Year End Tax Planning Letter
2020 has been quite a challenge, to say the least. The COVID-19 crisis brought massive unemployment, business closures, and an enormous amount of uncertainty. All of this has made 2020 seem like the year that never ends. In fact, I’m sure some of us can’t wait for it to be over. As we approach the end of the year, it’s time to discuss steps that can be taken to help reduce your 2020 tax bill.
The past 12 months have seen several major tax law changes. In response to the COVID-19 emergency, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law in March. In addition, the Taxpayer Certainty and Disaster Tax Relief Act (Disaster Act) and the Setting Every Community Up for Retirement Enhancement (SECURE) Act were passed in December 2019. The Disaster Act extended many beneficial provisions that had expired or were set to expire. Barring additional extenders, many of these will expire again at the end of the year. The SECURE Act, on the other hand, made significant changes to the retirement rules. We’ll highlight planning techniques stemming from these recent bills, as well as other year-end planning ideas.
Year-end Planning Moves for Individuals
Game Generous Standard Deduction Allowances. For 2020, the standard deduction amounts are $12,400 for singles, $24,800 for married joint filing couples, and $18,650 for heads of household. If your total annual itemizable deductions for 2020 will be close to your standard deduction amount, consider making additional expenditures before year-end to exceed your standard deduction. That will lower this year’s tax bill. Next year, you can claim the standard deduction, which will be increased a bit to account for inflation.
The easiest deductible expense to accelerate is your mortgage payment due in January. Paying that payment this year will give you 13 months’ worth of interest in 2020. Also, consider state income and property taxes that are due early next year. Prepaying those bills before year-end can decrease your 2020 federal income tax bill because your itemized deductions will be that much higher. However, the maximum amount you can deduct for state and local taxes is $10,000.
Accelerating other expenditures could help your itemized deductions to exceed your standard deduction. Consider accelerating elective medical procedures, dental work, and vision care. For 2020, medical expenses are deductible to the extent they exceed 7.5% of Adjusted Gross Income (AGI), assuming you itemize. Timing your donations can lower your tax bill. Here’s how it works: instead of giving the same amount to charity every year, combine a couple of years into a single year so you’ll have enough deductions – along with other deductible expenses – to itemize. If you want to continue to support your favorite charities during off years, consider contributing to a donor-advised fund. These funds allow you to make a large donation in one year and decide when to dole out the money. Most financial services firms offer donor-advised funds. The minimum investment at Fidelity Charitable and Schwab Charitable is $5,000. In addition, many charities will accept donations of appreciated publicly traded securities. As long as you have owned the securities for at least a year, you can deduct the fair market value of the securities when you donate them. You won’t have to pay taxes on the capital gains, and the charity won’t either.
The CARES Act offers two unique opportunities for charitably minded taxpayers in 2020. Individuals who don’t itemize will be allowed an “above the line” deduction of up to $300 in 2020. For those who do itemize, the CARES Act increases the limit on charitable deductions to 100% of the individuals AGI for cash contributions, excluding donations made to donor-advised funds. Note: there is no requirement that the contributions be related to COVID-19.
If you aren’t itemizing your deductions and if your 70 ½ or older you can help your favorite charity and reduce your taxes by taking advantage of a tool known as a qualified charitable distribution (QCD). A QCD allows you to donate up to $100,000 from your IRA directly to a charity. The transfer will count towards your required minimum distribution. The contribution isn’t deductible, but it won’t be included in your income. Lowering your income could also help you avoid the high-income surcharge for Medicare parts B and D. To take advantage of this break, your donation must go directly from your IRA to the charity or charities. Make the transfer well before year-end to ensure that the check is cashed by the charity by Dec 31.
Make the most of your flexible spending account (FSA). If you have a health care FSA, review its balance and rules. Some plans still require that you forfeit anything left over at year-end, but most will either allow you to carry over up to $500 or offer a grace period until March 15 for claiming expenses from the previous year. You can use the money to pay for out-of-pocket medical expenses, including uncovered dental and vision expenses. Beyond that, stock up on FSA-eligible products that you’ll use in the coming year, such as contact lens solution, first aid items and hearing aid batteries. For a list of eligible items, visit FSDAStore.com. For 2021, the maximum contribution to a FSA for self-only coverage is $1,400 & $2,800 for family coverage.
Prepay tuition. If you’re the parent of a college student, you may be able to lower your 2020 tax bill by prepaying the tuition bill due for the next term – and you don’t need to itemize to claim this tax break. The American Opportunity Tax Credit, which you can take for students who are in their 1st four years of undergraduate study, is worth up to $2,500 for each qualifying student. Married couples filing jointly with AGI of up to $160,000 can claim the full credit; those with AGI of up to $180,000 can claim a partial credit.
If you’re planning to take a class next year to boost your own career, consider prepaying the January bill before Dec 31 so you can claim the Lifetime Learning credit on your 2020 tax return. The credit is worth up to 20% of your out-of-pocket costs for tuition, fees and books, up to maximum of $2,000. It’s is not limited to undergraduate expenses, and you don’t have to be a full-time student. Married couples filing jointly with AGI of up to $118,000 can claim the full credit; those with AGI of up to $138,000 can claim a partial credit.
Carefully Manage Investment Gains and Losses in Taxable Accounts. If you hold investments in a taxable account, consider selling appreciated securities that have been held for over 12 months. The maximum federal income tax rate on long-term capital gains recognized in 2020 is only 15% for most folks, although it can reach a maximum of 20% at higher income levels. The 3.8% Net Investment Income Tax (NIIT) also can apply at higher income levels.
To the extent you have capital losses that were recognized earlier this year or capital loss carryovers from pre-2020 years, selling winners this year will not result in any tax hit. In particular, sheltering net short-term capital gains with capital losses is a sweet deal because net short-term gains would otherwise be taxed at higher ordinary income rates.
What if you have some loser investments that you would like to unload? Biting the bullet and taking the resulting capital losses this year would shelter capital gains, including high-taxed short-term gains, from other sales this year.
If selling a bunch of losers would cause your capital losses to exceed your capital gains, the result would be a net capital loss for the year. No problem! That net capital loss can be used to shelter up to $3,000 of 2020 ordinary income such as from salaries, self-employment income, interest and dividend income, and rents. Any excess net capital loss from this year is carried forward to next year and beyond.
In fact, having a capital loss carryover into next year and beyond could turn out to be a pretty good deal. The carryover can be used to shelter both short-term and long-term gains recognized next year and beyond. This can give you extra investing flexibility in those years because you won’t have to hold appreciated securities for over a year to get a preferential tax rate. Since the top two federal rates on net short-term capital gains recognized in 2020 are 35% and 37% (plus the 3.8% NIIT, if applicable), having a capital loss carryover into next year to shelter short-term gains could be a very good thing.
Key Point: If you still have a capital loss carryover after 2020, it could come in handy if the tax rates are increased for 2021 and beyond.
Watch Out for Capital Gains Distributions. If you’re shopping for mutual funds for a taxable account, check the funds website before you buy. Otherwise your investment could saddle you with a big tax bill. During the month of December, many mutual funds pay out capital gains that have built up during the year. If you own shares on what’s known as the ex-dividend date, you’ll have to pay taxes on the payouts even if you reinvest the money. Before you invest in a fund, call the fund company or check its website to find the date and estimated amount of year-end distributions. The estimates are often reported as a percentage of the fund’s current share price. A distribution of 2% to 3% of the share price probably won’t cause you a lot of tax headaches, but if the fund estimates it will pay out 20% to 30% of the share price, wait until after the distribution to buy – or consider investing in a different fund.
Take Advantage of 0% Tax Rate on Investment Income. For 2020, singles can take advantage of the 0% income tax rate on long-term capital gains and qualified dividends from securities held in taxable brokerage firm accounts if their taxable income is $40,000 or less. For heads of household and joint filers, that limit is increased to $53,600 and $80,000, respectively.
While your income may be too high to benefit from the 0% rate, you may have children or grandchildren who will be in the 0% bracket. If so, consider giving them appreciated stock or mutual fund shares that they can sell and pay 0% tax on the resulting long-term gains. Gains will be long-term, as long as your ownership period plus the gift recipient’s ownership period (before the sale) equals at least a year and a day.
Giving away stocks that pay dividends is another tax-smart idea. As long as the dividends fall within the gift recipient’s 0% rate bracket, they will be federal-income-tax-free.
In 2020, you can give away up to $15,000 to as many people as you want without filing a federal gift tax return. As long as your gifts remain below this limit, they won’t eat into your exemption from federal estate taxes.
Warning: If you give securities to someone who is under age 24, the Kiddie Tax rules could potentially cause some of the resulting capital gains and dividends to be taxed at the higher rates that apply to trusts and estates. That would defeat the purpose. Please contact us if you have questions about the Kiddie Tax.
Give away Winner Shares or Sell Loser Shares and Give away the Resulting Cash. If you want to make gifts to some favorite relatives and/or charities, they can be made in conjunction with an overall revamping of your taxable account stock and equity mutual fund portfolios.
Don’t give away or donate loser shares (currently worth less than what you paid for them). Instead, you should sell the shares and deduct the resulting tax-saving capital loss. Then, you can give the sales proceeds to your relative or charity.
On the other hand, you should give away winner shares to relatives or donate them to charity. Most likely, your relatives will pay lower tax rates than you would pay if you sold the same shares. As explained earlier, relatives in the 0% federal income tax bracket for long-term capital gains and qualified dividends will pay a 0% federal tax rate on gains from shares that were held for over a year before being sold. (For purposes of meeting the more-than-one-year rule for gifted shares, you can count your ownership period plus the gift recipient’s ownership period.) Even if the winner shares have been held for a year or less before being sold, your relative will probably pay a much lower tax rate on the gain than you would.
Pump up your retirement plan. In 2020, you can stash up to $19,500 in a 401(k), 403(b) or other employer-provided retirement plan, plus $6,500 in catch-up contributions if you’re 50 or older. Over the long-term, boosting retirement-plan contributions will reduce the risk that you’ll come up short in retirement, but there are near-term benefits also. Contributions to a traditional 401(k) are pre-tax, so the more you sock away before Dec 31, the less you will owe the IRS come April 15. Depending on how often you get paid, you may have enough time to increase the amount of money withheld from your paycheck before year-end. If you receive a year-end bonus, ask your employer of you can contribute it to your retirement plan.
If you don’t have a retirement plan at work, you can contribute up to $6,000 to an IRA, or $7,000 if you’re 50 or older. Single taxpayers who are covered by a workplace retirement plan can deduct traditional IRA contributions if their income is less than $65,000, with the amount gradually phasing out until their income reaches $75,000. For married couples filing jointly, if the spouse making the contribution is covered by a workplace retirement plan, the income phaseout is $104,000 to $124,000. You have until April 15, 2021 to contribute to an IRA for 2020.
If your employer offers a Roth 401(k), contributions won’t lower your tax bill, but you will be able to take tax-free withdrawals when you retire. Unlike Roth IRAs, there are no income limits on making contributions to a Roth 401(k).
Convert Traditional IRAs into Roth Accounts. This may be the perfect time to make that Roth conversion you’ve been thinking about. The current tax rates are still relatively low compared to a couple of years ago, and while they are scheduled to remain that way until 2026, president-elect Biden is proposing to increase tax rates much sooner. Also, your income may be lower in 2020 due to the financial fallout of COVID-19. On the bright side, that means you’re likely in a lower tax bracket than you normally find yourself. Since the CARES Act suspended Required Minimum Distributions (RMDs) for 2020, if you already budgeted to pay tax on your RMD, rolling that distribution to a Roth IRA could be a perfect move. No RMD for 2020 also means that 100% of the distribution can be classified as a rollover.
It’s possible the overall value of your retirement account suffered as a result of the economic downturn. The depressed value in your IRA means a rollover distribution will contain more assets. Once in the Roth IRA, the recovery of value and ultimate withdrawal will be tax free.
Traditional IRA Contributions for All. The SECURE Act removed the age restriction on making traditional IRA contributions. Individuals over the age of 70½ who are still working in 2020 are no longer prohibited from contributing to a traditional IRA.
Don’t Overlook Estate Planning. Thanks to the Tax Cuts and Jobs Act (TCJA), the unified federal estate and gift tax exemption for 2020 is a historically huge $11.58 million, or effectively $22.16 million for married couples. Even though these big exemptions may mean you’re not currently exposed to the federal estate tax, your estate plan may need updating to reflect the current tax rules.
Warning: The current exemption is scheduled to revert to about $5.5 million in 2026. Depending on political developments, that could happen much sooner than 2026. However, the IRS issued regulations that would protect estates that make large gifts while the ultra-generous TCJA exemption is in place.
Year-end Planning Moves for Small Businesses
Net Operating Losses (NOLs). The CARES Act temporarily relaxed many of the NOL limitations that were implemented under the Tax Cuts and Jobs Act (TCJA). If your small business expects a loss in 2020, know that you will be able to carry back 100% of that loss to the prior five tax years. If you had an NOL carried into 2020, you can claim a deduction equal to 100% of your 2020 taxable income.
Establish a Tax-favored Retirement Plan. If your business doesn’t already have a retirement plan, now might be the time to take the plunge. Current retirement plan rules allow for significant deductible contributions. For example, if you’re self-employed and set up a SEP-IRA, you can contribute up to 20% of your self-employment earnings, with a maximum contribution of $57,000 for 2020. If you’re employed by your own corporation, up to 25% of your salary can be contributed with a maximum contribution of $57,000.
Other small business retirement plan options include the 401(k) plan (which can be set up for just one person), the defined benefit pension plan, and the SIMPLE-IRA. In 2020, you can contribute $57,000 ($63,500 if your 50 or older) to a solo 401(k) plan.
The deadline for setting up a SEP-IRA and making the contribution is the extended due date of your 2020 tax return. Other types of plans generally must be established by 12/31/20 if you want to make a deductible contribution for the 2020 tax year, but the deadline for the contribution itself is the extended due date of your 2020 return.
Contact us for more information on small business retirement plan alternatives, and be aware that if your business has employees, you may have to cover them too.
Take Advantage of Generous Depreciation Tax Breaks. 100% first-year bonus depreciation is available for qualified new and used property that is acquired and placed in service in calendar-year 2020. That means your business might be able to write off the entire cost of some or all of your 2020 asset additions on this year’s return. So, consider making additional acquisitions between now and year-end. Contact us for details on the 100% bonus depreciation break and what types of assets qualify.
Also, the CARES Act made a technical correction to the TCJA that retroactively treats a wide variety of interior, non-load-bearing building improvements [known as Qualified Improvement Property (QIP)] as eligible for bonus deprecation (and hence a 100% write-off). Alternatively, if you elect out of bonus depreciation, you can depreciate QIP over 15 years (rather than the 39 years provided by the TCJA). Small businesses can take advantage of this provision by filing for a change in accounting method or by amending the applicable return.
Claim 100% Bonus Depreciation for Heavy SUVs, Pickups, or Vans. The 100% bonus depreciation provision can have a hugely beneficial impact on first-year depreciation deductions for new and used heavy vehicles used over 50% for business. That’s because heavy SUVs, pickups, and vans are treated for tax purposes as transportation equipment that qualifies for 100% bonus depreciation. However, 100% bonus depreciation is only available when the SUV, pickup, or van has a manufacturer’s Gross Vehicle Weight Rating (GVWR) above 6,000 pounds. The GVWR of a vehicle can be verified by looking at the manufacturer’s label, which is usually found on the inside edge of the driver’s side door where the door hinges meet the frame. If you are considering buying an eligible vehicle, doing so and placing it in service before the end of this tax year could deliver a juicy write-off on this year’s return.
Claim First-year Depreciation Deductions for Cars, Light Trucks, and Light Vans. For both new and used passenger vehicles (meaning cars and light trucks and vans) that are acquired and placed in service in 2020, the luxury auto depreciation limits are as follows:
- $18,100 for Year 1 if bonus depreciation is claimed.
- $16,100 for Year 2.
- $9,700 for Year 3.
- $5,760 for Year 4 and thereafter until the vehicle is fully depreciated.
Note that the $18,100 first-year luxury auto depreciation limit only applies to vehicles that cost $58,500 or more. Vehicles that cost less are depreciated over six tax years using percentages based on their cost. Contact us for details.
Cash in on Generous Section 179 Deduction Rules. For qualifying property placed in service in tax years beginning in 2020, the maximum Section 179 deduction is $1.04 million. The Section 179 deduction phase-out threshold amount is $2.59 million.
Property Used for Lodging. The Section 179 deduction may be claimed for personal property used predominately to furnish lodging or in connection with the furnishing of lodging. Examples of such property include furniture, kitchen appliances, lawn mowers, and other equipment used in the living quarters of a lodging facility or in connection with a lodging facility such as a hotel, motel, apartment house, dormitory, or other facility where sleeping accommodations are provided and rented out.
Qualifying Real Property. Section 179 deductions can be claimed for qualifying real property expenditures. Qualifying real property means any improvement to an interior portion of a nonresidential building that is placed in service after the date the building is first placed in service, except for expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework. The definition also includes roofs, HVAC equipment, fire protection and alarm systems, and security systems for nonresidential real property. To qualify, these items must be placed in service after the nonresidential building has been placed in service.
Time Business Income and Deductions for Tax Savings. If you conduct your business using a pass-through entity (sole proprietorship, S corporation, LLC, or partnership), your shares of the business’s income and deductions are passed through to you and taxed at your personal rates. If you assume next year’s individual federal income tax rate brackets will be roughly the same as this year’s, the traditional strategy of deferring income into next year while accelerating deductible expenditures into this year makes sense if you expect to be in the same or lower tax bracket next year. Deferring income and accelerating deductions will, at a minimum, postpone part of your tax bill from 2020 until 2021.
However, it’s quite likely that 2020 was a comparatively bad year thanks to COVID-19. Hopefully, you expect to be in a higher tax bracket in 2021. If so, take the opposite approach. Accelerate income into this year (if possible) and postpone deductible expenditures until 2021. That way, more income will be taxed at this year’s lower rate instead of next year’s higher rate. Contact us for more information on timing strategies.
Maximize the Deduction for Pass-through Business Income. For 2020, the deduction for Qualified Business Income (QBI) can be up to 20% of a pass-through entity owner’s QBI, subject to restrictions that can apply at higher income levels and another restriction based on the owner’s taxable income. The QBI deduction also can be claimed for up to 20% of income from qualified REIT dividends and 20% of qualified income from publicly traded partnerships.
For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member LLCs that are treated as sole proprietorships for tax purposes, partnerships, LLCs that are treated as partnerships for tax purposes, and S corporations. The QBI deduction is only available to noncorporate taxpayers (individuals, trusts, and estates).
Because of the various limitations on the QBI deduction, tax planning moves (or nonmoves) can have the side effect of increasing or decreasing your allowable QBI deduction. So, individuals who can benefit from the deduction must be really careful at year-end tax planning time. We can help you put together strategies that give you the best overall tax results for the year.
This letter only covers some of the year-end tax planning moves that could potentially benefit you, your loved ones, and your business. Please contact us if you have questions, want more information, or would like us to help in designing a year-end planning package that delivers the best tax results for your particular circumstances.
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