Last Chance! Tax planning strategies in light of COVID-19
The best tax planning not only looks are current year taxes but considers how you might reduce taxes over multiple years – 3, 5, or 10 years?
There are two basic approaches you can take: increase deductions to reduce taxable income, and/or declaring income when it will be taxed at the lowest rates. The idea is to recognize as much taxable income at lower marginal rates in as many years as possible. In some cases, this may mean paying higher tax in dollar now so that future income is taxed at a lower rate resulting in the sum of all taxes paid being lower.
It’s worth noting that tax rates are likely to increase at some point in the future, which will cause most people to pay higher income taxes. No matter who wins the Presidential election the current tax rates, set by the the Tax Cuts and Jobs Act (TCJA), are set to expire after 2025, reverting back to 2017 rates – a general increase of 3 to 4% in all, but the lowest, brackets. Then, there is the issue of the HUGE deficit piling up from lower revenue and the Covid-19 stimulus. It seems logical that at some point taxes have to go up to pay this debt.
Increasing Deductions
Bunching your giving/Charitable deductions - With the previous tax revisions, the standard deduction almost doubled, this meant that for many taxpayers they are now taking the standard deduction instead of itemized deductions (quick reminder that you take whichever is the higher of the two). In general, for the 2020 tax year the standard deduction is $24,800 for married filling joint and $12,400 for a single tax payor.
If your itemized deductions happen to be on the cusp of these numbers or if you do in fact itemize, you might consider “bunching” your giving (assuming you’re not already doing so that is). Simply put the idea is to group your annual giving, or double your giving into every other tax year. For example, donating 2020 and 2021 giving in the tax year 2020, then no giving in 2021, and in doing so creating a large enough deduction in 2020 to exceed the standard deduction reducing taxable income and minimizing your use of your deductions.
Already, bunch your giving - the CARES act, passed by congress in response to COVID-19, allows a $300 deduction for chartable giving for majority of taxpayers who are not claiming the itemized deduction on their 2020 federal tax return.
Bonus tips - Look at utilizing something like a donor-advised fund, which allows you to fund the account with multiple years’ worth of giving, get the tax deduction, and then give (or “grant”) those funds to qualified charities over time. Have an investment account with gains - talk to your investment advisor about using a donor-advised fund for an even greater impact.
Reducing Future Taxes
As mentioned above it seems reasonable that tax rates will increase sometime in the future. It is helpful to think of IRAs and other qualified retirement accounts, excluding Roth IRA accounts, as having a future tax debt payable to Uncle Sam. Ultimately you or your heirs will pay the taxes on all the money in your tax-deferred accounts. A significant thing to note is that you, the IRA owner, are able to spread out withdrawals for the remainder of your lifetime, however, for your heirs (outside of a spouse) as of 2019 will be required to liquidate your account within 10 years of your death, often creating large withdrawals some of which will be taxed at higher rates.
Roth Conversions – Consider converting some of your tax-deferred IRA to a Roth IRA. If you expect your tax rate to increase in the future or are in a low bracket this year funding a Roth IRA or converting some or all of you IRA to a Roth IRA may significantly reduce taxes in the future. Yes, your current tax liability is likely to go up, but all future growth will be available to you or your Roth IRA beneficiaries’ tax-free when withdrawn in the future. Often the best strategy is to plan on doing a series of small conversions over a number of years – something like $50k per year over the next 5 years.
A qualified charitable distribution (QCD) – This strategy will reduce your taxable income in each and every year that you use it by removing IRA funds at a zero tax cost. The problem is that it is ONLY available to someone over 70½ as it is tied to IRA distributions and the old required minimum distribution age. With a QCD, a donation is made directly from an IRA to a qualified charity, which means you don't have to include the money taken out of the IRA in your taxable income (the tax equivalence of getting the full charitable deduction).
This becomes particularly attractive when used to fulfill the Required Minimum Distribution (RMD) on your IRAs. Instead of taking the RMD and then giving to a qualified charity, a QCD can satisfy the RMD requirement, reduce your adjusted gross income, which in turn may help reduce taxation of social security benefits and your Medicare premiums.
One item to note is that RMDs were waived for 2020 by the CARES act in response to COVID-19, but only for 2020 and will be required again in 2021 and future years.
Estate Taxes - For those with higher net worth it is important to note that estate taxes will be going up in the future if for no other reason that the exemption amount which offsets the tax is set to be reduced by half for years after 2025.
Lower income this year?
COVID-19 impacted us all in numerous ways, one of which might be that you will have lower income for the year and find yourself in a lower tax bracket in 2020 than you might otherwise be in future years. If this is you, here’s a few ideas that may be worth considering...
Roth conversion or Fund a Roth IRA – see Roth Conversions above
Realize capital gains - your income may be low enough that you fall into a 0% long-term capital gains rate. If so and you have an investment account with gains, you might consider realizing some of that gain in 2020. You might have heard of tax loss harvesting well it’s the same idea only instead of realizing losses, realize long-term gain (you must own the investment for more than 12-months). That being said you want to be careful to not realize too much gain and throw yourself into the higher tax bracket or to disrupt an otherwise sound investment strategy – if you have questions contact your tax or investment advisor.
For additional information on implementation or to determine what year-end tax planning moves, if any, are right for you contact your financial professional today. And don’t forget, your tax strategies should align and be taken into account with your overall financial goals and financial plan.
Don’t wait – now is the time to plan!
* “Consider the above as an interpretation of the law—not personalized tax advice. For that, you should talk with a CPA or tax professional who is familiar with your particular situation”. Advisors of Cooke Wealth Mgmt are not CPA’s and recommend you confirm with your tax advisor prior to executing any tax strategy.