Like so many things this year, the recommended practices for your annual year-end 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 trims or even repeals the Tax Cuts and Jobs Act (TCJA) in 2021. Here are some year-end tax planning issues and actions to consider in light of this unusual year.
One common tactic to reduce taxable income has been to defer income into the next year. But this practice is advisable only when you do not 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 if you are among the millions of Americans who expect to have less income this year — for example, because of a job loss, less business income or 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 accelerate customer invoicing and collections, 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 enjoy it while they can.
Roth IRA conversions
If you have 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 do not 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 are in a lower tax bracket this year, your tax bill on the conversion will probably 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 are charitably inclined, you could leverage this provision to cut or completely offset your taxable income for 2020.
Note, too, that you can 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 have 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 are in a lower tax bracket than normal this year. The resulting deductions would be worth more in future years when you are in a higher tax bracket (or if you are in the same bracket, but the rates have gone up under a new tax law).
If you are 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 are subject to higher tax rates for 2021.
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). While QCDs are not 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.
There is 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.
You could benefit even more if you donate the proceeds from your sale of a depreciated investment to charity. Not only can you offset realized gains, but you also can claim a charitable contribution deduction for the cash donation (assuming you itemize). 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.