Like so many things this year, the recommended practices for your annual end-of-the-year tax planning reflect the COVID-19 pandemic and its far-flung effects. The economic impact, as well as federal relief packages like the CARES Act, may render some tried-and-true strategies for reducing your income tax liability less advisable for 2020.
Adding to the uncertainty is the outcome of the presidential election. It could result in new federal tax legislation that changes, trims or even repeals the Tax Cuts and Jobs Act (TCJA). There is also still the potential for additional COVID-19 relief legislation. Regardless of the election results, here are some year-end tax planning issues and actions to consider.
One common tactic to reduce taxable income has been to defer income into the next year. But this practice is advisable only when you don’t expect to land in a higher income tax bracket in the following year. Current tax rates are at their lowest in some time, but they may not stay there for high-income individuals.
It might be wise to accelerate income to take advantage of the current low rates. That’s especially the case if you’re among the millions of Americans who expect to have less income this year — for example, because of a job loss or because the CARES Act excused you from taking required minimum distributions (RMDs) from retirement accounts for 2020.
Several routes to accelerate income may be available. You can, for example, realize deferred compensation, exercise stock options, recognize capital gains or convert a traditional IRA into a Roth IRA (see below for more information on conversions).
This approach also could 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 and may not survive that long depending on the results of the election, so eligible taxpayers may want to utilize it while they can.
Roth IRA conversions
If you’ve been thinking about converting a pre-tax traditional IRA to an after-tax Roth IRA, this may be the time to do so. 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. But 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 probably will be smaller than it would otherwise. And, if the stocks bounce back, the increase in value would be tax-free. Each case is different so it would be wise to prepare a cash flow projection to estimate your best course of action.
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.
Another strategy to reap the full benefit is 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.
Bear in mind, though, that 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).
If you’re just looking to maximize the value of your usual charitable deductions, and you itemize deductions on your tax return, think about “bunching” your contributions, especially if your income is lower. If you normally 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. The deduction will be worth more if you’re subject to higher tax rates for 2021. If you exceed the threshold for deductible charitable contributions the excess may be carried forward which could allow a full deduction over time.
Taxpayers age 70½ or older can make tax-free qualified charitable distributions (QCDs) of up to $100,000 per year from their IRAs to public charities (donor-advised funds are excluded). If you file a joint return, your spouse can also have a QCD and exclude up to $100,000. While QCDs aren’t deductible like other charitable contributions, they nonetheless 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. This strategy existed before COVID and should be considered each year by eligible taxpayers.
There’s a “but,” though, due to the CARES Act’s waiver of annual RMDs for 2020. 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. Selling poorly performing investments before year-end lets you reduce realized gains on a dollar-for-dollar basis. 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. A capital loss carry forward can offset capital gains in future years which may more beneficial with the possibility of changes to the favorable taxation of capital gains.
Take care, though, 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.
Each of these strategies comes with both pros and cons that require careful analysis and balancing. We can help you determine which approaches will work best to minimize your income tax liability for the short and long term.