Year-end planning for 2021 is particularly challenging due to the uncertainty of the tax provisions in the current legislation known as the “Build Back Better” plan. While we wait to see if legislation passes and if there will be any provisions that affect 2021 we want to provide the following information for your tax planning consideration.
Tax Bracket Management
If you have the ability to control the timing of your income, you can accelerate or defer income and deductions to manage your income tax brackets. It is imperative to not only look at 2021, but also what lies ahead in 2022 and the future to time income, deductions, retirement plan contributions, charitable gifts, etc. to avoid higher tax brackets and the net investment income tax (NIIT).
Tax Efficient Investing
Work with your accountant and investment advisors to develop a plan for tax efficient investing that Includes: 1) increasing investments in tax-favored or tax-deferred assets; 2) deferring or accelerating gain recognition, 3) reviewing tax-sensitive asset location – know the state laws for taxing real estate sales, retirement benefits, stock options, etc.; 4) managing income, gains, losses and tax brackets from year-to-year; and 5) managing capital asset holding periods.
Maximize Charitable Contribution Deduction
For the 2020 tax year, a new above-the-line deduction was allowed for up to $300 of charitable cash contributions, even if you claimed the standard deductions on your tax return. This deduction is extended to 2021. The deduction is per person, so married couples filing jointly may deduct up to $600.
The adjusted gross income (AGI) limit for cash contributions made to qualified charities remains at 100 percent through 2021. Donations to donor-advised funds and private foundations are not eligible for the increase. Taxpayers, especially those that are close to the standard deduction, may want to consider bundling their charitable contributions into 2021 to take advantage of this deduction. Donor advised funds (DAFs) is a strategy to consider as well. DAFs allow you to make a substantial charitable contribution in a high income year while directing the payment of the actual grants in future years. Be sure to review the rules when considering a DAF as there may be minimum contribution requirements and investment fees.
Taxpayers with high income, where AGIs limits may not be a factor, should consider donating appreciated securities. When stock is donated to qualified charitable organizations, you receive a tax deduction for the full fair market value and avoid paying capital gains tax on the appreciation.
Taxpayers aged 70.5 or greater that do not itemize but instead take the standard deduction, may want to consider making a charitable qualified distribution (QCD). A QCD is a withdrawal from an IRA that is made directly to an eligible charity and reduces your AGI. Contributions must come out of traditional IRA accounts and they count towards your RMD. The maximum allowable QCD is $100,000 per person.
Health Savings Accounts
Consider setting up a health savings account (HSA). HSAs allow you to deduct contributions to the account, the investment earnings are tax-deferred until withdrawn, and any amounts you withdraw are tax-free when used to pay qualified medical expenses. Once you reach age 65 you can withdraw funds for any reason and the withdrawal is treated much like an IRA.
To be eligible for an HSA, you must have a high-deductible health plan (HDHP) and you must not be enrolled in Medicare. For 2021, to qualify for the HSA, your minimum deductible in your HDHP must be at least $1,400 for self-only coverage or $2,800 for family coverage.
HSAs for 2021 may be established and contributions made by April 15, 2022.
Maximize Contributions to Retirement Plans
Contributing to retirement plans may lower AGI and allow tax deferred savings. If allowed by your retirement plan, consider Roth contributions. (See further information below regarding Roth conversions.)
Required Minimum Distributions (RMD)
RMDs have resumed for the 2021 tax year and must be taken by December 31. Taxpayers that turned age 72 during the year may defer the start date to April 1. In this circumstance, consideration should be given to the timing of your initial RMD based on your other income sources and your income tax bracket.
Roth IRA Conversions
Consider converting traditional-IRA money into a Roth IRA in 2021.
Reasons to consider a conversion include 1) There is no RMD requirement for Roth IRAs, 2) With the impending reduction to the estate tax exemption, taxpayers may benefit by paying the income tax now and reducing their taxable estate, 3) Taxpayers that want to leave IRA assets to their families will provide tax-free post death distributions, and 4) Tax rates are historically low.
Keep in mind that the conversion will increase your income and tax for 2021.
529 Education Plans
Maximize contributions to your state sponsored 529 plans to take advantage of state tax deductions. 529 plans can now be used for elementary and secondary school tuition as well as college or vocational school.
Child Tax Credit (CTC)
For eligible taxpayers in 2021, the CTC was increased and became fully refundable. Advanced payments of these credits began in July and are spread over the six months from July through December 2021. If your gross income is over the threshold limits and you did not opt-out, receiving these monthly payments may increase taxes due or reduce refund amounts in April.
Avoid penalties and interest
In order to avoid penalty and interest for underpayment of taxes, you must pay in 90% of your current year tax or 110% of your prior year tax through withholding or timely estimated tax payments. If your withholding has decreased and/or income has increased substantially you should consider increasing your remaining withholding or estimated payment.
Estate planning, income shifting and gifting
Under current law taxpayers may exclude gifts of up to $15,000 per individual per year. Consideroutright gifts to children, LLC and partnerships, and non-grantor trusts. In addition, consider conversions of grantor trusts to non-grantor trusts. This will allow you to shift income, thereby avoiding the higher tax brackets, NIIT, & §199A Limits.
You may also make direct payments to medical providers for medical bills or qualifying educational institutions for grade school through higher education without gift tax consequences.
The current estate exemption is $11.7 million. Even without any legislative changes, under current law, this exemption will sunset on December 31, 2025 and revert to approximately $5.5 million. We previously advised updating estate plans with your attorneys. If you have not already done so you should review your estate plan to develop a strategy which may include gifting assets now to take advantage of the higher exemption.
Please contact us if you would like to discuss year end planning. We will provide updates if any legislation is passed that affects 2021 tax plans.