Year End 2020 Tax Planning

Bryan Strike

MS, MTx, CFA, CFP®, CPA, PFS, CIPM

November 20, 2020

 

I do not think most of us are sad to see 2020 come to an end.  With COVID, way too much rain early in the year, murder hornets, and the election, it has certainly been tumultuous!  However, the year is not quite over and there may be some actions to take, or not take, to minimize your tax burdens.

2020 RMDs are Cancelled

We talked about this early in the year and our client service team has most likely called and talked to those normally requiring distributions from their retirement plans.  As part of the CARES Act, passed in March, the normal requirement to take distributions was cancelled for the year.  This means you do NOT have to take your RMD for 2020.  Some clients have asked if this will hurt them in 2021 and the answer is “no.”  Your account balance will be higher by the amount of the distribution not taken in 2020 but this will have only a marginal impact on your RMD for 2021.

Example:  Let’s assume you have a $1 million IRA at the end of 2019 and you turn 75 in 2020.  Your RMD for 2020 (barring the change in law) would have been $43,668.  Assuming no change in value of your IRA for 2020, you would end the year at $1 million, if you did not take the RMD, or $956,332, if you did.  The RMD for 2021 would be $45,454 or $43,470, respectively.

A Biden Presidency

Now that Biden has been declared our next President, we can review more of his tax objectives and plan accordingly.  Most likely any major tax changes will not take effect until 2022, at the earliest.  It is possible that a bill could be made retroactive to January 1, 2021.  So, what are we in for?

    • Tax rates: Biden wants to reinstate the top tax rate of 39.6%, rather than the current 37%, and he wants this bracket to start at taxable income of $400,000.  For couples married filing jointly, this completely eliminates the 35 and 37% brackets, making them 39.6% instead.  For single individuals, the change would eliminate some of the 35% bracket and all the 37% bracket.

o   Planning: High income taxpayers may want to consider advancing income into 2020, if possible, to pay taxes at today’s lower rates if it makes sense in their specific situation.

    • QBI deduction: The tax law passed in 2017 reduced corporate tax rates to 21% and, in an effort to equalize tax consequences amongst other business entity types, the law introduced the qualified business income deduction.  Biden has proposed eliminating the deduction for those individuals with $400,000 or more of income.

o   Planning: High income business owners may benefit from advancing income to 2020 from 2021, if possible.  Real Estate Investment Trust (REIT) dividends have also been allowed the QBI deduction, so these investments may become more tax sensitive should this change take place.

    • Itemized deductions: Biden’s plan would cap the value of itemized deductions at 28%.  Granted, most individuals utilize the standard deduction now that it has been almost doubled under the 2017 tax act.  However, for those taxpayers making more than $163,300 (in 2020) or couples making more than $326,600, itemizing will become capped. 

o   I have done some math to determine the reduction in itemized deductions required to apply this rule (which may ultimately be applied differently but get you to the same result).  That formula is in the foot notes[i] but shows a reduction in itemized deductions as follows:

 

 

 

o   Several points on this are not clear at the current time:

1.       Will the 28% max rate of deductions also apply to the standard deduction?

a.       Example: A taxpayer in the 35% tax bracket may have a total of $15,000 in itemized deductions and their standard deduction (for 2020) is $12,400.  If the 28% max only applies to itemized deductions, as has been indicated, the taxpayer would be better off taking the standard deduction even though it is a lower deduction because it applies at a higher rate:

                                                                                                 i.      12,400*35%=$4,340 tax savings

                                                                                                 ii.      15,000*28%=$4,200 tax savings

2.       Democrats have favored removing the SALT cap (the $10,000 maximum allowance on state and local income tax deductions).  While it has not been addressed in Biden’s plan, this could make itemizing far more likely amongst higher income taxpayers.

a.       Planning: Although we don’t know if this is something that the Biden administration will pursue, it will not hurt for those taxpayers making fourth quarter tax payments to wait until early January 2021 to send in their checks.

3.       The thresholds to bump over the 28% bracket are less than $400,000 so this is inconsistent with the pledge that those making under $400,000 will not see their taxes increase.

o   Planning: If itemized deductions become limited to a maximum benefit level of 28%, it would generally make sense to pull deductions forward to 2020, if possible.  Charitable giving is the most prominent way of doing this using Donor Advised Funds (DAFs) or outright donations.

  • Social Security taxes: Social Security (SS) is funded through payroll taxes of 6.2% by the employee and 6.2% by the employer or 12.4% by the self-employed.  The taxes are only collected on earned income to a threshold, known as the wage cap, which is $137,700 for 2020.  Biden has proposed reinstating the tax on all earnings above $400,000, thus creating a “hole” where earnings are not subject to the tax.

o   Planning: There is not much planning around this tax for employees.  Self-employed individuals may consider utilizing the S Corporation structure to minimize earnings subject to self-employment tax.

  • Child Tax Credit: This credit was increased to $2,000 per eligible child under the 2017 tax law and Biden proposes increasing it to $3,600 for all eligible children under age 6 and $3,000 for 6 to 17.  Currently this credit is only refundable to $1,400 but Biden wants to make it fully refundable.

o   Example: I have a friend with 5 children, 2 under age 6 and 3 between age 6 and 17.  This family would receive $3,600*2+$3,000*3=$16,200 in refundable tax credits.  This, along with the standard deduction, would completely wipe out any federal income tax liability up to $136,000 of income!

o   Example: A more standard 2 child family will receive $6,000 of credits (age 6 and higher), which completely wipes out the federal income tax liability up to $77,800 of income.

  • Child and Dependent Care Credit: Although light on details, it appears this credit could be increased from $3,000 of eligible expenses for a single child/dependent to $8,000!  Double that for two or more dependents.  The intent is also to make this a refundable credit.
                 o  Planning: Have babies, I guess.
  • Capital Gains Taxes: Biden has proposed to increase long-term capital gains taxes for those making over $1 million in a single year from 20% to 39.6% (plus the Medicare surtax of 3.8%).  This will effectively double the taxation on capital gains from stocks, bonds, mutual funds, small businesses, and so forth.

o   Planning: Those expecting to have a big sale next year should try to get the sale completed before year end.  Sales should be staggered over multiple years to keep total income below the $1 million threshold using installment sales or charitable remainder trusts (CRT).

  • Retirement Plan Credit: The deduction for retirement plan contributions to IRAs, 401k, 403b, and 457 plans may go away, replaced with a credit.  While the credit percentage has not been disclosed, the Tax Policy Center estimates 26% to be revenue neutral.  This shifts the tax benefit from those in higher tax brackets to those in lower tax brackets to encourage savings by those less able to save.

o   Example: A $10,000 contribution to your 401k would no longer reduce your taxable income by $10,000 but instead provide you with a credit of $2,600, regardless of your marginal tax bracket.  Therefore, someone in the 10% backet would be $1,600 better off than before and someone in the 39.6% bracket would be $1,360 worse off.  In other words, the highest tax bracket taxpayer will still owe 13.6% on the income contributed to the retirement account.

o   Example (continued): Since the taxpayer will not gain basis in the retirement plan for these contributions, the income will be taxed at distribution from the retirement plan.  Assuming the taxpayer remains in the top bracket, the total federal tax on that income is 39.6%+13.6% = 53.2%.

o   Example (continued): When taxpayers get a deduction for retirement contributions, those deductions apply at both the federal and state level.  The credit, unless states take action to rectify this, will only apply at the federal level meaning these contributions will be double taxed at the state level (once at contribution and then again at distribution).  At Georgia’s current tax rate of 5.75%, that is an extra 11.5% tax, bringing the total tax rate on contributions to 64.7%!

o   Planning: Historically, it has made sense for younger and lower income folks to max out their Roth IRAs first before worrying about deductible contributions (after getting an employer match, if available).  Higher paid workers would focus on the deductions and eschew the Roth plans.  If this credit goes into effect, it is likely that the advice will flip since lower income earners will actually benefit more by taking the credit and higher income folks will be better off just paying the 39.6% upon contribution instead of 53.2% plus state!

Conclusion

Make sure you let us know what you want to do with your RMDs for the current year.  Please note, they are NOT required this year!  Second, a Biden presidency could certainly mix things up on the tax side.  While his plan is very uncertain currently, it is even more uncertain if the Senate remains in Republican control. 

Should you make any year-end 2020 moves based on this?  If your income is expected to drop next year, I would consider lump sum charitable giving via a DAF if you are otherwise close to itemizing your deductions.  The cap on itemized deductions at 28% will make those donations this year more important if you are in a high income tax bracket.  Advancing income for those making more than $400,000 will also help limit the impact of the higher tax rates that could come into place next year.  Lastly, time to start the next baby boom :)

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[1] Reduction Factor = (MTR - 0.28) / MTR where MTR is Marginal Tax Rate