2020 Year-End Tax Planning Tips:
Philadelphia Tax Attorney Offers Strategies To Save Taxes Before Year-End
As the year-end quickly approaches, there is still time to employ 2020 year-end tax planning tips to generate significant tax savings. The Covid-19 pandemic has made life really difficult for all of us. As with most things in life when bad things happen, there may be a way to take advantage of these circumstances in other ways. With many taxpayers income being less this year, there may be tax planning opportunities to save taxes before year end, depending on the taxpayer’s particular circumstance. Steven J. Fromm, Philadelphia Tax and Estates Attorney, has drafted this tax guide that offers the following income and estate tax strategies to save income taxes and along with tips on saving estate and gift taxes before year-end.
As always, each taxpayer situation is unique and as a result tax strategies and projections should be developed for each client for the greatest tax savings. While you will find that this year-end tax guide provides numerous tax strategies, there may other techniques that may arise from an in depth analysis of each taxpayer’s situation.
Where To Begin:
As a starting point, it is essential to know the customary year-end planning techniques that can cut income taxes. It all starts with a tax projection of whether you will be in a higher or lower tax bracket next year. In some cases it is imperative to project income and expenses for multiple years to smooth income out over time to avoid higher tax brackets over an extended period. Multi-year tax planning should be explored directly with tax counsel.
Once your tax bracket for this year and next year (or following years, if they can be projected) are known, there are two basic income tax planning considerations:
- Should income be accelerated or deferred?
- Should deductions and credits be accelerated or deferred?
However, life is never that simple. Tax laws always make for some real guesswork. As discussed below, when it comes to certain deductions that have tax threshold limitations, bunching of deductions in one year may force these deductions into a tax year where the tax bracket or percentage limitations are lower than the other tax year in question. This may be the only way to get a tax break for these deductions.
2020 year-end tax planning tax projections and tax minimization strategies must take into account the maddening and annoying alternative minimum tax and the parallel universe of the 3.8% Medicare tax.
For 2020 year-end tax planning purposes, the following strategies assume that the taxpayer’s income will be higher next year. Where income will be taxed at a higher tax bracket next year, accelerating income to this year may result in less overall taxes being paid. At the same time, deductions and tax credits deferred into next year will become more valuable as they offset income taxed at a higher marginal bracket.
Usually accelerating income to the current year and deferring deductions must take into account the impact on cash flow and the time value of money when paying taxes on income a year earlier. However, due to our current low-interest rate environment, time value of money implications are quite minimal and may not be a significant consideration.
If a taxpayer expects income to decrease next year they should use the opposite approach; namely, deferring income to next year and accelerating deductions into this year. You would simply reverse these strategies, if income is projected to be lower next year.
Important: Be sure to remember that the following lays out the basic ideas for income acceleration and deduction/credit deferral where income projects to be taxed at a higher level next year. In light of the pandemic and its adverse impact on many taxpayers earnings this year, the following 2020 year-end tax planning strategies may generate significant tax savings to many taxpayers.
For taxpayers who think that they will be in a higher tax bracket next year, or they may have to file in a less advantageous tax bracket in the following year, here are some targeted forms of income to consider accelerating into this year.
- Accelerate Bonuses: Receive bonuses before January 1 of the following year. If your employer allows you the choice, this may result in some significant income tax savings to you.
- Accelerate billing and collections: If you report income on a cash basis method of accounting, immediately sending out bills to increase collections before the end of the year may result in significant tax savings if you know income will be much higher next year.
- For Salary and Wages and Earned Income: Take Into Account the New 0.9% Wage Tax: High income earners will pay an extra 0.9% in social security taxes on earned income above certain thresholds. Where earned income is low this year and is going up next year, accelerating earned income into the current year may cut this wage tax on earned income entirely.
- Passive Income: Taking Into Account the 3.8% Medicare Tax: Also where income this year will be below the new 3.8% Medicare tax threshold, accelerating this passive income into the current year may result in it being taxed at your lower tax bracket this year and help completely avoid this Medicare tax on this income. For more on this read 2013 Sneaky New Tax – Not Too Early to Plan for 3.8 % Medicare Tax on Investment Income.
- Redeem U.S. Savings Bonds, Certificates of Deposit or Annuities: Taking these items into income this year may make sense where income projects to be higher next year. (Be sure there are no penalties or surrender charges involved.) This tax strategy may result in this income being taxed at a lower bracket and such income may avoid the 3.8% Medicare tax.
- Capital Gains: Selling appreciated assets if you expect capital gains at a higher rate next year: In such situation it may make sense to sell such assets before the end of the year.
- Example: Mr. Appreciation has low basis stock that has appreciated in value. The rate for capital gains can rise as taxable income increases. Before selling any securities he needs to run the numbers to see if it makes sense to sell this year or next year or spread such sales between the two years.
- He also needs to consider in the 3.8% Medicare tax on capital gains and how such decision impacts itemized deduction limitations.
- Capital Gain Tax Planning Strategy #1: If a taxpayer is in the 10% or 15% tax bracket in the current year, it would make sense to sell appreciated assets in this year since a zero tax rate would apply to such long-term capital gain. This special treatment does not apply to sales of collectibles (28% rate) and recapture property (25% rate).
- Capital Gain Tax Planning Strategy #2: If a taxpayer is in certain lower marginal tax brackets, it may make sense to sell appreciated assets this year to be taxed at 15% on capital gains. This is preferable to selling next year when it is projected that the taxpayer will be in a high tax bracket and be subject to capital gain tax rates of 20%. This special treatment does not apply to sales of collectibles (28% rate) and recapture property (25% rate).
- Capital Gain Tax Planning Strategy #3: For an older taxpayer or one in ill-health, this strategy may not make income tax sense. When a person dies their assets get a step up in basis to the date of death value. As a result, when the estate sells such assets there is no capital gain. So a sale right before death would trigger a needless capital gain tax. For an extensive discussion of this issue readers may want to explore The Biggest (Tax) Loser: Misguided Gifts of Real Estate By Uninformed Do It Yourselfers, Realtors & Attorneys
- Wash Sale Planning Note: The wash sale rules do not apply when selling at a gain, so taxpayers can cash out their gains and then repurchase identical securities immediately afterwards. For more on wash sale rules and how to avoid them, please see the discussion below.
- Possible Tax Law Changes To Capital Gain Tax Rates: President Elect Biden has proposed raising the capital gain rate from 20% to 39.6% for taxpayers with income over $1 million. Therefore, high earner taxpayers who are planning to sell in 2021 should perhaps consider doing so in 2020 instead, based on the possibility that Democrats could win both Georgia Senate seats which could result in this tax law change.
- Roth Conversions: Taking into income the monies in IRA accounts in a year (or years) before your tax bracket is due to rise may make for some significant income tax savings. There is no income based limit on who can convert to a Roth IRA. From a long-range planning perspective, a conversion can turn tax deferred growth into tax-free growth. There may also be estate planning benefits with a Roth conversion.
- Maximize Retirement Plan Distributions: Remember the required minimum distributions (RMDs) are the amounts distributed each year to avoid the draconian 50% RMD penalty once a taxpayer reaches 72 (formerly 70 ½). However, taxpayers with IRAs can choose to take larger distributions this year to have such income taxed at an anticipated lower income tax rate than the one projected in future years. However, be sure to account for the following:
- The lost tax deferral growth if the money were to stay in the retirement plan account,
- Whether the distribution would trigger more of Social Security payments to be taxable,
- Whether the distribution would increase income based Medicare premiums and prescription drug charges, or
- Whether such distribution would impact tax breaks sensitive to AGI limits. There are various phaseout thresholds for various tax breaks such as Coverdall education savings accounts, deduction for interest on qualified student loans, the lifetime learning and American opportunity credits, the child care credit and contributions to IRAs and Roth IRAs.
- Such distributions do not trigger the 10% penalty tax on early withdrawal.
- Note: The 2020 Cares Act has temporarily suspended RMD rules for 2020, so taxpayers do not have to take any distributions in 2020 if they so choose.
- Special CARES Act 2020 Retirement Plan Distributions: For 2020 year-end tax planning, taxpayers can take up to $100,000 from retirement plans and will not be subject to the 10% early withdrawal penalty. These distributions must meet the so-called “corona-virus related” definition. If a taxpayer’s situation improves, they can pay back their plan these distributions. The important point to keep in mind is that any income from these distributions can be taken into income in equal portions over three years.
- Electing Out or Selling Outstanding Installment Contracts: Disposing of your installment agreement may bring the deferred income into this year at a lower tax rate than anticipated in future years. It may be helpful to pay tax on the entire gain from an installment sale this year by electing out of installment sale treatment under Section 453(d) of the Internal Revenue Code, rather than deferring tax on the gain to later years when your tax bracket may be higher. Conversely, in certain situations installment sale treatment may be a better option since it allows for spreading of income over multiple years. The proper strategy depends on the specifics of each taxpayer’s tax situation.
- Take Corporate Liquidation Distributions This Year: Senior or retiring stockholders contemplating the redemption or sale of their shares of stock in their corporation can save considerable taxes by selling their shares this year if their expected tax bracket will be higher in later years. Warning: On the other hand consider carefully the step-up in basis implications for older or infirm taxpayers before considering this tax maneuver. For more insight on this issue read The Biggest (Tax) Loser: Misguided Gifts of Real Estate By Uninformed Do It Yourselfers, Realtors & Attorneys
- Accelerate Debt Forgiveness Income With Your Lender: In the past, acceleration made sense if income is being taxed at a lower tax bracket in the current year. Complete documentation for such a discharge before year end.
Deductions and Tax Credit Deferrals:
For taxpayers who think that they will be in a higher tax bracket next year, here are some actions to consider in deferring deductions into next year. Remember, we are assuming that income will be higher next year, so deductions are more valuable next year. (Obviously, if income is higher this year, it is better to have deductions accelerated into this year). With any tax strategy, once again, taxpayers must take into account the impact of the alternative minimum tax.
2020 Year-end Tax Planning Strategies To Consider When Deferring Deductions Into Next Year:
- Standard Deduction versus Itemized Deductions: Where income will be greater next year, taking the standard deduction this year and bunching itemized deductions to next year may yield the best tax result.
- Bunch Itemized Deductions Into The Year In Which They Can Exceed The Applicable Threshold: For medical expenses such as elective surgery, dental work, eye exams, it would be better to have this medical work done in the year that you are already above the applicable adjusted gross income (AGI) threshold that applies to these medical expenses.
- CARES Act Special Provisions For Charitable Contributions: Currently, individuals who make cash contributions to publicly supported charities are permitted a charitable contribution deduction of up to 60% of their AGI. Contributions in excess of the 60% AGI limitation may be carried forward in each of the succeeding five years. However, be aware that for 2020, the CARES Act modified the AGI limitations on qualifying cash contributions to 100% for individuals. This may dictate accelerating large anticipated cash contributions to 2020 to take advantage of this special 100% cash contribution limit.
- Any excess carries forward as a charitable contribution that is usable in the succeeding five years.
- Contributions to non-operating private foundations or donor-advised funds are not eligible for this special 100% AGI limitation.
- Plan For The Phase Out Of Itemized Deductions and Exemptions: This provision has been repealed under recently passed legislation, so this is no longer something to worry about.
- Postpone Paying: Postpone paying certain tax-deductible bills until next year if it generates a greater tax benefit.
- Fourth Quarter Estimated Taxes: Pay fourth quarter state estimated tax installment on January 15 of next year instead of December of this year. This would be beneficial if you are already above the state and local tax (SALT) tax limitation of $10,000.
- Postpone Economic Performance: Postpone “economic performance” for tax-deductible expenses until next year if you are an accrual basis taxpayer.
- Watch the AMT: Missing the impact of the AMT can make certain year-end strategies counterproductive. For example, aligning certain income and deductions to cut regular tax liability may not work if the deductions cut regular taxable income but do not cut alternative minimum taxable income. It is very easy to have your tax planning backfire by missing the difference between the regular tax and AMT tax rules.
- Example and Important Warning Concerning AMT: Do not prepay state and local income taxes or property taxes if subject to the AMT. It will generate no income tax savings and you will have made these payments without gaining a tax benefit.
- Personal exemptions are also disallowed for AMT. Watch out if you have increased your personal exemptions as this could result in an AMT issue.
- Incentive Stock Options have to be considered when looking at the AMT.
- Net Investment Interest: Watch net investment interest restrictions.
- Passive Income and Loss Limitations: Match passive activity income and losses. The passive loss limitation rules can result in the suspension and carry forward of losses until they can be used. To unlock the tax advantage of these carry forward passive losses, a sale of a limited partnership interest may make sense next year if you anticipate that your income will be higher. Such losses can offset other income upon the disposition of a passive loss activity.
- Harvest Tax Losses by Selling Securities or Mutual Funds: Selling shares of stock or mutual funds that have gone down in value can offset other capital gains and generate a tax loss of up to $3,000 against other income.
- Warning: If you want to buy back the same security beware of the so-called “wash sale” rules. These rules are complex but with proper planning losses can be taken while avoiding the wash loss limitation rules.
- Avoiding Wash Sale Rules: To avoid the wash sale rules, a taxpayer can (1) immediately buy securities of a different company in the same industry, (2) immediately buy shares in a mutual fund that holds securities much like the one sold, or (3) simply wait 31 days to repurchase the same security.
- Purchase Machinery and Equipment: Even if you are in a higher tax bracket next year, it may make sense to take advantage of the current Section 179 deductions. For property placed in service under current tax rules, the maximum amount that can be written off immediately is $1,040,000 and such deduction is phased out when total purchases of Section 179 exceed $2,590,000.
- Bonus Depreciation: Under Section 168(k) bonus depreciation rules, 100% of the cost of eligible property placed in service during 2020, 2021 and 2022 can be deducted. The percentage decreases to 80% in 2023, 60% in 2024, 40% in 2025 and 20% in 2026.
Other 2020 Year-End Tax Planning Strategies and Considerations:
Here are some other 2020 year-end tax planning strategies that taxpayers should keep in mind:
- Increase Withholding Taxes: Many taxpayers pay both estimated income taxes and withholding taxes. If you have fallen behind on quarterly estimated taxes, it is a good idea to increase withholding on your remaining wages to avoid underpayment penalties.
- Key Tax Planning Point: The IRS treats withheld taxes as if spread out evenly throughout the year. This strategy can cut or even eliminate penalties for the failure to pay timely.
- Change in Marital Status: Getting married or divorced during a tax year can have a hidden adverse tax impact on taxpayers. Remember, your filing status for the entire year is determined by your marital status on December 31. It is imperative in such cases to do some number crunching before the end of the tax year to avoid unforeseen penalties and tax liability when filing your returns.
- Retirement Planning: To reduce taxable income, taxpayers may want to consider establishing a 401(k) or profit sharing or defined benefit pension retirement plan for their business, a Keogh plan if self-employed or a SEP-IRA, or for individuals an IRA. In some of these situations, a plan needs to be established before the end of the taxable to be effective for that year. However, some of these arrangements can be set up after year-end and be retroactive for the prior year. Here are some new rules to keep in mind:
- Previously, individuals were not able to contribute to their traditional IRAs in or after the year in which they turn 70½. The 2020 SECURE Act eliminates this age cap, so taxpayers in this age group can make contributions to their IRAs.
- Required Minimum Distributions Must Begin At Age 72: The SECURE Act changes the age for required minimum distributions (RMDs) from tax-qualified retirement plans and IRAs from age 70½ to age 72 for individuals born on or after July 1, 1949. Generally, the first RMD for individuals who were born on July 1, 1949, or later is due by April 1 of the year after the year in which they turn 72.
- Use Credit Cards To Claim Deductions: Expenses charged to credit cards before year-end are deductible this year even though paid next year. Use credit cards to pay:
- Business Expenses
- Medical Expenses
- Property Taxes
- Other Deductions
- Be Careful When Investing in Mutual Funds at Year-end: Many mutual funds pay accumulated dividends and capital gains in November and December. This will result in a needless tax bill and a rude surprise come tax time for the unknowing investor.
- Kiddie Tax Law Changes: The SECURE Act reinstates the previous provisions. For tax years beginning after December 31, 2019, the unearned income of a child is no longer taxed at the same rates as estates and trusts. Instead, the unearned income of a child will be taxed at the parents’ tax rates if those rates are higher than the child’s tax rate. Taxpayers can elect to apply this provision retroactively to tax years that begin in 2018 or 2019 by filing an amended return.
- Cost Segregation Study: A taxpayer who recently purchased or built a building or remodeled existing space should consider a cost segregation study. It breaks down the improvements into divisible parts allowing faster depreciation, thus increasing current year deductions.
- IRA Distributions To Charity: The tax-free IRA distributions to charities was made permanent for tax years after 2015. This tax provision allows those age 70 ½ and older to make required distributions directly to charity avoiding income tax on such distributions. Note: They do not also get a charitable deduction for such contribution on Schedule A.
- Since the Tax Cuts and Job Act increased the base standard deduction, for 2019, to $12,200 for individuals, $18,350 for heads of household, and $24,400 for married couples filing jointly, many fewer taxpayers will itemize on Schedule A, making this upfront deduction potentially even more important.
- For 2021, the base standard deduction is $12,550 for individuals or married individuals filing separately, $18,800 for heads of household, and $25,100 for married couples filing jointly.
- The donation can also help meet all or part of the IRA’s required minimum distribution (RMD) for the year.
- These qualified charitable deductions are a good choice for individuals who otherwise could not deduct all or part of their charitable donations because of the IRS rule prohibiting a deduction for donation amounts that exceed 60% of a taxpayer’s AGI.
- Taxpayers whose annual income affects their Medicare premiums might also find that this provision helps control or reduce their premium costs.
- Use of Donor Advised Funds: If you are unclear as to which charity you want to contribute to at year end, you may want to consider a donor advised fund. Taxpayers can take the deduction in the year the contribution is made to the donor advised fund. This type of arrangement allows for the taxpayer to decide over time which charity should receive these funds.
- Annual Donee Exclusion and Estate Planning: If your estate is above your available unified credit, this traditional estate and gift tax planning tool allows for annual tax-free gifts of $15,000 in 2020. As a result, taxpayers can now give up to $15,000 to as many people as they wish each year and not use up their unified credit or pay a gift tax.
- Important Note: Present Interest Gifts: Only gifts that qualify as “present interest” gifts are eligible for the annual donee exclusion.
- Planning Point: Spousal Joinder: If you are married, your spouse can join you and, together, you can give up to $30,000 per person per year.
- Planning Point: Unified Credit: This annual donee exclusion is in addition to the $11,580,000 estate tax exclusion and can be combined with such exclusion. For more insight into how to combine these exclusions please read Gift Giving: A Way To Save Estate, Gift and Income Taxes. For combining these estate and gift planning tools with tax advantages of using the lack of marketability and minority interest discounts please read Gifting Shares of Stock In A Bad Economy.
- Important Estate Tax Consideration: Although this unified credit amount may seem extremely large, taxpayers need to be aware that this exemption may be reduced in the future in light of looming federal deficits. President-Elect Biden has proposed reducing the gift and estate tax unified credit exemption to $3.5 million from the current $11.58 million level. For certain high-wealth taxpayers, it may make sense to give away money in December 2020 to take advantage of the current unified credit while is still lasts.
- Updating Your Estate Plan: Many taxpayers still have estate planning documents that were drafted many years ago when the estate tax rules were quite different. As a result, there is a real need to revisit their estate plan and update their documents to minimize estate taxes. Most importantly, clients should make sure their wills and trusts and and beneficiary designations of life insurance, retirement plans and annuities reflect their current estate planning wishes and goals.
- These estate planning considerations are beyond the scope of this tax planning guide, but prudent and careful taxpayers should attend to this most important matter. If this is a concern be sure to call for my insight and assistance.
- For more on estate planning, please check out my Estate Planning: Wills, Trusts, Durable Power of Attorney, Living Will/Advanced Medical Directive and Other Related Estate Planning Documentation and for your elderly parents please read Estate Planning For Elderly Parents.
Final Thoughts and Warnings:
While this discussion offers some major 2020 year-end tax planning strategies, it is not all-encompassing nor is it intended to fit every taxpayer situation. Ultimately, 2020 year-end tax planning tax strategies depend on the specific income and expenses of each taxpayer and their overall income, gift and estate tax situation.
Taxpayers must stay alert for possible last-minute tax laws enacted before year-end and tax law changes for next year that may impact their short and long-range tax planning . For example, President-Elect Biden has talked about the raising the top individual income tax rate to 39.6%, raising the tax on capital gains at 39.6% for taxpayers with more than $1,000,000 in income and eliminating step-up of basis at death. At this point, no one knows whether these ideas will end up being law, but it is important to be aware of these possible tax changes and their impact on your tax situation.
The one certainty in this uncertain tax environment is to “run the numbers” for your particular tax and financial situation with tax counsel to craft specific 2020 year-end tax planning strategies to cut taxes owed.
I hope this article has been of value to my readers. Please feel free to make comments below, ask a question or contact me for help.
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