Year-end tax planning traditionally includes accelerating deductions into the current year and pushing off income into future years to the extent possible. With the threat of higher taxes on the horizon as we wait for a final tax law bill, we may be entering a time when just the opposite makes sense – accelerate income and defer deductions.
If we are entering a period of higher income taxes, the following strategies should be considered to reduce your “lifetime” tax bill.
Roth IRA Conversions
Converting funds from your Traditional IRA to a Roth IRA is a strong year-end planning strategy whereby you transfer funds from your IRA to a Roth IRA and pay tax on the amount you convert. Taxes are paid in the year of conversion. The benefit of doing this is that all the distributions from the Roth IRA are tax-free, including any earnings. You must meet specific criteria regarding age (59 ½ and older) and holding period (at least five years) when you distribute funds from the Roth IRA.
This strategy makes sense if you expect to be in a higher tax bracket in future years when you need the funds. For example, suppose you currently are in the 22% Federal tax bracket but expect that once you begin collecting social security and withdrawing the required minimum distributions from your retirement plan, you will be in the 32% Federal tax bracket. In that case, paying tax now (at 22%) by doing a Roth IRA conversion makes more sense than paying 32% at age 72.
The decision to do a Roth IRA conversion is not as simple as trying to predict your future tax bracket. For one, tax changes seem to occur frequently. Therefore, deciding on future tax rates, even those scheduled under current law, can be challenging since tax laws can change.
There are certain instances where you can be more confident you will be in a higher tax bracket in the future. Examples of this could be temporary reductions in taxable income due to a job loss or unusually large deductions such as unreimbursed medical expenses. These scenarios provide opportunities to make Roth IRA conversions.
Another example of this is often seen in young people starting in the workforce. They are likely in a lower tax bracket in their early working years as they build their career, making Roth IRA conversions a good strategy to consider. The one caveat for younger people is that they may not have funds in an IRA to convert, or if they do, the balance may not be that great. A corollary strategy for them would be to make Roth IRA contributions rather than IRA contributions, or if they have a retirement plan at work, make contributions to a Roth 401(k) or 403(b) plan. Roth IRA, 401(k), and 403(b) contributions work similarly to Roth conversions, except the money put into those accounts come from your salary (in the case of a Roth 401(k) or Roth 403(b)) or a bank account (for Roth IRA). There is no tax deduction for contributions to a Roth IRA or reduction in taxable wages for Roth 401(k) and Roth 403(b) plans. These amounts grow tax-free, and account balances are withdrawn tax-free, assuming similar age and holding period guidelines as Roth IRA conversions.
Realizing Capital Gains
Another year-end tax planning strategy to consider is realizing capital gains. The strong bull market in stocks that we have experienced over the past 13 years has resulted in taxable brokerage accounts with large unrealized capital gains. Selling these investments now would trigger a taxable capital gain, which can be taxed at ordinary income tax rates for short-term gains or more favorable capital gains rates for long-term gains.
When looking at the rates for long-term capital gains, most people focus on the 15% and 20% long-term capital gains rates. But there is also a 0% capital gains rate, which some people may take advantage of.
In 2021, for married taxpayers whose taxable income is $80,800 or lower, the long-term Federal capital gain rate is 0%. The amount of long-term capital gain is included in the $80,800 when determining which rate the gain is taxed.
The above strategy sounds like a great way to save taxes now, but what if you do not want to sell your investments because you like them and want to keep them? You can still sell the asset, pay zero capital gains tax, and repurchase the same investment immediately after selling it. This has the added advantage of resetting your cost basis to a higher amount, so down the road, when you sell the investment, you will pay less tax, even if you are not in a zero percent long-term capital gain bracket.
It should be noted that the above applies only to Federal taxes. States have different rates for taxing capital gains which should be considered before implementing the above year-end tax planning strategy.
State and Local Taxes
One of the most controversial provisions of recent tax law has been the $10,000 cap on the allowable amount taxpayers can deduct for state and local taxes (the SALT limitation). Since 2018, the $10,000 cap has forced more taxpayers to take the standard deduction, which is often greater than their itemized deductions. Almost from the moment it was put in place, there has been discussion about modifying or eliminating the cap. Recently, the House passed a bill increasing the limitation from $10,000 to $80,000, which would allow a full deduction for most taxpayers. Next, the bill must pass through the Senate and could be altered or eliminated. If an increase passes, it will make sense to consider deferring the payment of your fourth quarter property tax bill until January 2 or making your state estimated income tax payment on January 15, 2022, when due. Do not make any moves until the law passes and is signed into law. Careful consideration should also be given to the effective date of the change. If effective for 2021, you may want to prepay state taxes instead.
Year-end tax planning is important and, unfortunately, not always clear-cut. Keeping an open mind and carefully considering your options related to deferring the payment of taxes or accelerating the payment of taxes can help reduce the lifetime taxes you pay. The less you pay, the more you and your family get to keep, save, invest, and spend.