What do we want? To pay less taxes!
When do we want it? Now! (Financial planners cringe in the background.)
While that’s a chant we all can get behind, my counterargument is that we are all best served to lower our lifetime tax bills, versus lowering a single year’s tax bill.
This has been a difficult year to put it mildly, and we are looking at potentially higher tax brackets in the future to fund the enormous deficit spending used to get us through the Coronavirus shock earlier this year.
So… do you want to pay tax now on lower income, or pay in the future on potentially higher income (and in higher brackets)?
With 2020 almost in the books, utilize these twenty tax strategies to better manage your taxable income and minimize your lifetime, versus annual, tax bill.
Five Year-End Investing Tax Tips
Market moves have been exceptionally volatile this year, creating opportunities around tax-loss harvesting, rebalancing, and retirement income planning.
1. Understand Mutual Fund Distributions
Mutual funds are required to distribute net capital gains and accrued income to shareholders at least annually. There are four primary types of mutual fund distributions:
- Capital gains
- Return of capital
These distributions can either be reinvested back into the fund or paid out, but the choice does not affect the taxable status of the distribution.
Note, though, that distributions made by mutual funds held within a tax-advantaged account such as an IRA or 401(k) are not taxable.
2. Fund a 529 Education Savings Account
A 529 plan is a tax-advantaged savings plan designed to help you save for future education costs. 529 plans can be used to save and invest for K-12 tuition (up to $10,000 per year), in addition to college costs.
Federal tax law provides special tax benefits, such as five-year gift tax averaging and tax-free qualified distributions. Additionally, some states offer tax benefits, such as state income tax deductions and tax credits for contributions to the state’s 529 plan.
3. Utilize Tax Loss Harvesting
If you sold some of your taxable portfolio back in the March market swoon (and hey, it was a difficult time back then), it’s possible you have a tax loss on the sold position.
So, let’s make lemonade out of those market-loss lemons and reduce your taxable capital gains on other positions. You can sell other positions (in taxable accounts, of course) that have a gain and offset that gain with your earlier taxable losses. You will want to be mindful of whether or not the position with a taxable gain is considered short-term or long-term.
4. Look for Tax-Aware Investing Strategies
This strategy, also known as asset location, can add up to 0.75 percent to your overall portfolio performance if utilized properly.
The standard approach is to put the most tax inefficient investments (typically bonds, given the income tax treatment of interest payments) into tax-deferred accounts like 401(k)s and IRAs.
More tax-efficient investments, like broadly diversified stock index ETFs, should be slotted into the taxable accounts. And high-risk/high-return assets round out the tax-exempt accounts, like the Roth IRA.
5. Consider Converting Your Traditional IRA to a Roth IRA
This one is a favorite of mine! Particularly this year, given what we said above about lower incomes and potentially higher tax brackets in the future.
If your taxable personal, or business, income is lower than normal in 2020 due to the COVID-19 lockdowns, you can take advantage of lower tax brackets by accelerating income via Roth conversions.
Mechanically, you directly transfer cash (or, ideally, positions) from your traditional IRA to a Roth IRA and carve out a portion of your existing cash holdings (OUTSIDE of the traditional or Roth IRA) needed to pay tax on the conversion.
Why pay more tax today? Because Roth conversions convert a future, large tax liability to a known tax-free account today.
Five Year-End Income Tax Tips
There are many tax levers you can pull to manage your annual taxable income, even more so if you are a small business owner.
1. Decide if Itemizing is Right for You
With the removal of personal exemptions and the increase in the standard deduction as part of the Tax Cuts and Jobs Act of 2017 (TCJA), far fewer individuals now itemize their tax return.
There still may be opportunities to itemize, however. To figure out whether itemizing would be profitable for you, you need to determine whether the allowable expenses you paid during the year — for things like home mortgage interest and property taxes, state income or sales taxes, medical expenses, charitable donations, etc. — exceed the standard deduction for your filing status.
2. Make Sure to Spend Your Flexible Savings Account (FSA)
A Flexible Spending Account (or FSA) is a special account you put money into that you use to pay for certain out-of-pocket healthcare, or dependent care, costs.
Time is running out for you to use that cash in 2020. Depending on your employer’s rules, if you don’t spend your FSA money by the end of the grace period, you potentially lose some of it. Here’s a list of qualified expenses that qualify for FSA purchases.
3. Cover Healthcare Costs Efficiently with a Health Savings Account (HSA)
Health Savings Accounts are the holy grail of financial accounts. They offer an immediate tax deduction on your contributions, they compound growth tax-deferred, and if the funds are used for qualified medical expenses, withdrawals are income-tax free. Triple-tax advantage!
Plus, if you wait to use the funds and let them grow to retirement, withdrawals at age 65+ no longer have the medical use qualifier. It effectively becomes like a Roth IRA in retirement.
You can access HSAs if your firm offers a high deductible healthcare plan. Reach out to your HR or benefits provider to see if you can avail this type of plan.
Of course, you will want to check to see if your existing doctors are in network. We don’t want to let the tax tail wag the dog.
4. Contribute to Retirement Accounts
This is basic financial planning blocking and tackling, but this advice surprisingly goes unheeded year-after-year. It simple but effective: fund your future self by making contributions today.
There are no loans for retirement.
Your company may offer a 401(k) or other retirement plan. The decision to contribute on a tax-deferred basis, or utilize a Roth account, comes down to your individual tax bracket today versus in the future.
But don’t let those details discourage you from taking action — putting money in today is the tried-and-true way to build the retirement nest egg you need.
5. Make Up A Tax Shortfall with Increased Withholding
Hate having to pay additional taxes come filing season? I’d actually say congratulations! Assuming you don’t owe a penalty, of course.
Tax refunds always feel nice but getting money back in April means that you lent the government money, interest-free, for the year. Doesn’t sound so good now, does it?
If you prefer not to be surprised at tax filing time, then you can thread your tax needle by changing your withholding on your paycheck. The IRS created a tax withholding estimator to help you calculate an estimate of total taxes due.
Five Year-End Small Business Tax Tips
One of the benefits of being a small business owner, outside of building equity, is the enhanced set of tools available to manage both your personal and business taxes.
1. Take Advantage of 100 Percent Bonus Depreciation
For qualified assets acquired and placed in service between 09/28/2017 and 12/31/2022, the TCJA increases the first-year bonus depreciation percentage to 100 percent.
Even better, the 100 percent deduction is allowed for both new and used qualified assets. Under prior law, bonus depreciation was only allowed for new assets.
Note, though, that state treatment of bonus depreciation varies from state to state, so speak with your tax or financial advisor to understand the implications of purchasing qualified assets for bonus depreciation purposes.
2. Consider Carrying Back Net Operating Losses (NOLs)
Earlier this year, the Coronavirus Aid, Relief, and Economic Security (CARES) Act made changes to the net operating loss (NOL) rules to ameliorate the expected impact of COVID-19 on small businesses.
The CARES Act states that NOLs incurred in 2018, 2019, and 2020 may be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred.
Crucially, the CARES Act also temporarily removes the existing taxable income limitation (of 80 percent of taxable income), therefore allowing taxpayers utilize NOLs to offset 100 percent of taxable income in tax years 2018, 2019, and 2020.
3. Defer Income and Accelerate Expenses… Or Vice Versa
Postponing income and accelerating deductions are two techniques we help small business clients employ to better manage their tax liabilities. In many cases, you can control whether you incur an expense in the current tax year or in the next, thereby controlling the timing of your deduction. You may also have control over whether you receive some of your income in the current tax year or in the next tax year.
This year, however, you may choose to either accelerate income or postpone expenses to actually increase your 2020 taxable income. This decision will of course depend on your business revenue and gross profit for the year but given the uncertainty around future tax brackets and the likely dip in business revenue in 2020, there may be opportunities to better manage your tax brackets this year and reduce your lifetime tax bill.
4. Create A Retirement Plan (or Plans)
We often see small businesses underutilize the retirement plan options available to them to defer income and reduce taxes. But this is akin to coloring a picture with the miniscule Crayola 8-pack versus that wonderful-smelling box of 64 crayons. Why not use everything you can to manage your income, your tax bill, and your retirement?
Whether you use 401(k)s, cash balance plans, non-qualified deferred compensation (NQDC) plans, and everything in between, there are a bevy of options to hit on those three important business goals. Plus, you may be eligible for a tax credit when implementing a new retirement plan.
5. Maximize Your Qualified Business Income (QBI) Deduction
A perk put into place as part of TCJA is the qualified business income deduction. The deduction allows eligible taxpayers to deduct up to 20 percent of their qualified business income (QBI), plus 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, according to the IRS.
There are phaseout rules based on income and asset levels, in addition to wrinkles for businesses designated as a “specified service trade or business (SSTB).”
The calculation to maximize your qualified business income deduction is complicated, so consult with your tax or financial advisors to make sure you are getting the most out of this generous tax perk for small business owners.
Five Year-End Charitable Tax Tips
While it’s likely been a tough year financially for you or your business, the reality is that the negative effects amplify downstream to charities and the causes they support. Thankfully, there are great options to improve your own tax situation while still supporting those in need.
1. Use the Above-the-Line Charitable Deduction
The CARES Act allows people to deduct $300 for charitable contributions. Taxpayers can take this deduction no matter whether they itemize or take the standard deduction on their taxes. Note, if you are married and filing jointly, your deduction is still limited to $300.
Deductions must be in cash (which includes check and credit card payments). Unfortunately, contributions to nonoperating private foundations, support organizations and donor-advised funds (DAFs) don’t fall under this new deduction.
If you contribute cash of $250 or greater, be sure to request and keep your receipts and other documentation for tax filing purposes.
2. Don’t Forget about the $15,000 Annual Gift Limit
While the estate tax exemption limit is set to sunset in 2026 (or perhaps earlier, depending on the result of the election), there is a very easy way to reduce your taxable estate and contribute to individuals and causes important to you.
The IRS allows you to gift $15,000 annually, per individual per beneficiary, without affecting your estate tax exemption.
So, a retired couple who has three married children and eight grandchildren could gift a total of $420,000 each year without ever touching their estate tax exemption limit!
Further, direct payments you make for someone’s educational or medical expenses, regardless of whether they exceed the annual exclusion amount, are excluded from the federal gift tax.
3. Leverage Low Interest Rates and Generous Gift Exemptions (Before They Are Gone)
The current combination of some of the lowest interest rates in history and high federal gift tax exemptions creates a great planning opportunity for small business owners who would like to engage in succession planning and other estate planning.
The exact mechanics of how to take advantage of this are beyond the scope of this article (don’t worry, we will publish a blog post on this topic). However, consult with your legal, tax, and financial advisors to determine whether or not this opportunity is available to you.
4. Contribute to a Donor-Advised Fund (DAF)
A donor-advised fund (DAF) is a charitable investment account that allows you to support nearly any IRS-qualified public charity while also potentially receiving an immediate tax deduction.
When you contribute cash, securities, or other assets to a DAF, the assets will be invested for tax-free growth and you can recommend grants to the causes you support.
Note, contributions to donor-advised funds are an irrevocable commitment to charity and cannot be used for any purpose other than grantmaking to charities.
Check out our blog article that explains in more detail how to best optimize your charitable giving while also maximizing your tax benefits through DAFs.
5. Donate via Qualified Charitable Distributions (QCDs)
Qualified charitable contributions (QCDs) are a direct transfer of funds or assets from your IRA to a qualifying charity. The major benefit of QCDs is that the donation counts toward satisfying your required minimum distributions (RMDs) for the year (as long as certain rules are met, of course).
And while the CARES Act waived RMDs for 2020, QCDs still are a valuable tax planning tool this year because you can further your philanthropic goals while also reducing the size of your tax-deferred accounts in a tax-efficient manner.
Tax Planning with Harbor Crest Wealth Advisors
And there we have it, twenty tax tips for 2020! How’s that for alliteration?
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