Mid-Year planning – Rates, Roths and Rules

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. 

The IRS seems to have a similar thought about tax planning as they created a website with tools and resources at Steps to Take Now to Get a Jump on Your Taxes – if you check it out, let us know what you think.

First question:  did you get a tax refund, or did you owe? 

Refunds

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.

Owed taxes

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. 

If you want more on this decision, see “To Roth or not to Roth?” or check out Pros and Cons here.

Also, we discussed the back-door Roth IRA in our year-end post on 2021 tax planning.  

Last question:  how with this affect the rest of your finance?

Coordinate with investing and estate planning

Make sure any changes take for tax reasons do not foul your investment or estate planning. For more on estate planning, see estate planning checkup post

Summary

As you review your 2022 tax planning, check your 2021 returns for ideas on what to adjust, consider the impact of future tax rate increases and act when the impact on other planning also makes sense. 

Let us know if you have any questions. 

Good luck

Tax planning while laws are still changing – turn it on its head?

Many of the expected tax law changes have not materialized, but legislation remains in flux.  This means we plan year-end moves while we continue to monitor new legislation.  It is safe to bet that income tax rates will rise over the next several years.  This may mean putting year-end tax planning on its head, where you increase taxable income for 2021.  The goal is to lessen income ultimately taxed in future years.  However, you may not want to delay taking deductions until 2022 (so planning not completely on its head?)  For the standard approach, see our 2020 year-end post.

  • Roth Conversion – One way to increase income now, avoiding future income, is to convert part of an IRA to a Roth IRA, converting from taxable to non-taxable distributions in the future.  Decide on the amount to convert by projecting the impact of the conversion on your marginal tax rate.  Converting to a Roth also saves you from required minimum distributions, RMDs, in future years (but non-spouse beneficiaries still face the 10-year limit from the SECURE Act on IRA distributions). 
  • Back-Door Roth – Along with converting, the “back-door Roth” is still available, at least for 2021, so you can put more retirement funds aside with no tax on future distributions.  That is, for those who cannot contribute to a Roth due to income limits, they can contribute to a non-deductible IRA and then convert that IRA to a Roth IRA. If you have other IRAs, that may affect the amount that is taxed, so review this carefully first to see if it still makes sense.
  • More income – Other ways to increase income for 2021 include billing more for your S Corp., LLC or partnership in 2021, exercising stock options, and selling ESPP shares. 
  • Capital gains – You probably do not want to accelerate capital gains, as those should still be tax at a lower rate in future years. 

On to other considerations: first, SALT deductions

The limit on state and local taxes, or SALT, may increase from $10,000 to $80,000.  Also, a number of states have created pass-through entity elections so that the S Corp., LLC or partnership pays the tax and deducts against the income of the shareholder/member/partner.  This way, their net federal taxable income is reduced, and they get a credit for the payment on their personal tax returns. 

The SALT changes may affect your itemized deduction strategy if you are bunching.  

Check the details

  • Declare Crypto – If you had any crypto currency transactions during the year, selling, buying or receiving, be sure to declare on your federal 1040 filing.
  • Unemployment tax – Remember, unemployment benefits are fully taxable for 2021, so be sure you withheld taxes or paid estimates. 
  • Charities – If you cannot itemize, you still get up to $300 as an above the line charitable deduction, and up to $600 for a married couple. 
  • Child credits – There are changes in the credits for children and dependent care.  Let us know if you have questions on the benefits and strategies for maximizing.
  • Kiddie tax – The so-called kiddie tax has been restored to pre-TCJA terms, so you may want to review filings for the last two years.  
  • Address change – You will want to file form 8822B to indicate the change of address if your corporation, LLC or partnership moves.  On that form, you can also change the responsible party so that the IRS knows whom to contact – this is quite important if you sell your business!
  • IT PIN – If you are concerned about identity theft, consider obtaining an IT PIN as discussed in our post on IRS scams.  
  • Flex and retirement accounts – Check to see if you have any flex account balances that expire; contribute the maximum to your qualified plans; and setup a new qualified plan if you have a new business. 

Before you finish, check withholdings and estimates paid

Especially if you increase income in 2021, review your total paid to the IRS and state via withholdings and estimates make sure that you meet the safe harbor rules.  If not, you could owe interest for under-withholding.

IRS disaster relief 

Have you received a penalty notice from the IRS?  The Pandemic was declared a federal disaster.  This means it may provide an exemption to the penalties if you can show that you suffered from the Pandemic. 

And remember your estate plan review

While you review your taxes, review your estate plan as well.  The federal gift and estate tax credit  is close to $12 million for 2021, but that may change in 2022.  So, if you have excess wealth, you may want to gift while you can, especially if you want to use certain trusts, like a GRAT or QPRT, that may no longer be permitted in future years.  For more on estate planning updates, see our estate planning checkup post

Update: the annual exclusion for gifts rises from $15,000 per person, per year to $16,000 next year.

  • If you do review your estate plan documents, also review beneficiary designations and asset ownership to make sure everything is current and flows correctly. 

Summary

As you review your 2021-2022 tax planning, consider the impact of future tax rate increases: will bringing future income into 2021 avoid taxes on future income?  Then follow through on the details. 

Let us know if you have any questions. 

Good luck and best wishes for happy and healthy holidays!

Year-end tax planning – 2019 update on using the tax laws to save you money

we hope your planning does not look like this!

Last year, 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.  In this part, we update the third part posted last year, which is our guide for year-end moves to reduce total taxes between 2019 and 2020. 

Can you act at all?   

Each year we advise that you be practical, focusing on where you can actually take action. 

For many, the new $24,000 standard deduction for married couples, $12,000 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).  The standard deduction goes up when you reach 65. 

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!). 

Some possible deduction strategies

One technique for getting around the limit is to bunch deductions from two or more years into one year.  The one deduction that you can easily move is for charitable donations.  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 a single year, you can still use this bunching strategy.  Donate to a donor advised fund, from which you may be able to designate donations to particular charities in future years.

IRA donations:  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. 

Capital Gains:  Review your portfolio.  You may be able to “harvest losses” to offset capital gains realized on stock sales or mutual fund capital gains distributions.  If you have substantial unrealized gains, consider donating to a charity.  See below. 

The tax planning steps

If you are able to itemize, determine what income and deductions you can move from 2019 to 2020 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 review Roth conversions (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).  And business owners will want to review our post on planning under 199A for QBID

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.

But, watch for the Alternative Minimum Tax (“AMT”):

  • The exemption for the AMT and the threshold above which that exemption gets phased out are now higher than before 2018, so fewer taxpayers will owe the AMT.  

Finally, 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.

Capital gains

Your mutual funds may have large capital gains distributions.  Christine Benz says, “Brace yourself: 2019 is apt to be another not-so-happy capital gains distribution season, with many growth-oriented mutual funds dishing out sizable payouts.”  

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 2019, 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 asset allocation while not counting against the wash sale rule). 

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.  

Some reminders on itemized deductions

As you may recall, mortgage interest on new home purchases is deductible only for loans of up to $750,000 used to purchase or improve your primary or secondary residence.  Interest on home equity loans will not be deductible, except when the home equity indebtedness is used to purchase or improve the residence.

Also, all miscellaneous deductions were eliminated.  This includes investment and tax preparation fees, safe deposit box charges and unreimbursed employee business expenses.  And moving expenses are no longer allowed (except for military personnel in certain cases). 

Check taxes paid

Make sure your total paid in withholdings and estimates meets the safe harbor rules.  If not, you could owe interest for under-withholding. 

Estate plan review

While you review your taxes, consider reviewing your estate plan and your beneficiary designations.  The federal exemption is just over $11 million in 2019, so fewer people will owe any federal estate tax.  However, many states still impose estate taxes on smaller estates.  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.  If your spouse joins you, that is $30,000 per person.  This includes funding a 529 plan for education costs – expanded to provide for more than just college. 

Note, however, that holding appreciated assets for the step up in basis at death may be better for your heirs than gifting. 

Check on 2018

Check to see if you over-paid a penalty for under-withholding.  If you filed early, the penalty calculation may have over-stated the total you owe, so you will want to review your 2018 filing. 

Summary

Carefully review any income and deductions that you can still shift to see if moving will lessen the total taxes you pay for 2019 and 2020. 

Good luck and best wishes for the holidays!

Roth or not to Roth? Deciding requires predicting your future tax rate

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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 same 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 73 under the revised 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.

Conversions:

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.

Other considerations:

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).

Update on Roth conversions – to do or not to do?

In deciding whether to convert your traditional IRA to a Roth, there are many factors to weigh. At present, uncertainty about potential income tax reform makes the decision even more difficult: you are making a decision on what provides greater tax advantages, conversion or not, without confidence in the future tax impact.
Nonetheless, converting makes good tax sense if you expect your future marginal tax rate in retirement to be the same or greater than the rate on the conversion. However, if you expect your tax rate in retirement to be lower, then you will pay more taxes on conversion than you will in retirement.
There are other reasons to consider converting now:
> First, converting an IRA or other plan to a Roth account means that the assets are no longer subject to the Required Minimum Distribution (“RMD”) requirement reached at age 70½, thus allowing you to retain assets as long you wish. At death, your heirs must start withdrawing from the account, but the withdrawals will be income tax-free.
> Second, if you believe your IRA assets will grow significantly over time then it is advantageous to convert. If you convert now, you will have a lower conversion rate (less of the total will have been subject to income taxes). This calculation applies whether your current IRA assets are depressed or have yet to appreciate.
There is a reason not to convert now:
> If you’re single and the conversion puts your AGI over $200,000 (or you’re married and the conversion puts your AGI above $250,000), then the 3.8% Medicare surtax on unearned income may be triggered. However, you can avoid this (and other unintended consequences) by doing partial conversions over multiple years.
What if you err? If you convert and then your account value falls, you have until October 15th of the following year to undo the conversion, thus revering the income taxes paid.
Planning: If you’re considering a conversion, give us a call and we can help you make the right decision for you!