Year-End Tax Planning for Challenging Times
Justin L. Sylvan
The public health, social, political and financial upheaval of 2020 has given taxpayers plenty of reasons to focus on things outside of their taxes. Our “new normal” has given many taxpayers reasons to worry about their futures, not only regarding health and employment but also retirement savings and future tax rates. However, it is important to start thinking about year-end planning as soon as possible to optimize tax-saving opportunities and promote future growth. Having the right tax strategy will help individuals and businesses navigate this time of historic disruption and put them on the right track as a new year begins.
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For many people, a strategic approach to a Roth conversion can generate significant tax savings, asset growth and estate-planning advantages. Roth accounts offer two significant advantages:
- Although contributions are nondeductible, qualified withdrawals of both contributions and earnings are generally income tax-free.
- There are no required minimum distributions (RMDs) in future years, so funds can continue to grow tax-free indefinitely.
When you execute a Roth conversion, you are subject to income tax on the amount you convert if it is attributable to deductible contributions and earnings. Given the current volatility in the stock market, taxpayers have an opportunity to convert IRA assets that might be at a depressed value right now into a Roth IRA for tax-free growth. It is also possible that you will find yourself in a lower marginal tax bracket this year if income has been reduced. The combination of these factors means that the cost of a Roth conversion may be low for you right now.
Keep in mind that converting to a Roth account is not right for everyone, so it is important to weigh the benefits against the current tax cost. For example, from a tax perspective, investors who expect to be in a lower tax bracket in retirement may be better off keeping funds in a traditional IRA or 401(k). Also, in the past, it was possible to review the transaction and reverse it if it was no longer desirable. For instance, if the IRA value dropped after the conversion. This ability to “re-characterize” the transaction is no longer available.
Skipping Required minimum distributions
The CARES Act included flexibility for retirement savers including temporary waivers for 2020 RMD from an individual retirement account (IRA) or an employer-provided qualified retirement plan that is a defined contribution plan.
2020 RMDs are not required as of January 1, 2020 through December 31, 2020. For taxpayers who have not taken any distributions for the year and do not want to take a distribution, the rules are simple. The penalty for not taking an RMD does not apply for 2020. This waiver applies to individuals who turned 70½ before 2020 or heirs of an inherited IRA/Roth or retirement plan account subject to RMDs. The next RMDs for these plans will be for the calendar year 2021.
If you ordinarily take RMDs from IRAs, 401(k)s or other retirement accounts, and you do not need the money for living expenses, consider skipping this year’s distribution. It will enable you to defer the tax and reduce your 2020 tax bill.
Some taxpayers may consider taking RMDs even if not required. It likely makes sense to take some distribution to utilize low tax brackets. If you do not need the money, consider a Roth conversion. As we talked about above, if you expect to be in a higher tax bracket in the future, or you want to pass on your money to loved ones without creating a tax burden for them — converting some, or all, of your dollars to a Roth may be an option.
In general, if your total income in 2020 is expected to be unusually low compared to what you are expecting in 2021, it may be beneficial to take an IRA distribution and pay a potentially lower tax rate on the withdrawal today.
Harvest losses or gains
Think about harvesting some losses if you realized net capital gains earlier this year. Harvesting losses — selling investments that have declined in value — can offset the income from capital gains and reduce taxes. If doing so produces a net capital loss, you may use it to offset up to $3,000 in salary or other ordinary income. Harvesting losses also creates an opportunity to use the proceeds to acquire substitute investments at potentially lower prices and further diversify your portfolio.
What if you have already realized a net capital loss this year? You might consider selling some appreciated investments and using your net capital loss to neutralize the taxable gains they would otherwise generate. If not, the capital losses will continue to carry forward to future years.
Other options for reducing 2020 taxes may be available — even in these times of great uncertainty. Talk to your financial or legal advisor for suggestions based on your unique circumstances and about any new developments.
Related Read: Consider Reevaluating Your Tax Plans Based on the Outcome of the Presidential Election
For more information, contact Justin Sylvan at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.