Annual year-end tax planning strategies will reflect the COVID-19 pandemic and its effects. This year’s economic impact and federal relief packages will render some year-end tax planning strategies less advisable. In addition, this presidential election could result in new federal tax legislation that could affect the current Tax Cuts and Jobs Act. Below are a few year-end tax planning issues to consider.
Accelerate Your Income
A common tactic to reduce taxable income has been to defer income into the next year. However, this is only advisable when you don’t expect to land in a higher income tax bracket the following year. Current tax rates are at their lowest in some time and may change for high-income individuals. With that being said, it might be wise to accelerate income in order to take advantage of the current rates while they are still applicable. That’s especially the case if you’re among the millions of Americans who expect to have less income this year.
There may be several routes available to accelerate income. For example, you can realize deferred compensation, exercise stock options, recognize capital gains or convert a traditional IRA into a Roth IRA.
This approach could also help taxpayers who are eligible for the qualified business income (QBI) deduction to maximize their deductions. The QBI deduction is scheduled to end after 2025, however, it may not survive that long depending on the results of the election.
Convert to a Roth IRA
If you’ve been thinking of converting your pre-tax traditional IRA to an after-tax Roth IRA, now might be the perfect time. Roth IRAs don’t have RMDs, which translates to longer tax-free growth and distributions generally will be tax-free.
The drawback for most people is that you have to pay income tax on the fair market value of the converted assets. However, if your IRA contains securities that have declined in value or you’re in a lower tax bracket this year, your tax bill on the conversion might be smaller than it would otherwise. And, if the stocks bounce back, the increase in value would be tax-free.
The CARES Act temporarily raises the limit on charitable deductions for cash contributions to public charities from 60% of your adjusted gross income (AGI) to 100%. If you’re charitably inclined, you could leverage this provision to cut or completely offset your taxable income for 2020.
You can also reap the full benefit by “stacking” cash contributions with gifts that are subject to unchanged limits. For example, donations of appreciated securities are subject to limits of 20% or 30% of AGI, depending on various factors. You could donate securities you’ve held for more than one year (that is, long-term capital gain assets) in an amount equal to 30% of your AGI to avoid any capital gains tax on the securities. And then, you could donate 70% of your AGI in cash to public charities.
However, accelerating charitable donations to take advantage of this opportunity could be less lucrative if you’re in a lower tax bracket than normal this year. The resulting deductions would be worth more in future years when you’re in a higher tax bracket, or if you’re in the same bracket, but the rates have gone up under a new tax law.
You should think about bunching your contributions if you want to maximize the value of your usual charitable deductions, and you itemize deductions on your tax return. This could benefit you even more if your income is lower. If you typically make your donations in December, you can push the contributions into January to bunch them with your donations next December and ensure you exceed the standard deduction for 2021. This will allow you to claim the full amount as a charitable deduction and the deduction could be worth more if you’re subject to higher tax rates for 2021.
Taxpayers who are 70½ years or older can make tax-free qualified charitable distributions (QCDs) of up to $100,000 per year from their IRAs to public charities. QCDs aren’t deductible like other charitable contributions, however, they have the potential to reduce your tax liability. The QCD amount is excluded from AGI, which may, in turn, increase the benefit of certain itemized deductions and, consequently, lower your tax.
If you opt to skip your 2020 RMD, it may make more sense to hold off on a QCD until 2021, when it can reduce your taxable RMD and, in turn, your 2021 taxable income.
Loss harvesting gives you a way to offset any taxable gains. You can reduce realized gains on a dollar-for-dollar basis by selling poorly performing investments before year-end. Should you end up with excess losses, you generally can apply up to $3,000 against your ordinary income and carry forward the balance to future tax years.
If you donate the proceeds from your sale of a depreciated investment to a charity, you could benefit even more. Not only can you offset realized gains, you can also claim a charitable contribution deduction for the cash donation (assuming you itemize). However, remember to avoid triggering the “wash sale” rule, which disallows a capital loss if you purchase the same or “substantially identical” security 30 days before or after the sale.
Plan with Caution
There are pros and cons with each of the above strategies, and they all require careful analysis. Contact us today for help determining which strategies will work best for you in the short and long term.