Year-end Tax Planning and the Pandemic

Tax Planning and the Pandemic

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. 

Retirement contributions

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. 

Business expenses

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. 

Capital gains

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.  

Summary

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!

Rethinking Investing and Paying off Debts

the best path may have changed ….

Investing has changed as times have changed … financial planning rules need to change too

Old thinking

In the past, when asked by a client about adding principal payments to reduce mortgage debt, so that the mortgage would be paid off sooner, I advised them to invest that payment instead.  

That advice was based on the financial planning rule that you do not pay off debt when the after-tax cost of the debt is less than the after-tax return on the investments.  Instead, you use cash flow to add to the investment because this is how you increase your net worth – the total of all investments less all debt – over time. 

Also, by not paying down your mortgage quickly, you had the added benefit of not tying up working capital in your home.  You cannot sell a bedroom when you need funds for a child going to college. 

But that was then … things are different now ….

Changes

All components of the financial planning rule need to be reevaluated:  Interest rates and inflation are at or near historic lows.  The tax law on deduction of mortgage and other interest on debts has changed.  The disruption to the economy from the Pandemic has hurt businesses and that will affect future investment returns. 

Interest rates – With interest rates so low, the investment return on cash is near zero and the return on bonds is very low.  Rates are almost certain to rise, which will make bonds today worth less in the future (when low interest bonds compete against newer bonds that offer higher interest rates, they are re-priced to match the new rate and that decreases what anyone will pay for the old bonds). 

Tax deductions – The Tax Cut and Jobs Act made the standard deduction the option for more than two-thirds of taxpayers.  With the standard deduction, there is no benefit because the mortgage interest is not actually deducted to lower your net taxes due.  That means that the after-tax cost of mortgage debt is no better than the before-tax cost. 

Investment returns – to get a better sense of the likely investment returns for that side of the rule, I spoke to Hal Hallstein IV of the Sankala Group, LLC out of Boulder, CO.  He referred me to their post on Money Supply & Discount Rates, in which they discuss the impact of stimulus checks and PPP loans in an economy where recipients are likely to invest those funds or make financial purchases because simple consumption, travel and entertainment, has been shut down.  They also discuss the threshold return required for making an investment decision, viz. the discount rate.  In the post, he states:

But simultaneously, we also know buying bonds with zero yields won’t work for people’s retirements, which realistically require 3% yields. Where does this leave us?

He then presents a rationale for owning gold, an asset he has always avoided, as have I.  But now it serves as a protection against a downturn when you have a portfolio that invests primarily in the stock market. 

In our conversation, we compared the weighted cost of capital, the blended rate on all your debt, against the expected return from investing, which he pegs at 3.5 to 4.25% over the next decade, due to high equity valuations in the US and low interest rates.* 

One note of caution: to get those returns will require tolerating substantial volatility.

All of this leads to the following:  if your mortgage is at 3.5%, and you get no deduction value, and your potential return is 3.5% before taxes, on which you will have some tax hit, now or later, then paying off the debt is a better choice financially than adding to your investments.

New planning ideas

When you apply the debt to investment rule above, more people may find it best to pay down debt. 

For a mortgage, added to your monthly payment will have a substantial impact over time, cutting the total interest paid.  If you have a Roth IRA, it may even make sense to distribute funds to pay a student loan or car loan, depending on the loan interest rate.

There are still some reasons not to switch from retirement investing to debt reduction, such as when your employer offers a match for contributions.  For a good set of considerations to review before acting, see the Betterment 5-Step Action Plan.

Conclusion

While the planning rule used to lead to the conclusion that you are best off adding to investments rather than accelerating paying off long-term debt like a mortgage or car loan, the conclusion from applying that rule has flipped.  Many will increase their net worth by paying down debt sooner. 

I hope you and your loved ones are all managing this as well as you can during the Pandemic. 

Thank you, and be well

Steven

  * Sankala Group LLC’s communications should not be considered by any client or prospective client as a solicitation or recommendation to affect any transactions in securities. Any direct communication by Sankala Group LLC with a client or prospective client will be carried out by a representative that is either registered with or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. Sankala Group LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented in this communication, or by any unaffiliated third party. All such information is provided solely for illustrative purposes.

Steven A. Branson, retirement, investing, Financial Strategies, debt, discount rate, decision making, newsletter, cost of capital

CARES Act, Stimulus checks, and other tax law updates

Keeping in touch during these challenging times …

2019 due dates (tax season is not quite over yet)

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

If you want to check on the status of your stimulus check, here is the IRS website to find the status or apply for your stimulus check.  If you expect a check that has not arrived, check out the links in this Huffington Post article

And if you received a check for a deceased relative (over 1 million were sent!), you need to return it to the Treasury, sorry. 

Small businesses

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.

Personal impact

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! 

Thank you, and be well

Steven

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!

Will you leave a mess or a legacy? Don’t die without a plan

“where did they leave it?”

Estate planning is not fun.  You have to face what the world will be like after you leave it.  You want to leave a legacy so your survivors are happy.  However, less than one in five of you have taken the steps needed. 

If you completely ignore creating a post-death plan, then you will leave a chaos and confusion for others to sort out at a time when they will be grieving from your loss.  They will have to find where you put everything and sort out where you wanted everything to go. 

If people depend on you financially, not providing enough on which they can survive will mean major lifestyle changes for them.  Not something you want. 

You want survivors to focus on cherished memories, not on probate courts.  Take action! 

Now, what do you do?

First, leave enough so survivors can survive

Make sure you have provided for those who depend on you.  Usually, that means purchasing some form of life insurance.  You want to replace your earning power from now until the time that they are independent, either when a spouse or partner retires or when your children become gainfully employed. 

If you have been saving for retirement, those accounts may be enough so you don’t need to purchase life insurance.  Reviewing your potential estate with an advisor is wise to make sure survivors have enough. 

Second, sign the documents

Execute documents that ensure that your estate goes to the people who you want to benefit.  This usually means signing beneficiary designations for retirement plan accounts and executing a will.  You may even need a trust for young survivors.  We wrote this post detailing the steps a few years back.  If that’s too technical, ask me questions. 

You may want to consult an advisor to get all the proper documents in place.  Here is a good checklist to review.

Third, have the conversations

Talk to your spouse, to your adult children and to the people you name in your documents.  Make sure they understand your wishes.  Do you want to be buried or do you want to be cremated?  Do you want donations made to charities? 

What if you have a catastrophe the doesn’t kill you, but leaves you hooked up to machines forever?  Have a conversation so your loved ones know your wishes.  And, make sure you sign a health care proxy or medical directive, living will and even a “do not resuscitate” or DNR order. 

Fourth, leave a trail

Make sure the key people know how to find everything.  One way is to write a memorandum listing your passwords, where to find the safe deposit box key, and where you stored the life insurance policies.  Give copes to key people, such as the personal representative named in you will or the trustee of your trust. 

Finally, leave a legacy

When you take care of all you can, in advance, your survivors don’t have to suppress feelings while they clean up a mess:

“WE WERE WORRIED ABOUT MY MOM after my dad died, but he had everything in order. It allowed us to focus on our grief instead of being bogged down in financial paperwork and family bickering.” That’s one of the candid responses Merrill Lynch and Age Wave received when they interviewed more than 3,000 Americans 55 and older for a comprehensive look at attitudes and practices surrounding legacy planning.  From How do you want to be remembered…

planning and taking action

You will need to review and update your plan over time.  But, just knowing you took all these steps should improve matters for you and your family now!  Contact our office if you have questions so you can “don’t worry, be happy!”