Tax planning during November and December often delivers substantial savings on tax returns due the following year. In 2020, however, uncertainties abound.
For instance, what changes in tax laws can be expected, and when might any changes take effect? During his campaign, President-elect Joe Biden pledged to raise income tax and payroll tax on high earners, increase the tax rate on long-term capital gains, reduce gift and estate tax exemptions, and remove the limit on state and local tax (SALT) deductions, among other proposals.
However, any tax legislation would come from Congress and although the Democratic Party retained control of the House, control of the Senate in 2021 is still undecided as of this writing. It’s worth noting that Donald Trump was elected in 2016 with Republicans in control of both Houses of Congress, yet agreement on a major tax bill was not achieved until late December 2017, largely effective in 2018. There’s no guarantee that Washington will act more quickly now, so a widespread change in tax law might not take effect before 2022.
That said, COVID-19 is still very much in the news. Federal, state, and local governments have seen the cost of fighting the pandemic escalate while tax revenues have dropped because of health-driven measures that crimp the economy. Many observers believe that higher taxes will appear eventually; and even without immediate changes in the law, many tax rates are scheduled to rise in 2026.
Given this background, year-end 2020 tax planning may require some tradeoffs. There are steps you can take now to reduce your tax bill for this year while other tactics can hedge potential future tax hikes. Here are some points to consider in the coming weeks:
Standard deduction versus itemized deductions. Taxpayers can claim whichever is larger. For 2020, the standard deduction is $12,400 for single filers and $24,800 for married couples filing jointly. If you think your itemized deductions will top those numbers, you might want to make charitable donations and schedule elective medical procedures before January.
Note that the limit on SALT deductions is $10,000 for single and joint filers. Therefore, single taxpayers are more likely to find itemizing appealing. However, if real estate taxes in excess of the 2020 deductible amount have not yet been paid, they should be paid in 2021 since President-elect Biden’s tax plan calls for reinstating the SALT deduction.
If you can’t justify itemizing now, postponing donations and elective health care may increase your chance of itemizing in 2021. Keep in mind, however, that itemizing may become less rewarding next year even if taxes increase, as the value your deductions may be limited to 28% under President-elect Biden’s proposal.
Harvesting capital gains or losses. Turbulent investment markets during 2020 have caused some investors to see their holdings lose value while others have paper profits. Realizing losses by year-end can not only deliver a deductible loss of up to $3,000 for 2020, you can carry forward excess losses indefinitely, to offset future gains which may be taxed at higher rates. If you still like the securities you sell at a loss, you can buy them back after 30 days or buy something similar immediately, without losing the tax benefit from the loss. Alternatively, if you expect your 2021 income to exceed $1 million, you may want to consider taking gains in 2020 since the President-elect’s plan would raise the long-term capital gain tax rate from 23.8% to 43.4%.
Timing income and losses. Conventional year-end planning calls for delaying income to the following year, when possible, to postpone tax payments for 12 months. Sole proprietors, for example, might delay sending out bills for work they’ve done until late December, so that January payments will be reported as income in 2021. This year, if you think your tax rate, including proposed increases to FICA and self-employment taxes might be much higher in 2021, you might consider billing in late November or early December to receive income that will be taxed at 2020 rates.
The same principle holds if you are an employee expecting a significant bonus for this year’s efforts. Delaying the bonus until next year may postpone the tax payment but asking your employer to treat the bonus as 2020 compensation could turn out to be a savvy plan, if you think your tax rate will be higher in 2021.
A similar choice may be faced by people who will be buying business equipment. If you place the equipment in service before year-end you can take depreciation deductions for 2020, even if payment for the equipment comes later. Depreciation deductions might even produce a meaningful net operating loss for 2020, which you can carry back to prior years and generate a refund. Such cash flow could be welcome if your business has struggled during the pandemic lockdown.
Conversely, you might want to place new equipment in service in 2021, thus delaying depreciation deductions. As mentioned, if tax rates rise next year, deductions will be more valuable and that goes for depreciation deductions as well.
Reconsidering RMDs. Under legislation passed earlier this year, there are no required minimum distributions in 2020. If you do not need the money for living expenses, skipping taxable withdrawals from IRAs and other retirement plans this year would provide immediate tax relief.
However, taking some money from your retirement funds may make sense, even if it is not required. Current tax rates are low by historic standards. You may prefer to fill up today’s brackets rather than defer withdrawals to years when they could be subject to higher tax rates.
For example, suppose Janice and Kurt Martin reported taxable income (after deductions) of $200,000 in 2019; and by this December, they have reason to believe that their 2020 income will be similar. This couple might withdraw, say, $100,000 from their IRAs in December. The 24% tax bracket goes up to $326,600 in 2020, so their IRA distributions would cost them only $24,000 (24% of $100,000) in federal income tax. The large withdrawals from their traditional IRAs will reduce future RMDs.
The above example illustrates some key points. Even if you are old enough to be subject to RMDs (over age 70-1/2 or age 72 for those beginning RMDs after 2020), you do not have to follow the RMD table precisely. You can take more depending on how much tax you’re willing to pay sooner rather than later. Nevertheless, following the RMD table is a practical way to ensure that your retirement funds will last your lifetime, even if you live well beyond life expectancy.
What’s more, you do not have to be in the RMD stage to take unneeded retirement account withdrawals. You may withdraw enough money at any age to use up the 12%, 22%, 24%, or even the 32% tax bracket, if you fear that future tax rates on such distributions might be much higher. However, you should also consider the early withdrawal penalties before doing so.
Going the Roth route. In the above example, the Martins withdraw $100,000 from their pretax IRAs and pay $24,000 in taxes. (We will ignore any state or local income tax for simplicity.) What should they do with their net $76,000? Spend it on bucket list items? Fund home improvements? Make family gifts?
Those may be worthy goals but, from a tax perspective, an excellent plan would be to put the money into their Roth IRAs. After five years and age 59-1/2, Roth withdrawals are completely tax-free, regardless of the taxpayer’s overall income. Moreover, Roth IRA owners never have RMDs.
The appeal of funding Roth IRAs has been enhanced by the SECURE Act, which took effect this year. Starting with deaths in 2020, most nonspouse beneficiaries must completely distribute their inherited retirement accounts within 10 years. (For deaths before 2020, beneficiaries could spread RMDs over their life expectancy, possibly enjoying decades of tax deferral.) Under this 10-year rule, affected beneficiaries may have to take large distributions, perhaps taxed at high tax rates in the future.
If money is moved into a Roth IRA, the picture changes dramatically. Beneficiaries would be able to withdraw money if and when they need it, tax-free or they can leave the inherited Roth account to compound for 10 years and then withdraw a lump-sum, tax-free. Essentially, moving money from a pretax account at year-end 2020 and paying tax at today’s rate is buying some insurance against higher future tax rates, whether they appear in 2021 or later.
Looking at life insurance. On the topic of insurance, another possible use of the Martins’ $76,000 in after-tax money is to buy life insurance on one or both spouses. Depending on their ages and health, the death benefit could be sizable and tax-free to the policy beneficiaries. Such a plan might help to make up for the SECURE Act’s curtailing of Stretch IRAs, as explained above.
Estate and gift tax exemptions. The IRS has just announced that the estate tax exemption for decedents who die in 2021 will be $11.7 million, up from $11.58 million in 2020. The same exemption numbers apply to lifetime gifts.
The President-elect has promised to reduce the exemption; observers speculate that it might be capped in the $3.5 million-$5 million range. Estate tax rates might move up from the current 40% to 45%. Therefore, if you are concerned such changes would subject your estate to higher taxes, making substantial gifts in late 2020 could be an astute strategy. First, make sure you are making the most of the $15,000 annual gift exclusion per recipient.
For example, suppose Janice and Kurt Martin have two children, a son-in-law and a daughter-in-law, and four grandchildren. Janice could give each of them up to $15,000, for a total of up to $120,000 (eight times $15,000). Kurt could do the same. There would be no tax consequences and no need to file a gift tax return for 2020. Repeating the process in January could move even more assets from their taxable estates.
But suppose $15,000 gifts do not fully address gift tax concerns. If so, larger gifts could be made to use up some of the lifetime exemption amounts, which now exceeds $11 million.
Say Nora Parker has $12 million net worth, even after using her annual gift tax exclusions. Assuming she could maintain her lifestyle with a $4 million net worth, Nora might give away $8 million to her heirs. If no other taxable gifts have been made, Nora would owe no gift tax.
In Nora’s case, what would happen if the estate and gift tax exclusion drops to, say, $5 million in the future? Nora’s $8 million gift in 2020 would decrease her estate tax exemption to $0 million, leaving $4M subject to the estate tax. The IRS has ruled that there would be no “clawback” of taxable gifts that were lawfully made. In this case, Nora would be left with a $4 million estate and no estate exemption left. If Nora had not made the gifts, her taxable estate would have been $7 million ($12 million estate less $5 million exemption), instead of $4 million. So making the gifts in 2020 saved the estate tax on $3M.
Major moves such as seven-figure family gifts should not be taken lightly. Thorough conversations with our firm’s tax experts can help you find the balance between acting at year-end or waiting to see what the future might bring for year-end estate and gift tax planning, as well as income tax strategies.
If you have any questions, please reach out to your Citrin Cooperman Advisor.