As we enter the last few days of 2020, we are encouraged by the introduction and initial deliveries of a COVID-19 vaccine yet remain in the midst of a new surge in the pandemic. The economic impact of the pandemic and election results have created unique but difficult tax planning strategies.
As we noted in our August 7 Advisor Insights, now President-elect Joe Biden unveiled proposals to increase the payroll tax on incomes over $400,000 per year, increase the maximum individual tax rate to 39.6% and eliminate preferential treatment on long-term capital gains tax rates for taxpayers with incomes above $1 million.
The outlook for tax reform legislation in 2021 largely hinges on which party controls the Senate; Republicans currently hold a narrow edge (50-48), with the final two seats – both for Georgia – to be decided in special run-off elections on January 5, 2021. Should Republicans win at least one of those Senate seats, Republicans would retain control of the Senate, which would, in turn, greatly reduce the odds of significant near-term tax reform.
Optimum tax planning includes developing and implementing short and long-term strategies to achieve the most effective results. Each taxpayer’s planning opportunities are specific to their individual circumstances. It is important to know what tax bracket you are in now and project to be over the next few years.
Manage Taxable Income to the Tax Brackets:
The Tax Cuts and Jobs Act (TCJA) brought major tax law changes in 2018. Income tax rates of 10%, 12%, 22%, 24%, 32%, 35% and 37% replaced rates of 10%, 15%, 25%, 28%, 33%, 35%, 37% and 39.6%. The potential return to the pre-TCJA rates makes tax bracket planning even more necessary for 2020. The 2020 tax brackets based on filing status and indexed to account for inflation are as follows:
2020 Thresholds for Estates and Trusts:
2020 Long-term capital gains and qualified dividends are taxed differently from ordinary income using the following brackets and rates:
The Net Investment Income Tax (NIIT) is a 3.8% surtax on a portion of modified adjusted gross income over certain filing status-based thresholds. Net Investment Income includes interest, dividends, capital gains, non-qualified annuity distributions, income from passive investment activities, etc.
Estates and Trusts
The long-standing strategies of deferring income and/or accelerating deductions to lower taxes will continue to be effective for many taxpayers; however, at times, accelerating income or deferring deductions may allow a taxpayer to maximize the benefit of a lower tax bracket. This process can be very helpful in managing annuity and retirement income to minimize taxes over time. Consider harvesting long-term capital gains if you can benefit from the 0% or 15% capital gain rates and/or stay below your NIIT threshold. High income taxpayers who could be impacted by the Biden proposed changes to the tax on capital gains should consult with their CPA’s to determine if capital gains should be accelerated into the 2020 tax year.
Contributions to Retirement Accounts: You may be able to reduce your taxes by contributing as much as you can to IRAs and employee retirement plans. These contributions are subject to the following limits:
- IRA Contributions: The maximum you can contribute to all your traditional and Roth IRAs for 2020 is $6,000 ($7,000 if you are 50 or older). Remember, you can make contributions to your IRA until April 15, 2021 for the 2020 tax year
- 401(k) Contributions: The 2020 employee deferral limit on 401(k) contributions is $19,500 (plus an additional $6,500 if you are 50 or older).
Satisfy Required Minimum Distributions (RMDs) using the IRA Charitable Rollover
The SECURE Act raised the beginning age for required minimum distributions (RMDs) to 72, from age 70½, previously. However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act waived Required Minimum Distributions (RMDs) for the 2020 tax year.
The SECURE Act did not adjust the age 70 ½ requirement for taxpayer eligibility to make a Qualified Charitable Distribution (QCD) up to $100,000 each year from an IRA to qualified 501(c) (3) charitable organizations (donor-advised funds, private foundations and supporting organizations are excluded). A qualified charitable distribution neither counts as an itemized deduction nor as taxable income, though it does count towards satisfying the RMD for that year.
This strategy may be beneficial for charitably inclined individuals who receive a greater tax benefit from the increased standard deduction rather than itemized deductions.
Note: While taxpayers can still make a QCD in 2020, with 2020 RMDs being waived under the CARES Act, it may instead be beneficial to delay any QCD’s until 2021.
Roth Conversion: Determine if a traditional IRA should be converted to a Roth IRA. Factors to consider include your current and future anticipated tax status, family situation, and the ability to pay the tax due from other sources. High income earners might consider a “Backdoor” Roth IRA. This is an IRS sanctioned method that may enable taxpayers to fund a Roth even if their income is over the regular Roth contribution limits.
Tax Loss Harvesting: At NEIRG, we monitor taxable portfolios throughout the year for available losses. Depending on your tax situation, it may be beneficial to purposely “harvest” investment losses to offset capital gains that have been realized during the year (reminder: this only applies to taxable accounts). Keep in mind that net losses up to $3,000 can offset income and any further losses can be carried forward to future years.
During 2020, we were able to take advantage of the sharp selloff in February and March, rotating out of positions that were not long-term holdings and capturing the loss. These losses have been used offset gains throughout the year and for many clients, will result in carry forward losses for next year and beyond.
Accelerating Charitable Donations
Itemized deductions typically provide a tax benefit equal to a taxpayer’s marginal income tax bracket. A taxpayer in the 37 percent federal income tax bracket generally receives a 37 percent benefit for the total of itemized deductions.
President-elect Joe Biden proposed limiting the benefit of itemized deductions to 28 percent for individuals with more than $400,000 of taxable income. If passed, there could be a significant disconnect between a taxpayer’s marginal tax bracket (say, 37 or 39.6 percent) versus the benefit provided by itemized deductions (28 percent).
Charitably inclined individuals who could be affected by this change should evaluate whether to accelerate charitable gifts prior to year-end. This consideration may also be particularly beneficial for taxpayers who experienced higher-than-normal income in 2020, as increased charitable giving shields a portion of income from otherwise being taxed at a higher rate.
Coordination with an experienced tax professional is advisable, given certain adjusted gross income (AGI) limits that apply to charitable gifts. Should charitable gifts exceed the AGI limits, the excess becomes a charitable carryforward to be used within the next five years, albeit potentially subject to the proposed 28 percent limit.
Of special note, while the Tax Cuts and Jobs Act increased the deduction for cash contributions to public charities to 60 percent of adjusted gross income (previously 50 percent AGI limit), the Coronavirus Aid, Relief, and Economic Security (CARES) Act increased the deduction for contributions to public charities (other than donor-advised funds) to 100 percent of AGI for the 2020 tax year. As a result of this CARES Act-provision, high income taxpayers may have a unique 2020 charitable planning opportunity.
With equity markets near all-time highs, investors with taxable accounts may hold highly appreciated equity positions. From a tax planning standpoint, gifting long-term appreciated securities is an efficient charitable-giving strategy as the charity receives the same economic benefit as a cash donation, while the taxpayer receives a tax deduction for the full market value of the gift and avoids paying capital gains taxes on the gifted security.
Using the Lifetime Gift Tax Exemption
The Tax Cuts and Jobs Act (TCJA), passed in December 2017, approximately doubled the estate exemption – from $5.49 million per person in 2017 to $11.18 million per person in 2018. The increased exemptions amount, under TCJA, are scheduled to run through 2025, after which the basic exclusion amount is set to revert to the 2017 level of $5 million per person, plus inflation adjustments.
The lifetime gifting exemption currently stands at $11.58 million per person (with a top federal estate tax rate of 40 percent), though President-elect Joe Biden has proposed to “return the estate tax to 2009 levels” which would imply an exemption of $3.5 million per person (plus inflation adjustments), with a top federal estate tax rate of 45 precent.
The Treasury Department and IRS issued final regulations in November 2019 clarifying that taxpayers taking advantage of the increased exemption amounts would not be subject to a clawback, should the exemption amount decrease from current levels.
High net worth individuals should evaluate current assets and assess how much might be needed for their remaining lifetime, with consideration to gift ‘excess assets’ to loved ones, which would reduce the size of an otherwise taxable estate. Depending on the size of an outright gift, estate planning which incorporates making gifts to trusts may be advisable to provide parameters/safeguards for the intended beneficiaries.
Individuals who are likely to one day have a taxable estate should also consider direct payments (to the educational/medical provider) for tuition and medical expenses, which do not constitute gifts, as well as annual exclusion gifts ($15,000 for 2020 and 2021). Such gifts can be an effective strategy for further reducing the size of a taxable estate.
Keep in mind that any gifts in excess of the annual gift tax exclusion ($15,000 to each donee) should be properly recorded on a gift tax return.
There are many other tax planning strategies that may be applicable to your situation; however, we hope that the above methods are helpful as you plan for the remainder of the year. Please feel free to reach out to us if you would like to discuss your specific circumstances or if we can be of further assistance.
Happy Holidays and best wishes for a safe, healthy, and prosperous New Year
Your Team at New England Investment & Retirement Group
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