It’s that time of year when thoughts turn to, you guessed it, year-end tax planning opportunities. Tax planning strategies should always be looked at with a view toward multiple years. It’s not just about minimizing taxes this year, but looking at how the years fit together in a holistic sense. For example, if you are retiring in the next year or two or if you plan to sell a business in the near future that would drive some of the decisions you would make for this year. There is a good chance significant tax law changes will happen soon, as they have the past couple of years, which may also inform some tax planning decisions.
Tax Laws Changes We Know About
Under the current law the tax rates in effect now are schedule to expire in 2025, but the tax laws could change dramatically even before that. The Build Back Better plan is not final yet, however there are some significant changes to tax laws in the bill as it stands now, especially to Roth conversions. It’s impossible to know what will make it into the final bill, so it’s best to plan with what is known but stay ready to make changes if needed to your year-end tax planning strategies.
Year-End Tax Planning Topics
1) Roth Conversions
If a Roth conversion makes sense for your financial situation, you’ll want to get your Roth conversions done before the end of the year. Like many businesses, some custodians have been struggling with a shortage of qualifed workers and have a back-log of requests from customers. It’s best to give yourself extra time to complete the transactions this year. Perhaps you’ve been making conversions each year to fill up your marginal tax bracket. Give yourself a little extra time this year to make sure the conversion is completed before year end.
For a description of what it means to make a Roth conversion and the factors to consider before you make one, this article provides more information on what to consider before making a Roth conversion.
2) Charitable Contributions
$600 Deduction for Those Who Take The Standard Deduction
Even if you take the standard deduction in 2021, you can still take a deduction for donating cash to a qualified charity for up to $300 per taxpayer or $600 if you are married filing jointly. This deduction is in place only for 2021. Cash contributions to most charitable organizations qualify. However, cash contributions made to a donor advised fund, a private foundation, or a charitable remainder trust, among others don’t qualify as eligible charitable organizations. More details are here.
100% Limit on Eligible Cash Contributions Made By Those Who Itemize Deductions
For those taxpayers who have enough deductions that it’s beneficial to itemize deductions, the limit for cash contributions made to qualified charities increased for 2021 to 100% of your adjusted gross income (AGI). The limits typically range from 20% to 60% of AGI and vary by type of contribution and type of charity receiving the contribution. Similar to the $600 deduction available to taxpayers who take the standard deduction, the qualified charities exclude donor advised funds, private foundations, and charitable remainder trusts, among others.
Contributions to charity don’t reduce your tax liabilty unless you itemize deductions, with the exception of the $600 cash contribution noted above. The standard deduction is at a relatively high amount of $25,100 for married filing jointly in 2021, $25,900 for 2022 and $12,550 for single filers in 2021 and $12,950 in 2022. The higher standard deduction makes it difficult to have enough deductions to make it worthwhile to itemize. A strategy to deal with this is to bunch charitable contributions. With this strategy over time you give the same amount you would anyway, but you combine the amounts you would give over multiple years into one year. That way you have a higher charitable contribution in one year and it’s worth it to itemize, then in the next year or two you take the standard deduction and don’t donate to charity. The total amount of the donation is the same, but you receive a greater tax benefit from itemizing a larger amount in one year and taking the standard deduction in the other years when you don’t make a contribution.
3) Required Minimum Distributions
In 2020 the Required Minimum Distributions for tax-qualified retirement accounts was suspended. For 2021, the RMD’s are back in place. The penalty for not taking an RMD is steep, 50% of the RMD amount that wasn’t taken when it should have been, so it’s important to keep track and make sure you take the distribution in the year it is required.
The are recent changes to when the RMD’s begin. You must begin to take RMD’s from your retirement account once you turn 72, unless you turned 70 1/2 before January 1, 2020. If that is the case your RMD age remains at 70 1/2. The amount you need to withdraw is determined by the fair market value of your IRA’s at the end of the previous year, factored by your age and life expectancy as determined by IRS tables.
4) Tax Payment Estimates and Tax Withholding
Income tax payments due to the IRS should be paid as you earn the income. You could incur a penalty if the income tax wasn’t submitted to the IRS when it was due, even if you get a refund when you file your taxes. If you have self employment income or income from any other source which doesn’t have income tax withholding, you need to submit a quarterly payment to the IRS for the estimated tax due.
Revised Withholding Form W-4
The W-4 form was changed in 2020 to reflect the significant changes in the tax laws, especially the elimination of the personal exemption and the higher standard deductions. The IRS has a calculator to see if you are having the correct amount withheld. Submit a new W-4 to your employer if needed and make an estimated payment to the IRS if you believe you have not paid enough in estimate taxes.
Safe Harbor Amounts for Underpayment Penalty
There are safe harbor amounts for taxes due. If you have paid at least the safe harbor amount then you will not be subjet to an underpayment penalty, but you may have a large surprise tax bill when you file your return. The safe harbor amounts are the following: if you owe less than $1,000 in taxes, if you paid at least 90% of the current year tax liability, or if you paid at least 100% of the prior year’s tax liability, then you will not be subject to an underpayment penalty. The safe harbor amounts increase for taxpayers with adjusted gross income over $150,000 in 2020. The higher income taxpayers would need to have submitted at least 110% of the prior year’s tax liability in order to meet the safe harbor threshold.
5) Capital Losses/Capital Gains and Year-End Tax Planning
If you have realized capital gains and capital losses during the year, you net the gains and losses against each other to determine your recognized gain or loss. If the end result is a net capital loss, you can deduct up to $3,000 of the net capital loss from your taxable income. If you had greater than $3,000 in net capital loss you can carry forward the unused loss indefinately until it is used up.
6) Solo 401(k) Contributions
If you own a business and you are the only employee, or you and your spouse are the only employees, a solo 401(k) is a retirement plan which allows you to defer a larger amount than alternative plans while also providing more flexibility with funding the plan over time. The plan is relatively easy to set up and administer, but it must be set up by the last day of the year to be in effect for that tax year.
There are two parts to the Solo 401(k) contributions, just as there are for a larger employer’s 401(k) plan. There is the employee’s salary deferral portion and the employer’s contribution portion, even though the employee and the employer for a Solo 401(k) is the same person.
Your salary deferral can be either a Roth contribution or a traditional pre-tax contribution. The salary deferral limit is $19,500 in 2021 for under 50 years old and $26,000 if you are 50 or older. In 2022 the salary deferral limit is $20,500 for under 50 and $27,000 if age 50 or older. In addition, you can make a pre-tax contribution as the employer to bring up the total contribution to the IRS limits of $58,000 in 2021 if you are under 50 years old and $64,500 if you are 50 or older. In 2022 the limits are $61,000 and $67,500 if you are 50 or older. The maximum limit includes both the salary deferral as the employee as well as the employer contribution. The employer contribution must be made as a pre-tax contribution and cannot be made as a Roth contribution.
7) Gifting and Year-End Tax Planning
If you are planning on giving gifts during the year, you have until the end of the year to give up to $15,000 per recipient and not have to report the gift. The recipient of the gift does not have to report receiving the gift either. It is a beneficial way to transfer assets to beneficiaries without incurring additional taxes.
Often grandparents or other relatives will use their gift tax exclusion to make a contribution to a 529 account for their grandchildren. For 529 account contributions only, up to 5 years worth of the $15,000 annual gifts can be lumped together into one gift in one year, but treated as if the up to $75,000 gift was spread over 5 years for gift tax reporting purposes. So anyone can make up to a $75,000 gift to a 529 account in one year tax-free as long as they don’t make any additional contributions to the 529 over the next four years.
8) FSA Accounts
Flexible Spending Accounts, or FSA’s, are a use it or lose it type of account. They allow you to use pre-tax dollars to pay for certain out of pocket health care costs. There are some small differences in plan specifics between employers. You may have need to use all the funds by the year end or you may have up to a 2 1/2 month grace period at the end of the year to submit for reimbursement. Either way, you don’t want to forget about the money you have in an FSA or it will be gone.
9) HSA Accounts
Health Savings Accounts, or HSA’s, are different from FSA’s in that they are not a use it or lose type of account. They are also the only opportunity to receive a triple-tax benefit. The money going into the HSA is pre-tax, the money in the HSA grows tax deferred, and if the money in the HSA is withdrawn for qualified expenses, then the money is tax-free when it is withdrawn.
You may only qualify for an HSA if you have a high deductible health plan (HDHP). For 2021, if you have an HDHP you can contribute up to $3,600 for self-only coverage and up to $7,200 for family coverage into an HSA. HSA funds roll over year to year if you don’t spend them. The earnings on the assets in the HSA are not taxable. Even if you leave your employer, your HSA is yours to keep. Many people put money into an HSA and don’t touch it until retirement when they use it to pay their medical expenses on a tax-free basis.
Individuals who are eligible to contribute to an HSA can make contributions at any point during the year, including up through their federal tax return due date, which is usually April 15 of the following year. Any employer contributions made to an HSA don’t count toward your maximum contribution limit, which is another nice feature of the HSA.
10) ABLE Account Contributions
If you are planning on making a contribution to an ABLE account for a disabled beneficiary, the annual contribution limit to the ABLE account is $15,000. The ABLE account can be used in addition to a Special Needs Trust for the disabled beneficiary. The assets in an ABLE account are not considered countable assets for SSI benefits as long as the total value of the ABLE account is less than $100,000.
11) Bonus Year-End Tax Planning
I Bonds are a great way to invest up to $10,000 per entity in inflation adjusted, US government issued bonds. They can only be purchased directly from the US Government on www.Treasurydirect.gov or by requesting that an income tax refund be issued in I Bonds. If you request I Bonds through an income tax refund, you can purchase an additional $5,000 per year.
You cannot redeem I Bonds less than one year after purchasing them. After one year but less than 5 years if you redeem the bonds you will lose 3 months of interest. After holding the bonds 5 years there is no penalty for redeeming them before their maturity of 30 years. The interest received on the bonds is exempt from state income tax but subject to federal income tax.
Currently, the bonds are paying 7.12%, which is unheard of for a security with so little risk in today’s market. The interest on the bond consists of two components, a fixed portion and a variable portion. The fixed portion is set for the life of the bond and the variable portion is reset every 6 months based on inflation.
Year-End Tax Planning Summary
It is impossible to predict what will eventually become law, but you can still take into consideration the current tax law to make sure you are making intentional decisions to minimize your income tax liabiilty as allowed by law. It is important to look at year-end tax planning in a holistic way and not simply try to minimize the current year’s tax liability.
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.