The key to any year-end planning strategy is to minimize taxes. This is done by either reducing the amount of income received or increasing the amount of deductions, which is all easier said than done. However, there are a few simple things that can be done in the waning weeks of 2020 to accomplish this.
As discussed above, a Biden victory in the election could mean higher taxes in 2021, in which case an acceleration of income into 2020 might be the best option for reducing taxes
Delaying/Reducing Income and Gains
Ordinary income is taxed at seven rates, depending upon the amount of income. Taxes on capital gains also apply at different rates depending upon the amount of taxable income. For 2020, the rates are as follows:
|MFJ/SS||$0 – $80,000||$80,001 – $496,600||over $496,600|
|MFS||$0 – $40,000||$40,001 – $248,300||over $248,300|
|HoH||$0 – $53,600||$53,601 – $469,050||over $469,050|
|Single||$0 – $40,000||$40,001 – $441,450||over $441,450|
|E&T||$0 – $2,650||$2,651 – $13,150||over $13,150|
For taxpayers whose income tends to fluctuate from year to year, it would be wise to examine the impact of sales of investment items. For taxpayers who think they may have lower income in 2021, it would be smart to hold off on a sale of a capital item if their income is at or near a threshold for a higher capital gains bracket.
This type of consideration should not be limited to capital gain taxes, but also the net investment income (NII) tax. The 3.8% NII tax kicks in at $200,000 of modified adjusted gross income for single and head-of-household filers, $250,000 for joint filers, and $125,000 for married taxpayers filing separately.
Since the NII thresholds fall right in the middle of the 15% capital gains bracket, a taxpayer to whom the NII applies because of a sale of a capital item would likely not be able to reduce the tax to 0%. But, a taxpayer who is barely in the 20% bracket could defer a sale and get into the 15% bracket, meaning a sale of a capital item would only be taxed at 18.8% instead of 23.8%.
For 2020, the inflation adjusted standard deduction amounts are $24,800 for joint filers, $18,650 for heads of households, and $12,400 for all other filers. With standard deduction amounts so high, coupled with the $10,000 limitation on the deduction of state and local taxes, it is difficult for many taxpayers to claim enough deductions to make itemizing deductions beneficial. Thus, maximizing deductions may not be beneficial for all taxpayers.
One of the best ways to maximize the amount of deductions is to develop a bunching strategy. This involves accumulating charitable contributions, or even medical expenses (see below), from two or more years into one year. For example, a taxpayer may have not made any of his or her normal charitable contributions in 2019, and then made double the normal amount in 2020 in order to help surpass the standard deduction amount.
Again, depending on the outcome of the election, it may be more beneficial to minimize deductions in 2020 to maximize them in 2021 if higher taxes are likely under a new administration.
Note that the CARES Act does allow an above-the-line charitable contribution deduction up to $300 for individuals who do not itemize deductions for 2020 only. This special deduction applies regardless of the individual’s income level.
The same strategy can be employed for deductible medical expenses where the timing is somewhat flexible, such as for elective procedures (remember that purely cosmetic procedures are not deductible). However, the floor for deductible medical expenses in 2021 is 10%, whereas the floor is 7.5% in 2020.
The increase in the floor for deductible medical expenses in 2021 causes a dilemma if planning is taking into account a potential tax increase in 2021, depending on the election. While generally pushing deductions to 2021 would take advantage of higher tax rates, the higher floor on the deduction for medical expenses in 2021 could undermine the benefits of a delay.
Bunching can be a very effective strategy, but it has to be effectively used, and potentially planned out two or three years in advance to maximize the benefit, while also taking into account shifts in tax policies as a result of political change.
The CARES Act included a $1,200 credit for the 2020 tax year that was paid to individuals in advance during the spring of 2020 as economic income payments. The payments were meant to stimulate the economy during the early stages of the COVID-19 crisis. The amount of the credits was subject to phase-out based upon individual income amounts for 2019 (or 2018 if taxpayers had not yet filed returns for 2019).
As the crisis continues, politicians across the political spectrum have called for a second round of stimulus payments. In all likelihood, if legislation were to be passed now, the phase-out would be based on 2019 income amounts. However, it is conceivable that legislation could be delayed far enough into 2021 that the phase-out would be based on 2020 income amounts. Thus, it may be smart to delay income to 2021 in order to maximize the amount of a potential second round of economic income payments.
While this strategy would seem to run counter to the theory that income should not be delayed to 2021 because taxes could increase in 2021, the reality is that taxes will likely only increase in the even of a Biden victory, and Biden has stated that he will only increase taxes on incomes above $400,000. The first round of economic impact payments phased out well below this level, thus there would be no risk of higher taxes.
Other Year-End Strategies
A number of other traditional year-end strategies may apply. These include:
- Maximizing Education Credits and Deductions – Individuals can claim a credit or a deduction for tuition paid in 2020 even if the academic period begins in 2021, as long as the period begins by the end of March. This is especially important because, absent legislation, the tuition and fees deduction is not available in 2021.
- Increasing 401(k) Contributions – Adjusted gross income (AGI) can be reduced if individuals increase the amount of their 401(k contributions.
- IRA Contributions – Individuals eligible for deductions for IRA contributions can claim deductions, and thus reduce AGI, for amounts contributed through April 15, 2021.
- Teacher deductions – Educators can claim a deduction for up to $250 of classroom expenses (like books, supplies, computer equipment), and should maximize those expenses by year-end.
For more information about year-end tax planning, contact your tax advisor at Larson & Company.