribution deadlines for deductions to apply to last year's income.
For 2022, employees with a traditional 401(k) can contribute up to
For 2022 tax purposes, those with Roth 401(k)s can kick in the same amount, but it's not deductible — contributions to those plans are made with payroll dollars on which taxes have already been paid. Withdrawals of gains are tax-free once an investor is age 59½ and has had the account for at least five years.
For 2022, investors with a traditional or Roth individual retirement account can kick in $6,000, plus an extra $1,000 at age 50 and older for catch-up contributions. Only dollars put into a traditional plan are deductible; Roth money, which is after-tax, is not.
If you have an IRA but
If you are filing single and made $68,000 or less last year, you can take a full deduction. Those who made above that amount but under $78,000 can take a partial deduction; with income above that amount, the benefit goes away. For married couples filing a joint return, the income levels are $109,000 or less (full deduction), more than $109,000 but less than $129,000 (partial deduction) and $129,000 or more (no benefit).
SEP IRAs have more time
The timing for contributions by people who are self-employed and own a simplified employee pension individual retirement arrangement, known as a SEP IRA, is different. With those plans, investors can contribute all the way up to the extended filing deadline. That gives clients and the
For 2022 returns now being filed, taxpayers can stuff a SEP IRA with up to 25% of their compensation or $61,000,
"We are certainly seeing the typical extensions being filed to allow for more time for SEP contributions," said Nicole DeRosa, a certified public accountant at accounting firm Wiss & Co. in Florham Park, New Jersey. What's different this year, she added, is that clients were using their accounts not just to generate bigger deductions, but also to rebalance their portfolios after Wall Street's double-digit decline last year.
"I have a client who actually said 'for the first time in a long while, I am concerned with getting a little more conservative with the equity-to-bond ratio' and is in touch with their financial advisor to make some changes," DeRosa said.
Disaster-area residents in most of California and parts of Alabama and Georgia automatically have until Oct. 16 to file their federal returns.
Maxing out contributions is usually an advantage no matter what your tax liabilities are: It builds a long-term nest egg and generates a deduction.
"When you max out your traditional 401(k) plan contributions, you not only save more for retirement, but you also potentially pay less in taxes that year since your taxable income would be lowered,"
'Hosed'
But for an investor with unpleasant capital gains distributions from mutual funds, there's an added benefit to boosting retirement contributions at the last minute: a reduction of overall taxable income that makes those capital gains less painful.
Mutual funds send out taxable distributions at the end of the year, after managers have to sell a fund's underlying holdings to raise cash for investors who want out.
Some 296 mutual funds made distributions to retail investors for 2022 that totaled between 10% and 19% of a fund's net asset value,
The allocations can total thousands and, for affluent investors with lots of mutual funds, tens of thousands of dollars, Steffen said.
The distributions are always taxed at the long-term capital gains rate, now a top 20%, plus
Investors receive the distributions even if they haven't sold their fund shares. With most funds posting losses last year and many investors running for the exits, it's a double punch to those who stayed in.
"They pay all the tax on all the gains generated by people leaving," Steffen said, calling distribution recipients "hosed."
Still, investors can un-hose themselves by maxing out their retirement plan contributions.
In a simplified example, let's say Melissa had $4,000 in distributions on which she faces a long-term capital gains tax bill of $800. She makes $150,000 a year in wages, so her taxable income is $137,050, once the standard deduction is applied. Because she's in the 24% tax bracket, she pays the federal government
Contributions to a traditional 401(k) winnow your taxable income, with the shrinkage calculated as the amount of the contribution multiplied by a taxpayer's marginal rate, which is the bracket a taxpayer falls into. (The IRS taxes chunks of income at different rates until the pot reaches the top rate.) So if Melissa puts an additional $5,000 into her 401(k) by April 16, she saves $1,200 ($5,000 x 0.24). That more than wipes out her mutual fund surprise.apr
