2020 Year-End Tax Planning Opportunities

Quote: “The hardest thing in the world to understand is the income tax” – Albert Einstein

Welcome back to Jay’s Tax Insights, where we take the time to break down complex tax items and cover trending tax topics on a monthly basis to provide you with insight on the topic and assist with improving your financial standing for years to come. In today’s blog we focus on 2020 Tax Planning Opportunities to consider before December 31, 2020.

2020 Year End Tax Planning:

As the holidays approach, many of us become distracted with Amazon purchasing, gift wrapping, Hallmark Christmas movies, eggnog, and family gatherings, that we lose sight of those last-minute tax planning opportunities to reduce that 2020 tax bill. (Yes, I am completely trying to focus your mind away from your holiday festivities to focus on your taxes; trust me you’ll thank me later). With two weeks left before year-end, individuals, business owners and family offices should be taking the time to review their financial situations to identify any opportunities for reducing, deferring, or accelerating tax obligations.

As we all know, year end tax planning isn’t as straightforward as usual in 2020. Uncertainty about whether President-Elect Joe Biden can enact tax hikes next year is a complicating factor, and some folks can’t predict their 2021 income after earning less this year due to COVID-19 related job losses, shortened work hours, or forgoing a required retirement account distribution as allowed under the Cares Act. And with these unknowns, some planning is about hedging your bets. But taxpayers can still make informed decisions by taking into consideration four key aspects from Biden’s tax proposal, which are as follows (previously mentioned on my “How the Presidential Election Could Impact Your Taxes” Blog):

• Increase in the top individual income tax rate to 39.6% from 37%
• Raising the tax on capital gains at 39.6% for taxpayers with more than $1,000,000 in income
• Capping the value of itemized deductions at 28%
• Decrease in the estate-tax exemption from $11.58 million per person to around $3.5 million.
• Eliminating step-up of basis at death
• In addition, areas that should also be looked at in particular include tax reform provisions that remain in play as of year-end, as well as new opportunities and relief granted earlier in 2020 under the CARES and SECURE Acts.

Below you will find a few ideas to cover with your CPA/CFP in the next two weeks, if not already discussed; consider it an early Christmas present from us here at AWM Capital:

Accelerate Income (Roth Conversions):

One common tactic you may have heard of in the past is to defer income into the next year as a way of reducing taxable income in the current year. But this practice is advisable only when you anticipate the following year to be a lower income year than the current year, which does not seem to be the case for many in 2020. Thus, if you expect 2020 to be a lower income year, either because you’ve earned less or tax laws will change, then you should consider actually accelerating taxable income in 2020.

For example, this may be a prime time to convert your regular individual retirement account to a Roth IRA, because income taxes are owed on converted assets. Here at AWM Capital, we’ve been assisting our clients who are in a relatively low tax bracket with these conversions. The key here is determining how much is the right amount to convert. We’ve seen that a partial conversion was just enough to keep people in their current income-tax bracket.

Why trouble with a Roth? Well, assets can be left growing intact for a lifetime and are tax-free upon withdrawal. In contrast, investors in regular IRAs must take required minimum distributions after turning age 72, even if they don’t need them, and payouts are subject to income taxes. For more guidance on year-end planning related to retirement accounts, reference our “Year-End Tax Planning: Maximizing Your Net Worth” blog written by our very own Erik Averill (AWM Capital Partner).

An additional consideration in relation to accelerating income is the timing of compensation. Certain types can be flexible. If you’re due a bonus, an employer may pay it in 2020 rather than early in 2021. Or if you recently received stock options, you may be able to trigger taxes this year. Normally options are recognized as taxable income when they vest, but if they were awarded within 30 days prior, you can recognize income early with a so-called Section 83B election.

There’s a potential downside to accelerating compensation: If your rate doesn’t go up next year, you will have paid taxes earlier than needed and lost the time value of the cash used, so be sure to crunch the numbers under different scenarios.

Fatten Deductions (Charitable Donations):

Any time you accelerate income, accelerating deductions to offset it makes sense and even more so if you believe Biden will succeed in limiting the value of deductions next year. For taxpayers earning more than $400,000, Biden aims to cap the value of itemized deductions at 28% and reinstate the Pease Limitation, which reduces deductions on every dollar by three cents.

Thus, to inflate 2020 deductions, consider condensing several years of charitable gifts this year, and take advantage of a rule under the Cares Act that raised the deductibility of cash contributions this year from 60% to 100% of adjusted gross income.

The generous deductibility of cash this year may turn some conventional planning on its head: Normally, investors are advised to donate appreciated stock to charity rather than cash, because this avoids a future capital-gains tax hit. But deductions for stock gifts are limited to 30% of AGI, so if your goal is to plump deductions, cash gifts may be best.

In some cases, it may even make sense to sell a stock, pay capital-gains taxes, then make a cash donation with what’s left and claim a deduction valued at 100% of your adjusted gross income. The smaller the appreciation you have in the stock, the better, with the aim being to minimize capital gains taxes. You can get more benefit if you use the strategy to make the next, say, five years’ worth of charitable contributions in the current year.

Harvest Tax Losses:

Year end is always a good time for tax-loss harvesting, and this year there is an added motivation for wealthy investors to realize gains and lock in a higher cost basis: Biden is intent on raising taxes on capital gains of more than $1 million. Tax 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 bifurcated stock market is a prime landscape to pair losses with gains. While the S&P 500 is up almost 15% over the past 12 months, performance by sector varies wildly. Information technology stocks are up 39%, for example, while energy stocks are down by 38%. 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, you also can claim a charitable contribution deduction for the cash donation (assuming you itemize) as I mentioned above. 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.

Estate Tax Planning:

If you want to transfer money out of your estate and into your heirs’ names during your lifetime and take advantage of the estate-tax exemption, aim to do this by year end. For 2020, the estate, gift and generation-skipping-tax exemption is set at $11.58 million per person and is scheduled to increase each year by a cost-of-living factor. However, that level of exemption is due to sunset after 2025, when it would return to half that amount. The $5 million level of exemption (adjusted annually by a cost-of-living adjustment or COLA) came into the law in 2011. Prior to then, the exemption level had reached $3.5 million.

The question is whether any gift given now that uses up the exemption will be grandfathered if there is a future change to the exemption amount. The IRS has issued favorable proposed regulations, so no claw-back is expected. Thus, if you have not done so already and are comfortable surrendering control of assets to the next generation, it might be a good idea to take advantage of the $11.58 million per individual lifetime exemption in 2020, or $23.16 million for a married couple. The prevailing view is that the current lifetime exemption amount is as good as it gets and using it up before it’s gone might be your best bet.

State and Local Tax (SALT):

While in general, deferring deductions is not a favorable strategy, it’s better to claim a tax deduction sooner rather than later (if only to capture the time value of money), and higher-income households actually face the potential that their itemized deductions could be less valuable in the future. Thus, there are situations where households may want to consider deferring expenses that may qualify as itemized deductions. A prime example of such an expense would be state and local tax payments, from income (e.g., fourth-quarter estimate) taxes to property (e.g., real estate or automobile) taxes.

The reason is that under the Tax Cuts and Jobs Act, deductions for state and local taxes (“the SALT deduction”) are ‘capped’ at no more than $10,000 for both single taxpayers and married couples filing a joint return. And unfortunately, the $10,000 cap includes both state and local income taxes, as well as property taxes. Given this fairly modest cap, many clients have already far exceeded their $10,000 maximum SALT deduction, and therefore, making additional SALT payments in 2020 will yield no additional tax benefits.

By contrast, making the same payments in early 2021 could lead to some sort of tax benefit if the SALT cap is repealed. Sure, there’s no guarantee that will happen, but do you know what is certain? That it won’t happen this year! So, why not push the expense out until 2021, when there’s at least a chance?

The Bottom Line:

In conclusion, it is fair to say you should examine all of your current and future tax obligations for your 2020 filing and planning for 2021 so that you can reduce your obligations where you have the chance. Moreover, depending on the fate of the Senate, you, as a business owner and/or individual taxpayer, should be sensitive and ready to make rapid and significant changes in your tax and estate plans, given potential drastic changes in the coming years.

For planning assistance going forward or if you may have any questions regarding the topics discussed above, please feel free to reach out to our team at the link below.

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