The end of the calendar year is the time to do a check-up of your personal finances and investments. As we enter December, there are a few important things to do in order to ensure that you are taking advantage of tax breaks, performing needed investment portfolio maintenance, and adapting your personal finances for inflation. Here is a short list of eleven tasks for your financial health to do before the end of the year.
Eleven point financial checklist
1. Do a “backdoor” Roth IRA.
I believe that everyone should have a Roth IRA as part of a diversified retirement portfolio. Unlike a traditional IRA, 401k, or 403b, once you put money into a Roth IRA, you never have to pay any taxes when you withdraw money from it. This allows you to withdraw money in retirement from different types of investments in order to take maximal advantage of your income tax situation in any given year of retirement. If your income is less than $129,000 (or $204,000 if filing a joint income tax return), then you can directly contribute to a Roth IRA using post-tax income. If your income exceeds these amounts, then you cannot directly contribute to a Roth IRA but you can do a “backdoor” Roth by first contributing post-tax income into a traditional IRA and then promptly doing an IRA conversion by transferring that money from the traditional IRA into a Roth IRA. For 2022, you can contribute $6,000 to an IRA if you are under age 50 and $7,000 if you are older than age 50.
The best time to do a backdoor Roth is when the stock market has fallen. Stocks inevitably go up and down – your goal is to buy stocks when the market falls so that you can make the most money when you sell those stocks in the future. Stocks have taken a real beating this year… and that is good for the long-term investor since this creates a buying opportunity. For example, the S&P 500 index has fallen 17% since January 1, 2022. By contributing to a backdoor Roth today, when the stock market eventually recovers to its January 2022 value, you will have made a 17% return!
In 2021, Congress proposed eliminating the backdoor Roth in the Build Back Better Act but the legislation died in the Senate leaving backdoor Roths alone for now. With the U.S. House of Representatives and the U.S. Senate now controlled by different political parties, the resultant gridlock makes backdoor Roth elimination in the next 2 years unlikely. However, predicting Congressional legislation is difficult so anything is possible. Nevertheless, now is the best time to do a backdoor Roth – when they are still legal and when the stock market is down.
2. Do a Roth IRA conversion.
If you already have money in a traditional IRA, then you can convert some (or all) of that money into a Roth IRA without doing a backdoor Roth conversion. There are 2 ways that you can contribute to a traditional IRA, with pre-tax income or with post-tax income. If your current annual income is less than $129,000 (or $204,000 if filing a joint income tax return), then you can contribute pre-tax income into the traditional IRA and then when you withdraw money from that traditional IRA in retirement, you pay regular income tax on the entire amount. If your current annual income is higher than these values, then you cannot contribute pre-tax income into the traditional IRA but you can contribute post-tax income into a traditional IRA. In this latter situation, your tax on withdrawals in retirement gets complicated – you do not pay income tax on the amount of money that you originally invested but you do pay income tax on the accrued value of the investment. This requires you to keep careful record of the amount of your contributions over the years and then do some mathematical gymnastics to calculate the percentage of any given year’s withdrawals that are taxed and not taxed.
I see no reason why anyone should put post-tax income into a traditional IRA and leave it there since you would have to pay income tax on the accrued value when you take withdrawals in retirement. If you had instead converted that post-tax money in the traditional IRA into a Roth shortly after making the original contributions to that traditional IRA (i.e., a backdoor Roth), you would never have to pay taxes on the withdrawals in retirement. So, if your traditional IRA is composed fully (or mostly) of post-tax contributions, convert that traditional IRA into a Roth now in order to minimize your taxes.
Traditional IRAs composed of pre-tax income are different and the decision of whether or not to convert these traditional IRAs into a Roth IRA requires some strategic financial analysis. Your overall goal is to pay the least amount in income taxes. When your traditional IRA is funded by pre-tax income, then when you convert money from that traditional IRA into a Roth IRA, you have to pay income tax the year that you do the conversion. In other words, that conversion to a Roth IRA counts as a withdrawal from the traditional IRA for income tax purposes. There are 2 situations when it is advantageous to do convert money from a pre-tax traditional IRA into a Roth IRA:
- When your income tax rate today is lower than your income tax rate in retirement. This is difficult to know with certainty since no one can predict what the income tax rates will be 30 years from now – tax rates go up and go down, depending on how much money the federal and state governments need to keep running. As a general rule, your income tax rate is likely to be lower when you are early in your career and higher after you have been working for 20-30 years. Therefore, doing a Roth conversion in your early working years is generally preferable to doing a Roth conversion later in your career.
- When the stock market is down. Since you pay regular income tax on any withdrawals from a traditional IRA that was originally funded with pre-tax income, you will pay less tax if you do a Roth conversion when the stock market has fallen and the overall value of the traditional IRA is lower. Then, when the stock market recovers, all of the accrued value will be in your Roth IRA and you will not have to pay income tax on it when you take withdrawals in retirement. Conventional wisdom is that when it comes to stocks, you should sell when the value of a stock is high. In order to minimize taxes when doing a Roth conversion it is just the opposite: sell (convert) when the value of the traditional IRA is low. Since the stock market is currently down 17% compared to January 1, 2022, now is a great time to do a traditional IRA to Roth IRA conversion in order to minimize the total amount of income tax that you will pay over the course of your lifetime. However, don’t forget that the amount of the conversion will add to your adjusted gross income for the year of the conversion and will result in an increase in your income tax rate that year. You will need to weigh the cost of the increased income tax rate against the benefit of the IRA conversion.
3. Contribute to a 529 plan.
The 529 college savings plans allow you to invest money today and then never have to pay any taxes when you withdraw money for college expenses in the future. Think of 529 plans as Roth IRAs for college savings. That tax-free feature of 529 plans make them an unbeatable tool to save for college and you can use the money to pay for college for yourself, your spouse, your children, or your grandchildren. There are several reasons to consider contributing to a 529 plan in December.
- Get a tax deduction. Each state has its own 529 plan and they all vary considerably with respect to their state income tax advantages. For example, here in Ohio, residents of the state can deduct the first $4,000 of annual contributions to an Ohio 529 plan. That tax deduction applies to each child’s account you hold so if you have 3 children, you can deduct $4,000 of annual contributions from each child’s account for a total of $12,000 state tax income deduction!
- The best time to contribute is when the market is down. The 529 plans are designed to be long-term investments. When you open an account at the birth of a child, that money will not be withdrawn for at least 18 years. The U.S. bond market is down 13% this year and the U.S. stock market is down 17%. This means that stocks and bonds are the cheapest that they have been in 2 years. Now is a time when you can “buy low”.
- They make great Christmas presents. I have a granddaughter who lives in a different state. Last year, I opened an Ohio 529 plan in her name when she was born. This year, we’ll contribute to her 529 plan for her Christmas present. Older children usually expect tangible stuff for Christmas but for toddler grandchildren, a 529 plan contribution is perfect. A Lego set will hold a kid’s attention for a couple of weeks but an education lasts a lifetime.
4. Maximize your deferred income retirement contributions.
In 2022, the maximum amount that you are permitted to contribute to a 401k, 403b, or 457 plan is $20,500 if you are younger than 50 years old and $27,000 if you are over 50. Some people (such as employees of state universities) can contribute to both a 403b and a 457. This can bring your annual contribution up to $41,000 ($54,000 if you are over age 50). If you have not yet contributed the maximum allowed amount this year, you still have time to do a one-time contribution in December to bring you up to the annual contribution limit.
In addition, this is also the time to change your monthly 401k, 403b, or 457 plan contributions. In 2023, the contribution limit to these plans will increase to $22,500 for people younger than 50 and $30,000 for people older than age 50. Be sure to get the contribution forms submitted to your human resources department now so that your monthly contributions increase in January.
5. Consider tax loss harvesting.
Tax loss harvesting is when you sell an investment that has lost value (capital loss) on in order to offset a profit that you make selling another investment that increased in value (capital gain). The amount of capital gains tax that you pay is the total of all of your capital gains minus all of your capital losses for that year. If you have more losses than gains, then you can take up to $3,000 of the excess losses and apply them as a tax deduction to your regular income tax. December is normally the best time to decide if selling an investment for tax loss harvesting makes sense and to determine how much of that investment should be sold to optimize your taxes. Because the stock market has fallen so low this year, many people have lost money on investments making tax loss harvesting a viable financial option for more people than in previous years.
There are a couple of important caveats to tax loss harvesting. First, the losses only apply when the selling price is lower than the purchase price. For example, the S&P 500 has fallen in value by 17% in 2022 but it increased in value by 27% in 2021. Therefore, if you bought an average stock on January 1, 2022, you would have a capital loss. But if you bought that same stock on January 1, 2021, you would have a capital gain if you sold the stock today, even though that stock lost value in 2022.
Second, tax loss harvesting is more of a capital gains tax-deferral strategy than a capital gains tax-reduction strategy. If you sell a losing stock today to take advantage of tax loss harvesting and then turn around and invest the proceeds of that stock sale into a second similar stock that has also lost value recently, then when that second stock eventually increases in value in the future, you’ll pay more capital gains taxes on the sale of the second stock because your capital gains will be higher. For example, say Ford and GM shares are always the same price. You buy shares of Ford in 2021 at $100 per share and then today, Ford has fallen to $80 per share. You then sell your shares of Ford for tax-loss harvesting purposes and turn around and buy shares of GM at $80 per share. In 2024, you sell your shares of GM at $120 per share. If you had held onto Ford until 2024, then you would have $20 per share in capital gains when you sold it in 2024. Instead, you would have $40 in capital gains when you sell the GM stock in 2024. In other words, tax-loss harvesting just postpones when you pay capital gains tax if you re-invest the proceeds of your investment sale.
Tax-loss harvesting can be to your benefit if you take the capital losses as an income tax deduction since most people’s federal income tax rate is higher than their capital gains tax rate. However, this can be tricky since you have to be able to estimate what your 2022 income tax rate will be in order to ensure that it is less than your capital gains tax rate. Also, many people forget that their mutual funds will usually have capital gains each year since the fund managers are constantly buying and selling the component stocks within that fund so even if you do not sell any of your shares of that mutual fund this year, you may still have capital gains from that mutual fund. You have to calculate what all of those mutual fund capital gains will be this year in order to be sure that your capital losses from tax-loss harvesting exceed those mutual fund capital gains so that you can apply those capital losses as an income tax deduction. And remember, the maximum income tax reduction from tax-loss harvesting is $3,000.
6. Optimize schedule A deductions.
The Tax Cuts and Jobs Act of 2017 increased the standard income tax deduction from $12,700 in 2017 to $24,000 in 2018 (married filing jointly). This reduced the amount of income tax that most Americans paid but it also eliminated itemized deductions for most Americans. The standard deduction for 2022 is $25,900 (married filing jointly). Therefore, you cannot make any itemized deductions unless those itemized deductions total more than $25,900. Itemized deductions can include charitable donations, mortgage interest & points, medical & dental expenses, and taxes paid (property, state, and local). However, the maximum amount of property and other taxes that you can apply to itemization is $10,000.
December is the time to estimate the amount of your itemized deductions. If those itemized deductions are close to your standard deduction amount ($25,900 if married filing jointly), then you may be able to increase your itemized deductions now so that those itemized deductions exceed the standard deduction amount. For example, you could make extra charitable contributions now rather than in 2023. Or, you could pay your next property taxes early, before December 30th. Or, you could buy the new eye glasses now that you had planned to wait until next summer to buy.
7. Contribute to an SEP.
An SEP (simplified employee pension plan) is a deferred income retirement account for self-employed people. Even if you have a regular employer but have a side gig doing consulting, getting honoraria, or selling artwork, you can open an SEP for the income that you earn from that side gig. The SEP allows you to invest pre-tax income and then pay taxes on the the withdrawals from the SEP when you are in retirement. In that sense, the SEP is functionally similar to a 401k, 403b, 457, or traditional IRA. Although you have until April 2023 to make contributions to an SEP for your income earned in 2022, it may be better to contribute to an SEP now, since the stock market has lost so much value recently – in other words, contribute to an SEP now, while stocks are “on sale”. You can contribute up to 25% of your total self-employment income and up to a maximum contribution amount of $61,000. December is a time that you should be able to reasonably estimate your total self-employment income for the past year and then calculate the amount that you can contribute to an SEP.
8. Review your beneficiaries.
Every investment account should have a designated primary beneficiary and secondary beneficiaries in the event of your death. If you are married, the primary beneficiary will probably be your spouse. If you have children, they will probably be your secondary beneficiaries. By specifying beneficiaries on those investment accounts, you can make it faster for your family to access those funds in event of your death. Also, your heirs can avoid costly legal fees that would be incurred if no beneficiaries were listed and the accounts need to go through probate court. For most investment companies, you can do this quickly and easily online.
9. Rebalance your portfolio.
This has been a wild year for investors. The bond market is down, the stock market is down more, and real estate is down even more. Meanwhile, inflation is reducing the value of fixed income pensions and increasing the interest rates on certificates of deposit. The net result is that the relative percentages of stocks, bonds, real estate, and cash in most people’s investment portfolios has changed significantly since January.
Now is the time to rebalance those portfolios to ensure that the percentage of each type of investment is at its desired amount. For example, since real estate investments have fallen more than stocks, you may need to sell some shares of your stock mutual fund and buy some shares of a real estate investment trust (REIT) fund to rebalance. Since stocks have fallen in value more than bonds, you may need to sell some shares of your bond mutual fund and buy some shares of a stock mutual fund. Rebalancing not only ensures that your portfolio has a healthy diversification but it also results in you “selling high and buying low” in order to maximize your overall returns.
10. Increase disability and life insurance policy amounts.
The U.S. inflation rate has risen with the result that the consumer price index has increased 13% over the past two years. In other words, you need 13% more money today to buy the same amount of stuff you bought in 2020. However, most disability insurance policies and life insurance policies have not changed their values. The $100,000 life insurance policy that you bought in 2020 would only be effectively worth $87,000 in today’s money. December is a good time to critically evaluate those policies to see if the payout amounts are still appropriate – in many cases, you may need to increase those amounts to ensure that should you become disabled, you will still have enough money to live on. Or, should you die, your family will still have enough money to live on.
11. Update next year’s budget.
Inflation does not affect everything you buy equally. For example, for the 12 months ending in October 2022, the price of food was up 10.9%, gasoline was up 17.9%, new cars were up 8.4%, and clothes were up 4.1%. This means that the amount that you budgeted for all of these items a year ago has changed. Each family’s inflation is a little different. So, although housing costs nationwide are up 11%, if you bought your house a year ago and have a fixed monthly mortgage, then your housing costs may not have gone up at all. Similarly, if you heat your house with electricity, your energy costs went up 14.1% in the past year but if you heat your house with fuel oil, your costs went up 68.5% in the past year.
To prepare next year’s budget, start with your credit card statements. Most credit card companies will divide each of your purchases into different categories, for example, groceries, transportation, housing, utilities, etc. You can often do the same with your checking account. This will give you a reasonable idea of where you spent your money over the past year. You can then use the Bureau of Labor Statistics Consumer Price Report to estimate how much each of those categories will need to be increased for your next year’s budget. Keeping to that budget ensures that you will have enough cash to pay off your credit cards and loans each month without dipping into your cash emergency fund.
Your annual financial checkup should be in December
The end of the year is the best time to do your annual financial checkup. By December, you should have a good idea of your total 2022 income and know whether you are likely to get a raise next year. Retirement account contribution limits usually change in January giving you the opportunity to change your monthly contributions. Also, you should be able to estimate how much you can spend this year on charitable contributions, 529 account contributions, IRAs, and SEPs. The best way to start the new year is to finish the old year on solid financial ground.
November 30, 2022
