The standard year-end individual tax planning strategies taxpayers have relied upon in prior years may no longer prove useful in light of the wide-spread effects of the COVID-19 pandemic this year. The impacts of COVID-19 on the economy coupled with relief measures included in the CARES Act will impact and alter the way you approach your year-end individual tax planning for 2020.
Here are some year-end individual tax planning issues you should be aware of, along with some ideas you may want to consider implementing to maximize your tax savings this year.
Utilizing Income Acceleration Under Current Tax Rates
Accelerating income into the current year is one common strategy individual taxpayers may use if they anticipate falling into a higher income tax bracket in the year to come. Those choosing to accelerate income can do so by:
- realizing deferred compensation;
- exercising stock options;
- recognizing capital gains; or
- converting a traditional IRA into a Roth IRA.
Although the current income tax rates are lower than they have been in years, there’s no guarantee that they’ll remain there. Because individuals who typically earn higher incomes are particularly vulnerable to falling into a potentially higher tax bracket in 2021, utilizing income acceleration could prove to be an effective year-end individual tax planning strategy in 2020.
Those whose income levels were reduced because of the pandemic due to a cutback in wages or the loss of a job are prime candidates for taking advantage of accelerated income. If you exercised the CARES Act option which excused you from taking required minimum distributions (RMDs) from your retirement accounts in 2020, this strategy may also provide you with some tax savings come tax time.
Converting Traditional IRAs into Roth IRAs
Another wise year-end individual tax planning strategy for 2020 is to convert your pre-tax traditional IRA into an after-tax Roth IRA. Because Roth IRAs don’t have required minimum distributions, they enjoy a longer period of tax-free growth with distributions that are primarily tax-free.
Because, with a Roth IRA, you need to pay income tax on the fair market value of the assets that are being converted, you may think that executing the conversion may not be a good idea. However, traditional IRAs that have experienced a decline in the value of the securities included within them may offer you an opportunity to make the conversion at a lesser tax consequence to you than you might experience in another year. Additionally, the lower tax bracket you happen to find yourself in, in 2020, may also make the conversion from traditional to Roth IRA, attractive. If, once the conversion has been completed, the securities inside your IRA increase in value, that increase provides you with a tax-free benefit you would not otherwise have received.
Raised Limits on Charitable Deductions
The limit on charitable deductions for cash contributions to public charities was temporarily raised via The CARES Act. These limits shifted from 60% of the taxpayer’s adjusted gross income (AGI) to 100%. Making charitable contributions in this way could help you either cut or completely offset your taxable income for 2020.
A charitable deduction tactic used in year-end individual tax planning is “stacking” cash contributions with gifts that are subject to limits that remain unchanged. Donations of appreciated securities, which are subject to limits of 20% or 30% of AGI (depending on various factors), can be used in this way. By donating appreciated long-term capital gains securities (those which you’ve held for over a year), in an amount equal to 30% of your AGI, you can avoid capital gains taxes on the securities. You may then make a cash donation of 70% of your AGI to public charities.
One drawback of this approach applies to those who find themselves in a lower tax bracket than usual, this year. Should you move back into a higher tax bracket in a future year, it may be worthwhile to wait to claim the charitable deductions at that time. Similarly, if you remain in the lower tax bracket but the tax rates increase due to changes in tax law, it may pay you to make the charitable contributions in a future year.
If you expect your income to be higher in 2021 and you normally itemize your deductions on your tax return, you may choose to maximize your normal charitable contributions and the tax benefit they may throw off by waiting to make your 2020 contributions in 2021. By adding your 2020 contributions to the contributions you would normally make in 2021, you can help ensure that you exceed the standard deduction for 2021. This will help you claim the full amount as a charitable deduction in 2021 and you may receive a larger deduction on the combined contribution amount if you’re subject to a higher tax rate in 2021.
Individual taxpayers who are age 70½ or older can earmark up to $100,000 per year in tax-free qualified charitable distributions (QCDs) to go directly from their IRAs to public charities. It’s important to note that donor-advised funds are excluded when it comes to QCDs. QCDs can potentially reduce your tax liability though, unlike other charitable donations, they are not deductible. The QCD amount is excluded from AGI which may serve the dual purpose of both increasing the benefit of certain itemized deductions and lowering your tax.
However, due to the CARES Act’s waiver of annual RMDs for 2020, if you opt not to exercise your 2020 RMD option, you may wish to hold off on a QCD until 2021 when it can reduce your taxable RMD and your 2021 taxable income, as well.
Offsetting Taxable Gains with Loss Harvesting
A good way to offset any taxable gains you have is by using loss harvesting. Essentially, loss harvesting allows you to sell your poorly performing investments before the end of the year to reduce your realized gains on a dollar-for-dollar basis. If you end up with excess losses, you can generally apply up to $3,000 against your ordinary income and carry forward the balance to future tax years.
You can further maximize your benefit by donating your sale proceeds from depreciated investments to a charitable organization. If you itemize, you can both offset realized gains and claim a charitable contribution deduction for the cash donation you make. Be careful to avoid triggering the “wash sale” rule, which disallows a capital loss if you purchase the same or a “substantially identical” security 30 days before or after the sale.
2020 has been a year of volatility and change that brought many tax changes with it so before making any significant tax planning decisions, we encourage you to consult with your Untracht Early advisor on your year-end individual tax planning to find an approach that best positions you to minimize your tax liability for the current year and in future years. For more year-end individual tax planning strategies, access our 2020-2021 Tax Planning Guide here.