Checking your income tax planning now is a good idea – tax planning can be done year-round. As with any planning, acting while you can have an impact is best. Tax laws may change before the end of 2022, e.g. Secure Act 2.0 may be adopted, but it’s still wise to know where you stand now.
First question: did you get a tax refund, or did you owe?
Some people enjoy seeing a big refund, but as you may have heard, you are giving the government an interest-free loan with your money. If you want to save, there are better ways, like an auto-debit to an IRA or to a savings account.
Not sure what happened to your refund? There is a updated IRS tool for “where’s my refund” that now goes back three years at “Where’s My Refund?”
The tool confirms receipt of your tax return, shows if the refund has been approved and indicates when it will be or has been sent. If three weeks pass without receiving the refund, then you may want to contact the IRS.
If you owed a significant amount for 2021, the IRS has another tool that helps make sure you have enough withheld for 2022 at Tax Withholding Estimator. This way you can avoid penalties and interest for under withholding.
If you do not get clear answers using the estimator tool, try comparing your 2022 paystub to your 2021 tax return, review the IRS guidance at Publication 505, or contact us for help.
Second question: what happens if you act now?
Marginal vs. average tax rate
Knowing the rate at which additional net income will be taxed helps you make decisions such as the one in the next section, whether to convert an IRA to a Roth IRA or not.
The marginal rate is your tax bracket, the rate at which the last portion of your income is taxed. Any additional income would be taxed at this rate. Your average tax rate is the percentage of income taxes to total taxable income. You can have a low average rate but hit a high marginal rate, which may mean that taking more income into the current year would be costly.
Time to convert to a Roth IRA?
The decision to convert a traditional IRA to a Roth IRA depends on several factors. One is the rate of tax you pay now compared to the rate you expect to pay in retirement. If your rate will be the same at retirement as now, then there are many reasons to convert, such as no required minimum distributions at retirement for a Roth IRA. If your tax rate at retirement will be significantly less than currently, then converting now would be less tax efficient.
We face a challenging time for planning: The election resulted in a new President while the rate of Covid-19 infections (and deaths) continues to rise. This has affected the economy, resulted in some tax law changes and may yield more stimulus to restore the economy. Also, there may be more changes in 2021. This post is intended to help you make the best tax-efficient moves before 2021 begins.
2020 year-end tax planning – update on using the tax laws to save you money
In 2018, we provided a three-part series explaining the impact of the new tax law. In our first part, we discussed the impact of the new law on personal taxes and in our second part, we discussed planning for small businesses. This update replaces the third part from December 2018, as updated December in 2019 – it is our guide for year-end moves to reduce total taxes between 2020 and 2021. But, before getting to the planning steps, we address the uncertainty caused by possible tax changes in 2021 and review some recent changes from earlier this year.
Possible Tax Law Changes under Biden
President-Elect Biden campaigned on raising taxes for corporations and for individuals making over $400,000 of income. However, even if the Senate seats in Georgia go to Democrats in January, the lack of a “Blue Wave,” a sweeping Democratic mandate, means that the tax hikes are unlikely to pass. Furthermore, the President-Elect has made clear that controlling Covid-19 and economic recovery are the top priorities of his new administration.
What did President-Elect Biden propose? He would restore the 39.6% bracket for couples making $622,050 or more ($518,400 for singles), add a 12.4% social security tax for income over $400,000, place a 28% limit on itemized deductions for high income taxpayers, restore the 20% long-term capital gains rate for high income returns (and even apply ordinary rates on gains of taxpayers over $1 million), and limit the Qualified Business Income Deduction and opportunity zone credits. For estate taxes, he would reduce the current $11.58 million exemption to a lower amount, perhaps $5 million or even $3.5 million, and eliminate the step-up in basis at death.
While none of these changes are likely, there may be narrow tax hikes to fund infrastructure building and small tax breaks for lower earners (child/dependent care and elderly long-term care credits). There may also be more stimulus action, such as more Paycheck Protection Program loans and business tax breaks for worker safety measures, as well as retirement savings incentives, tax extenders for items expiring this year, and tax breaks to encourage US manufacturing. We will monitor activity on these matters for comment in future posts.
Changes from the SECURE and CARES Acts for 2020
We wrote about the CARES act earlier this year, which waived the 10% penalty for coronavirus-related distributions from qualified plans of up to $100,000, with three years to pay the taxes due or redeposit as a roll-over, and suspension of required minimum distributions (“RMDs”). The act also allows larger plan loans.
The Secure Act delayed RMDs to age 72 and allowed individuals to contribute to IRAs after age 70 ½ if still working. But the Act also limited the distribution of IRAs to a 10-year maximum for beneficiaries other than spouses and certain others, thus eliminating the “stretch IRA.”
The Families First Act created credits for people unable to work due to Covid-19 illness and due to caring for others. If you are affected, check to see if you are eligible for any of these tax credits.
A reminder on the mortgage interest deductions
As you may recall, mortgage interest on new home purchases is deductible only for loans of up to $750,000 used to purchase your primary and secondary residences. Interest on home equity loans is not deductible, except when the home equity indebtedness is used to purchase or improve your primary or secondary residence.
Check taxes already paid
Make sure your total paid to the IRS and state via withholdings and estimates meets the safe harbor rules. If not, you could owe interest for under-withholding.
Now to the planning: Can you act at all?
Each year, we advise that you be practical, focusing on where you can actually make moves. For many, the $24,800 standard deduction for married couples (more for over 65 taxpayers, and $12,400 for single taxpayers) means you will not itemize (i.e., your total for itemized deductions is less than the standard amount so you take the higher standard deduction). And, if you are not itemizing, you have fewer ways in which to affect change in the taxes due in either year (but you can also stop collecting receipts for those deductions).
There is one exception from the CARES Act, which provides a $300 above the line charitable deduction for cash contributions. You get this regardless of itemizing.
Some possible deduction strategies
One technique for getting around the limit on deductions is to bunch certain deductions from two or more years into one year. However, the only deduction that you can easily move is for charitable donations, because your state, local and real estate taxes are limited to a $10,000 maximum and you cannot accelerate, or delay, significant amounts of mortgage interest.
If you do not want any one charity to receive the full amount in one year, you can still use this bunching strategy to donate to a donor advised fund, from which you may be able to designate donations to particular charities in future years.
The tax planning steps
What can you move? If you are able to itemize, determine what income and deductions you can move from 2020 to 2021 or vice versa. You want to minimize total taxes for both years. Make sure your planning includes the 3.8% Medicare tax on high income and a review Roth conversion. Roth distributions are not taxed, so converting a traditional or roll-over IRA to a Roth could be beneficial, as long as the tax cost now is not too great – see more at Roth or not to Roth? With the waiver of the 10% penalty for early withdrawals, a Roth conversion may be more attractive. Business owners will want to review our post on planning under 199A for QBID.
What is the effect of moving? Next, review the impact of moving income and expense to see what happens if you shift any of these amounts from one year to the other year.
The AMT – Finally, watch for the Alternative Minimum Tax (“AMT”). The AMT affects fewer people, but it is still wise to review so you avoid it.
If you have not maxed-out your 401(k) plan, IRA, Health Savings Account or flex plan account, consider doing so before the end of the year. The contributions reduce your tax able income while adding to savings. But check out our post on paying debts vs. investing.
If you are 70½ or older, you have the option of distributing up to $100,000 from your IRA or other qualified plan to an IRS-approved charity and having none of the distribution taxed. The provision was great when you had an RMD to satisfy, but that was suspended for 2020. That should not stop you if you still have the charitable intent.
The deduction of unreimbursed business expenses was terminated by the new tax law. That hurts many who are working from home this year, as they cannot deduct associated costs.
We wrote about forming an LLC or S Corp. to report business expenses or taking expenses on Schedule C in our 2018 Part III post, but that applies to expenses for that business and we stressed that you will need a valid business purpose to form the LLC or S Corp. or use Schedule C for self-employment and take expenses. Be sure to consult with an attorney before trying any of these ideas.
Review your unrealized losses to see if you can “harvest” those losses to offset or “shelter” realized gains, reducing your total taxable income. If you have more losses than gains, you can take up to $3,000 of capital losses against other income.
If you sell an asset that you would prefer to retain, in order to shelter gains in 2020, make sure you do not run afoul of the wash-sale rule (any loss on an asset that you repurchase in 30 days will be disallowed, so you have to either wait 30 days or purchase a similar asset that fits your portfolio while not counting against the wash sale rule). N.B. – when buying mutual funds late in the year, check for distribution dates so you do not purchase just before dividend and capital gains distributions, as you will owe taxes on those distributions.
If you have significant unrealized gains, consider using appreciated stock for charitable donations – that way you avoid the tax on the gain while still getting the full fair market value for your charitable donation. That is very effective tax leverage!
Estate plan review
While you review your taxes, review your estate plan as well. The federal exemption is over $11 million in 2020, so fewer people will owe any federal estate tax. However, that may change in 2021; also, many states still impose estate taxes on smaller estates.
The individual gift and estate tax exemption is due to return to $5 million, adjusted for inflation, in 2026 and could be lowered sooner, as noted above. That tax rate could also go up.
If you have “excess wealth” and want to reduce your taxable estate by gifting assets to children or others, you can give $15,000 per person, per year now. If your spouse joins you, that is $30,000 per person. This includes funding a 529 plan for education cost – expanded to provide for more than just college – or an ABLE account for disabled dependents. Note, however, that holding appreciated assets for the step up in basis at death may be better than gifting, but this could be eliminated as noted above.
If you do review your estate plan documents, also review beneficiary designations to make sure everything is current. And review your medical directive and durable power of attorney.
Carefully review any income and deductions that you can still shift to see if moving will lessen the total taxes you pay for 2020 and 2021.
Good luck and best wishes for happy and healthy holidays!
The IRS extended all of the following deadlines to July 15th:
2019 return or extension filing;
Payment of 2019 taxes due;
Q1 2020 estimate payment; and
Q2 2020 estimate payment.
Most states have followed the same delayed dates (but not all). Let me know if you have a question on payment and filing.
So “tax season” will be over soon, yea!
Stimulus checks and other changes
Many people are asking about their stimulus checks and expanded unemployment benefits under the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The Act also has other provisions including tax credits for self-employed affected by Covid-19, student loan payment delays, and relief on mortgage payments and rent.
Of the many posts regarding the stimulus checks and benefits, student loans and 401(k) distributions, here is a good summary from the NY Times.
And if you received a check for a deceased relative (over 1 million were sent!), you need to return it to the Treasury, sorry.
CARES Act includes benefits for small businesses: Payroll Protection Program loans; payroll deposit delays; and tax credits. The SBA funds for the PPP ran out initially, but Congress added more funding.
The key is to file so that the loan is forgiven, so that the funds become a grant. The forgiven loan is not treated as income.
If you need more information on these programs, let me know.
2020 tax law changes
The required minimum distributions or RMDs are suspended for 2020. This way, you do not need to sell funds at a low to withdraw and may even be able to redeposit funds that you already withdrew.
The CARES Act waives the 10% penalty for early withdrawals from qualified plans for up to $100,000 for coronavirus-related circumstances. The distribution is taxed over three years. And, if the funds withdrawn are repaid to the plan within 3 years, that is treated as a tax-free roll over. The act also allows loan from the plan up to the lesser of the vested balance and $100,000.
For 2020, there is an above-the-line charitable donation deduction up to $300. This should help charities that are responding to those impacted helping them raise money now.
More Scams and Hackers
Be wary of messages asking for personal information because scams are on the rise. And be careful working from home, as there are more hacker attempts to gain access via the home connections to companies.
If you want help dealing with any, let me know.
Being cooped up is challenging, even if it is the best way to stay healthy. Make sure you practice self-care so you can handle this!
I hope you and your loved ones are all managing this as well as you can.
If you want to just talk, I would be glad to set up a time, just let me know!
More employers now provide the option of a Roth 401(k) as well as a traditional 401(k), so you may ask:
Which should contribute to a Roth 401(k) or a traditional 401(k)?
The answer is not so simple and it depends on your income tax rate now and at retirement. Before offering background and explanation, we start with this Quick Summary
If you have a high tax rate now, and expect a low tax rate later, pick the traditional 401(k)
The traditional plan is better because get the current tax deduction, reducing taxes now at the higher tax rate. This may be true for people in middle or later years of employment.
Note: this is only financially better if you invest the amount of taxes saved.
If you have a low tax rate now, and expect a high tax rate later, pick the Roth 401(k).
The Roth plan is better because you avoid higher taxes later. This may be true for most people starting work now.
If expect to have the tax rate later as you have now, pick the Roth 401(k)
The Roth plan has other benefits described below.
Background – How the Plans Work:
Tax deferred growth
Earnings on both the traditional 401(k) and the Roth 401(k) are not taxed. Not paying taxes on investments in your retirement account means more grows and compounds tax-free – that is why contributing to a retirement plan is so important.
Contributions “pre-tax” vs. after tax
Contributions to a traditional 401(k) are made “pre-tax,” meaning that the amount contributed is excluded from your taxable income for the year.
Contributions to a Roth 401(k) are made after tax – they are not excluded from taxable income.
Taxing withdrawals vs. no tax
Withdrawals from a traditional 401(k) are taxed in the year of withdrawal.
Withdrawals from the Roth plans are not taxed. That is, the after-tax contributions are not taxed a second time and neither is the growth on those contributions.
Other rules – early withdrawal and require minimum distribution
There are penalties for withdrawal before reaching age 59½, unless certain exceptions are met, such as disability or first-time home buyer.
You must begin withdrawing when you reach age 70½ under the IRS Required Minimum Distribution or “RMD” rules. For more on RMD rules, see IRS Retirement Topics – RMDs
Hedging your bets:
If you are not sure of your tax rates, or if you just want more options because you cannot predict, then you can opt to combine plans. For example, you can contribute to your traditional 401(k) up to the employer match and then put the rest in a Roth IRA, if the contribution limits allow.
When you change jobs, you can convert a 401(k) to a Roth IRA, but doing so is a taxable event. If you expect your tax rate to be higher in the future, this is a good move. However, you will want to pay taxes due from other sources. If you have to take funds from the IRA to pay the taxes, you reduce the amount going into the Roth IRA which dramatically reduces the future benefit.
If you convert after-tax contributions made to a traditional 401(k) or non-deductible IRA, you have less on which taxes are due because the after-tax portion is not taxed in converting to a Roth IRA.
While a Roth 401(k) is subject to RMD, a Roth IRA is not. If you can re-characterize the Roth 401(k) to a Roth IRA, you avoid the RMD. This may mean that you pass more on to your heirs. Also, you may gain investment flexibility compared to a company plan.
If you use a Roth plan, then your taxable income at retirement will be less than if you were withdrawing from a traditional plan where withdrawals are taxed. This could lessen tax due on social security benefits.
On the other hand, if you expect to use funds in your retirement plan to donate to a charity, you are better off getting the tax savings for yourself now. The charity is not subject to much if any income tax.
Also, if you expect your heirs to receive your retirement plan assets and know that those heirs will be in a lower income tax bracket, you should use a traditional plan now to get the tax benefit for yourself. How can you possibly determine that heirs will get more of your retirement than you and also be in a lower tax bracket? I cannot imagine – well, maybe I can, but none of the ideas sound good. Anyway, it seemed like a good idea to mention (they teach you to think this way in law school).
The goal for tax planning, as always, is to minimize the total that you pay for 2012 and 2013. However, this year is tricky. Here is why:
First, if your 2013 income is expected to be over $250,000 ($200,000 for singles), you cannot just accelerate write-offs from 2013 into 2012 and defer income to 2013 because your taxes will be higher in 2013. There is a new 3.8% tax that works like this, for example: recognizing a capital gain in 2012 avoids that tax in 2013 and also reduces your 2013 adjusted gross income, which may keep it below the threshold for imposing that tax next year. (See below for more details on the new tax.)
Second, regardless of who becomes President, Congress is likely to reduce the amount or value of itemized deductions. Thus, you may want to accelerate what you can into 2012.
Third, as always, combine your tax planning with your investment strategies, such as tax loss harvesting and rebalancing (see explanations at the end).
Last, there are other issues to review for 2012, including converting your Roth IRA; gifting to children and grandchildren for estate planning purposes (to use the $5 million unified credit); and funding college for children or grandchildren.
However, if you will owe the alternative minimum tax (AMT), you may have to revise your strategy. Many write-offs must be added back when you calculate the AMT liability, including sales taxes, state income taxes, property taxes, some medical and most miscellaneous deductions. Large gains can also trigger the tax if they cost you some of your AMT exemption.
The best tool for planning is to do a projection for both 2012 and 2013, then see what items you can affect to reduce the total tax for both years.
Assuming you will not have an AMT problem in either year, then in 2012 you could:
• Take a bonus this year to save the 0.9% for a high-income earner;
• Sell investment assets to save the 3.8% tax next year so the gain or income is in 2012 (e.g., sales of appreciated property or business interests, Roth IRA conversions, potential acceleration of bonuses or wages);
• Defer some itemized deductions to 2013 (but, be wary of the possibility that these will be capped in 2013 and can affect your AMT for either year);
• Accelerate income from your business or partnership, depending on whether it is an active or passive business; and
• Convert Roth IRAs in 2012 as noted above.
Then in 2013 and future years, you could:
• Purchase tax-exempt bonds;
• Review your asset allocation to see if you can increase your exposure to growth assets, or add to tax-exempt investments, rather than income producing assets. Also, place equities with high dividends and taxable bonds with high interest rates into retirement accounts;
• Bunch discretionary income into the same year whenever possible so that some years the MAGI stays under the threshold;
• While we do not recommend tax-deferred annuities, they can help save tax now to pay taxes in the future when the payments are withdrawn. (These are not recommended due to high fees, illiquidity and often poor performance);
• Add real estate investments where the income is sheltered by depreciation;
• Convert IRA assets to a Roth. Even though the future distributions from both traditional and Roth IRAs are not treated as net investment income, the Roth will not increase the threshold income; and
• Reduce AGI by “above-the-line” deductions, such as deductible contributions to IRAs and qualified plans, and health savings accounts and the possible return of the teach supplies deduction.
Note, however, Congress has not finalized the 2012 rules. Some expected steps are:
• An increase in the AMT exemption to $78,750 ($50,600 for singles), raising it from 2012 rather than dropping back to 2001 rates;
• Teacher $250 supplies deduction on page 1 of 1040, as mentioned above; and
• IRA $100,000 tax free gifts to charities.
Here are the details on the 2013 tax increases, enacted to help fund health care:
• A new 3.8% Medicare tax on the “net investment income,” including dividends, interest, and capital gains, of individuals with income above the thresholds ($250,000 if married and $200,000 if single);
• 0.9% increase (from 1.45% to 2.35%) in the employee portion of the Hospital Insurance Tax on wages above the same thresholds;
• Increase in the top two ordinary income tax rates (33% to 36% and 35% to 39.6%);
• Increase in the capital gains rate (15% to 20%);
• Increase in the tax rate on qualified dividends (15% to a top marginal rate of 39.6%).
• Reinstatement of personal exemption phase-outs and limits on itemized deductions for high-income taxpayers (effectively increasing tax rates by 1.2%).
• Reinstatement of higher federal estate and gift tax rates and lower exemption amounts.
If these changes take effect, the maximum individual tax rates in 2013 could be as high as follows:
2012 vs. 2013
Wages: 36.45 vs. 43.15%
Capital gains: 15 vs. 20%
Qualified dividends: 15 vs. 46.6%
Other passive income: 35 vs. 46.6%
Estate taxes: 35 vs. 55%
*Includes 1.45% employee portion of existing Hospital Insurance Tax.
**Estate and gift tax exemption also drops from $5.12 million to $1 million, if Congress does not act soon.
>Review your investments to find stocks, mutual funds or bonds that have gone down so that selling now will create a loss. This loss shelters realized gains and up to $3,000 of other income.
N.B. – If you replace the stock, mutual fund or bond, wait 30 days or use similar, but not identical, item. Otherwise, the “wash sale” rules eliminate realization of the loss.
>review your asset allocation to see if any portion is over or under-weighted. Then sell and buy to bring the allocation back in line. However, if you sell and re-buy now, before a dividend is declared, you will receive a 1099 for a taxable dividend in the new fund for investment returns in which you did not participate.
Thanks to the Kiplinger’s Tax Newsletter, Sapers & Wallack and others for ideas and information.