The end of the year is always a good time to do a financial check-up and make any needed adjustments, but this year it is even more important. This year is unique for many reasons. Just one of them is the many signficant tax law changes which were in effect this year. Here are three important tax planning tips for 2020 which may help you reduce your tax burden for this year.
1) Roth Conversion:
If your income was lower this year than you expect it to be in the future and you have retirement savings in a tax-deferred account such as an IRA, it may be a good time to convert it to a Roth account. A Roth account is a retirement account in which you pay taxes on contributions to the account now, any growth on the assets are tax-free, and when you withdraw the money it is also tax-free as long as you follow a few rules associated with the withdrawal.
The big downside to a Roth conversion is you have to pay income taxes on the amount of money you convert to Roth assets at the time of the conversion. That can mean a big tax bill at the time of the conversion, but if your income was unusually low in 2020 it may be a good opportunity to take advantage of the lower tax rate on the Roth conversion assets. Think of it as a sale on income taxes for this year.
Besides the tax-free withdrawal of the Roth assets including the growth of the Roth assets, another advantage of the Roth account is there are no required minimum distrubutions in retirement. It gives you more flexibility for deciding when to take the assets out of the account and include them in your taxable income, or to let the assets grow and have the account eventually pass to your beneficiaries.
Income Too High for an IRA:
If your income is too high to make a deductible IRA contribution this year but you are still in a low enough tax bracket that a Roth conversion makes sense, you can make a non-deductibe IRA contribution and still convert it to a Roth IRA. This is accomplished through a back-door Roth IRA. A back-door Roth IRA is nothing more than putting the money into a non-deductible IRA first, then moving the money to a Roth IRA account.
Ideally, the Roth conversion would take place immediately so there are no earnings on the traditional IRA assets. The earnings on the non-deductible IRA assets would not be eligible for the Roth conversion, so you want to move the assets to a Roth account before any earnings accumulate if possible.
Required Minimum Distribution Pause:
If you are over 70 years old, you are probably used to taking the RMD, required minimum distribution, from your tax-deferred retirement accounts to avoid large penalities. The IRS now requires most people to start RMD’s once they reach age 72 rather than age 70, but either way the RMD’s are on pause for 2020. This could mean your income for 2020 is lower than usual if you choose not to take your RMD this year. The lower income may push you into a lower tax bracket, which would make converting assets to a Roth account more attractive.
2) Charitable Giving
Charitable giving will be a major focus for 2020 given the global crisis effecting so many people. There are three things to keep in mind when planning your charitable giving for 2020 and your reviewing your tax planning tips for 2020. A $300 charitable deduction for people who are using the standard deduction in 2020, bunching charitable deductions, and qualififed charitable deductions.
Usually you can’t deduct charitable contributions on your income tax return unless you are itemizing deductions. Fewer people are itemizing dedcutions now that the standard deduction is $24,800 for married filing jointly and $12,400 for single filers. However, even if you are using the standard deduction on your 2020 tax return, you can take a $300 deduction if you give cash to a charity in 2020.
If you are charitably inclined and when you add up your potential itemized deductions it is getting close to the standard deduction amount, you may want to consider donating to charity to push you over the threshold so you can itemize deductions. If you need more than your usual charitable contribution in order to exceed the standard deduction, consider bunching.
Bunching Charitable Contributions:
Bunching means concentrating charitable contributions in a single year, then skipping them for a few years. The catch is that this strategy requires having the financial capacity to pack all of your deductions into one year.
If you are considering a bunching strategy, a donar-advised fund may be appealing. That way you can contribute several years of charitable contributions in one year, making the most of the dedcution in that year. The actual giving to the charity will be spread out over multiple years.
Qualifed Charitable Distribution:
Some people who have RMD’s and are charitably inclined will use Qualified Charitable Distributions, QCD’s, to meet their required RMD amounts. A QCD is donating appreciated stock from the retirement account directly to the charity. It helps the taxpayer avoid getting hit with capital gains on the appreciated stock, gives the taxpayer a charitable deduction, and it satisfies the required RMD.
For 2020, there is a pause for RMD’s, however it is still worth looking at QCD and whether they make sense for 2020 or not. If your goal is to reduce your taxable income in 2020, you may want to use a QCD in 2020. However, if you would rather wait and use the money to offset a RMD for 2021, it may be better to push off the QCD until 2021.
3) Investment Portolio Review:
We saw big lows and big highs in the stock market during 2020. Your investment portofolio may benefit from a review to see if there are opportunities to reduce taxes or if a rebalance is needed to get your portfolio back in line with your risk profile. Rebalancing is always important, but even more so for tax planning tips for 2020 given the big swings in securities prices which we’ve seen this year.
Tax Loss Harvesting:
Tax loss harvesting is the practice of selling an investment for a loss. By realizing, or harvesting, a loss, investors can offset taxes on gains and income. It is used for investments in a taxable account and not in a tax-deferred retirement account because assets in a tax-deffered account are not subject to capital gains income tax.
If an investor wants to recognize the loss for tax plannning purposes but still wants to stay invested in the position, they will purchase a similar investment to what they sold at a loss. Per IRS rules, you must wait at least 30 days from the day the loss was realized before purchasing a “substaintially identical” investment or the loss will be disallowed for tax purposes. Purchasing a similar but substaintially different investment would allow the investor to have the loss recognized and still stay invested in the market. One strategy is to purchase a mutual fund or exchange traded fund (ETF) that targets the same industry as the security which was sold.
Capital losses which are greater than capital gains in a tax year can be used to reduce taxable income up to $3,000 for a married filing jointly couple. Any additional capital losses which are not used can be carried forward to future years indefinately to offset future gains.
Ideally, an investor will have a portfolio of investments which is perfectly in line with their risk tolerance profile. But as markets move and different securities increase or decrease in value, the risk level of the portfolio will also change. Rebalancing is the process of buying and selling securities in a portfolio in order to bring it back in line with the investor’s risk tolerance.
It may sound counterintuitive to sell outperforming securities, but unfortunately past performance does not dictate future performance. If too much of the investor’s portfolio is invested in one or more securities, the total portfolio will have a higher risk profile due to the overweighting of the securities. Rebalancing will provide the discipline to keep the total portfolio risk at an appropriate level for the investor.
Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.