With so many changes in the tax law, it is strongly recommended to have a tax plan in place. Even though most laws are the same for 2020 as they have been since 2018, your income and deductions may have changed which will make your tax results very different. The best way to start is by identifying any changes in your personal tax situation.
Postponing income is typically desirable for those taxpayers who anticipate being in a lower tax bracket next year due to a change in their financial circumstances. In the past postponing income went hand in hand with accelerating deductions; however, accelerating deductions into 2020 may not be advisable due to the increased standard deduction. Instead, you may want to consider bunching your deductions (see bunching deductions discussion below). If you think you will be in a higher tax bracket in 2021 due to increased income or perhaps increased tax rates, then postponing income to 2021 may not be advisable. One of Biden’s tax proposals was to increase the top rate from 37% to 39.6% for those with taxable incomes over $400,000.
Capital Gains and Losses
If you currently have large, realized capital gains, you should consider harvesting capital losses. You can realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, the original holding can be sold, then buy back the same securities at least 31 days later. Minimizing the net capital gains will also help lower the 3.8% surtax on net investment income and the QBI deduction described below. If you are in a lower tax bracket, your long-term capital gains tax rate may be 0% so make sure to analyze your situation before you sell stocks at a loss. One of Biden’s tax proposals is to increase capital gains rates for taxpayers making over $1 million so you may be paying a higher capital gains rate in the future.
Another way to lower your 2020 income is through retirement plans. Employees wishing to defer income to future years should take advantage of maximizing the amount contributed to their employer-sponsored retirement plan. For 401(k) plans, the maximum deferral for 2020 is $19,500 with an additional catch-up contribution of $6,500 for those over 50 years old as of December 31, 2020.
Qualified Business Income (QBI) Deduction
The rules for this new deduction are very complex. Adding to the complexity are taxable income limitations, wage limitations, and/or asset limitations. If you are in a specified trade or business (most service businesses), the taxable income limitations are critical and will likely make the difference of getting the QBI deduction or not. For these business owners, lowering your taxable income may help you take full advantage of this new deduction. Lowering your taxable income can be done in various ways, including postponing income into 2021, increasing itemized deductions such as charitable contributions, and increasing retirement plan contributions. You can also elect to aggregate several businesses together potentially allowing you a larger 20% deduction. One of Biden’s tax proposals is aimed at eliminating this QBI deduction for taxpayers with taxable income above $400,000.
For divorces finalized on or after January 1, 2019, alimony is no longer deductible for the payer, or taxable to the payee. For divorces finalized on or before December 31, 2018, the old rules still apply.
Required Minimum Distributions
Due to Covid-19 RMDs are not required for 2020. This year, unless you need the cash or you need the tax withholding to avoid penalties, it is most likely better to leave the money in your retirement account for another year.
Consider funding a 529 Plan for educational purposes. There is no current-year federal deduction for 529 plan contributions, but Ohio doubled the state tax deduction to $4,000 per beneficiary. In addition, 529 plan distributions can now be used for grades K-12 tuition (up to $10,000 per year) making them even more advantageous. If you have kids in college, you may be eligible for some tuition tax credits, even if they are working on their master’s degree.
Verify Your Withholding
The IRS allows tax to be paid via several methods: payroll withholding, retirement withholding, and quarterly estimates. The IRS has two safe harbors to avoid underpayment penalties. The first is by paying 100% of your prior year’s tax amount (110% if your prior year’s adjusted gross income was over $150,000), and the second is paying 90% of your current year’s tax amount. Because the payroll withholding tables have changed again, it is likely that your payroll withholding changed even if your income stayed that same. It is important to verify that you will meet one of these safe harbors to avoid penalties.
Maximize Above-the-Line Deductions
Health Savings Accounts (HSA) If you become eligible on or before December 2020 to make HSA contributions, you can make a full year’s worth of deductible HSA contributions for 2020. Simplified Employee Pension (SEP) Contribution If you have self-employed income, consider putting money into a SEP. This option is available to you even if you have already deferred the maximum amount into your employer-sponsored 401(k) plan. By contributing money to a SEP, you can typically avoid both current year federal and state taxes on the amount contributed. The maximum SEP contribution for 2020 is $57,000 and it can be funded as late as the due date of your federal tax return, including extensions. Student Loan Interest You may be eligible to take an above-the-line deduction for student loan interest paid up to a maximum of $2,500. Self Employed Health Insurance Partners and S-Corp shareholders owning more than 2% of the entity stock and self-employed individuals are permitted a deduction for their health insurance for themselves and their dependents. This is different than the Schedule A itemized deduction as it is above-the-line and not subject to the 7.5% AGI limitation. NEW! Charitable Deduction for Non-Itemizers | As part of the CARES Act a new charitable deduction of $300 is allowed for gifts to qualified charitable organizations in 2020, even if you are not itemizing your deductions.
Bunching Itemized Deductions
With the TCJA, many itemized deductions were either eliminated or severely limited. Bunching deductions may be a way to preserve deductions that would otherwise be wasted or lost due to the higher standard deduction. The deduction for state and local taxes and real estate taxes is limited to $10,000. If your mortgage is paid off and you don’t have any high medical expenses, your only other itemized deduction would be charitable contributions. It may be worth your while to fund several years’ worth of charitable contributions in one year to accelerate the deduction into that year, and then use the standard deduction in the subsequent years. One good way to do this is through a Donor-Advised Fund. This vehicle allows you to donate the money for one year and get a tax deduction while keeping the money in the fund until you distribute it to the various charities in subsequent years. Medical Expense Deduction For 2020, medical expenses are only deductible to the extent that they exceed 7.5% of your adjusted gross income (AGI), even for taxpayers over age 65. Medical expenses include health insurance premiums, Medicare premiums, amounts paid to doctors for medical care, prescriptions, etc. Unless you have a high amount of medical expenses, you most likely will not qualify for this deduction. State and Local Tax Deduction The TCJA limited the total deduction for state and local income taxes and real estate taxes to $10,000. If you can itemize your deductions and have not reached the $10,000 limit, you may want to consider paying your real estate taxes in December as opposed to January 2021. If you have already met the $10,000 limitation, then there is no benefit to pre-paying these taxes. Mortgage Interest Deduction Interest you pay on your home is typically deductible to the extent that the average mortgage balance does not exceed $750,000. For mortgages placed in service prior to December 15, 2017, the limit is $1,000,000. Home equity loan interest is only deductible if the loan was used to buy, build or improve the home. The old rule allowing a deduction for the first $100,000 of home equity interest was eliminated. Also, don’t overlook mortgage points paid upon purchase or refinancing as these may be deductible as well. Charitable Contribution Deduction | Consider making charitable contributions before year-end either in cash or non-cash such as highly appreciated stocks. If you donate highly appreciated stock, you can get a donation deduction for the fair market value of the stock and avoid capital gains tax. You can also make contributions at year-end using your credit card, even if the credit card is not paid until 2021. You can write a check to charity and mail it on December 31, 2020, and take a 2020 tax deduction even if the check doesn’t clear your bank until January 2021. Non-cash donations valued at over $5,000 (except publicly-traded stock) require a written appraisal and a letter from the charity acknowledging the donation to be deductible. If you are over age 70 ½, you can make a charitable contribution up to $100,000 directly from your IRA to satisfy the required minimum distribution requirement. However, since no RMDs are required as mentioned above, this may not be the best tax strategy for 2020.
Estate Tax Planning
Gifting Take advantage of the annual gift tax exclusion. Make gifts sheltered by the annual gift tax exclusion before the end of the year to save gift and/or estate taxes. The exclusion applies to gifts of up to $15,000 made in 2020 to each of an unlimited number of individuals. You can’t carry over unused exclusions from one year to the next. The transfers might also save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax. Lifetime Exemption Planning | Although the estate tax exemption is now $11,580,000 and is indexed for inflation, there is a sunset clause after December 31, 2025. After this date, the estate tax exemption will revert to the pre-TCJA amount of roughly $5.5 million. The IRS has recently confirmed that it will not retroactively “clawback” gifts made during this temporary increase in the exclusion amount. However, Biden has proposed lowering the lifetime exemption to 2009 levels which were $3.5 million for estates, $1 million for gifting, and a 45% tax rate. It is important to consider whether additional wealth transfer strategies should be implemented before any change in lifetime exemption amounts takes effect.