What are appropriate checklists for year-end tax planning?
From our experience, tax planners often develop checklists to guide taxpayers toward year-end strategies that might help reduce taxes. Throughout the year, we publish many timely tax-related articles (summarized here). In August this year, we also published our Top 10 Tax Planning Ideas for 2020. The tax filing season is now behind us. We have put together a year-end checklist of things that you should review. We have grouped the list into several different categories, such as “Filing Status” or “Employee Matters,” for ease of reading. As year-end approaches review each category that applies to your situation and consult with your tax advisor. Also, as this is an election year, we created a pice to compare the Trump vs. Biden Tax Policies.
Coronavirus Retirement Update for 2020:
- If you suffered from the coronavirus or experienced financial hardships such as job loss as a result of the pandemic, you may be able to dip into your 401ks or IRAs without an early withdrawal penalty if prior to age 59 ½ for up to $100,000. Additionally, the tax associated with a coronavirus related distribution can be spread over three years or you may replace the funds within three years to avoid any tax together. We covered some of this in our Coronavirus Resource Center’s Retirement Plan Relief Provisions.
- 2020 RMDs have been waived.
Filing Status and Exemptions:
- If you’re married (or will be married by the end of the year), compare the tax liability for yourself and your spouse based on all filing statuses that you might select which may include married filing jointly or married filing separately. Determine which status results in a lower tax bill. Generally speaking, filing jointly is the more advantageous method, however, there are reasons for which couples may file separately such as keeping separate accounting for tax bills. If you are in a community property state, additional disclosure may be required on each tax return.
- Exemptions for yourself, spouse, and kids are no longer available under the Tax Cuts and Jobs Act of 2017, however, the standard deduction has doubled. It would be smart to analyze the numbers to determine if these changes result in higher taxes so that you are not surprised when you file your taxes. Some taxpayers may end up with a higher tax bill if their withholdings are not updated with their employer.
Family Tax and Education Planning:
- It may be advantageous to direct income to other family members in lower brackets. Review your planning and determine whether you can and should direct income to other family members such as your minor children who are in lower tax brackets to minimize overall taxes. Caution, however, because the kiddie tax rules apply to those who are:
- Ages under 19, and
- Ages 19 to 23 who are dependent full-time students and whose earned income doesn’t exceed one-half of their support.
- For 2020 and Beyond, Kidde Tax Rules prior to the Tax Cuts and Jobs Act restored due to unintended consequences of higher taxes on GOLD STAR families (families of deceased combat members). NOW parental marginal tax rates apply above the child’s unearned income threshold versus all income taxed at Estate and Trust tax rates. For 2018 and 2019, there was one important change to the Kiddie Tax rules under the Tax Cuts and Jobs Act of 2017. Prior to 2018, parents could elect to treat their kids’ income to be taxed at the parent’s rates. Under current law, the kid’s unearned income such as interest and dividends would now be taxed at Trust tax rates which may be significantly higher than their parents! Check to see if this change results in your children paying higher taxes.
- Under the new tax law, the child tax credit was increased from $1,000 to $2,000 per eligible child and the phaseout amounts were increased so that more households would qualify for the full credit. Given the elimination of the exemptions previously discussed, this change in the law ended up offsetting the punitive effects that would have otherwise existed due to the increase in taxes on families with multiple children that no longer received exemptions.
- Don’t forget to use any remaining balances in your flexible spending account balances that will be lost if not used. Understand the rules of your benefits package. In some cases, employers may allow small rollover amounts to the following year that will be lost if not used in the following year as well.
- If your insurance plan qualifies for a Health Savings Account or HSA, take advantage of the triple tax savings benefit by contributing to it. HSAs receive a tax deduction for the contribution, tax deferral on all earnings and growth of the account, and tax-free distributions if used for qualified medical expenses. It’s a win-win-win.
- Take advantage of tax credits for higher education costs paid during the tax year if you’re eligible to do so by utilizing the American Opportunity (Hope) credit or the Lifetime Learning Credit. These credits are based on the tax year rather than the academic year. Therefore, you should try to bunch expenses to maximize the education credits. These credits are also subject to phaseouts and may not be available for higher-income earners. Because of the phaseout potential, it’s important to taxpayers to take advantage of all possible deductions that are above-the-line (before AGI and Itemized or Standard Deductions) to see if they can reduce or eliminate any phaseout.
- If you have qualified student loans (and meet all necessary requirements), you may be entitled to take a deduction for the interest you paid during the year. The maximum amount you can deduct is $2,500. This tax benefit is subject to phaseouts so your benefit may be reduced or eliminated.
- Make sure that you take distributions from your children’s Section 529 Plans that can be for qualified education expenses that occurred during the calendar year. Keep good receipts. Some plans may require proof submitted in order to be reimbursed.
Estate Planning Matters:
- Consider making nontaxable gifts of up to $15,000 (2020) by using the annual gift tax exclusion. Split gifts with your spouse to double the amount of gifting you can make to any person. To maximize estate tax savings, give assets that are likely to appreciate significantly after the gift is made. Avoid giving assets that have depreciated in value. It’s better to take the losses yourself to offset any gains you may have on assets elsewhere. Use all losses during your life to avoid losing the benefit.
- Consider max funding 529 plans as early as possible for your kids by accelerating 5 years’ worth of gifts in one contribution of $75,000 or $150,000 with split gifting for maximum possible tax deferral. Don’t worry about not using all the 529 assets for a child, you can always change the beneficiaries.
- Under the Tax Cuts and Jobs Act of 2017, the unified estate exemption has been dramatically increased to $11,580,000 per taxpayer in 2020, up from $5,490,000 in 2017. Because the increase is set to disappear and revert in 2026 to prior levels, now is the time to update your estate plan and maximize the use of your estate tax exemption.
- Trust tax brackets are far more progressive when compared to individual tax brackets, meaning, the rates at which income is taxed grows higher much faster. The highest rate of tax at 37% starts at only $12,950 (2020) of income for trusts that retain income without distributing it to their beneficiaries. Consider taking advantage of the “65 Day Rule” election and distribute income up to 65 days after the new year to the beneficiaries so that the taxes are paid at their brackets which could result in the income being taxed at lower rates.
- Before a spouse passes away due to illness or other reasons, ROTH conversions (discussed in detail more latter) are “worth” more while your spouse is still alive before you will inherit their assets due to the largely expanded tax brackets of married joint taxpayers. In other words, converting before the death of a spouse may be less expensive from a tax perspective rather than after a spouse dies and the surviving spouse inherits the IRA from their deceased spouse.
Employee / Employment Matters:
- Self-employed individuals (and businesses who qualify) using the cash method of accounting need to understand that collections on their accounts receivable prior to year-end will be included in their taxable income. Conversely, payments made on account payable will be deducted from taxable income if paid prior to the year-end. It’s important to pay close attention to your year-end billing cycles to avoid any unnecessary accelerated collection efforts and to pay expenses if there is an appropriate cash flow available.
- You can delay recognition of tax on capital gains by using installment sale agreements to spread out any payments received from a sale to future taxable periods.
- A BIG change under the Tax Cuts and Jobs Act of 2017 for employees is that they can no longer deduct their unreimbursed employee expenses on Schedule A as an itemized deduction if these expenses exceed 2 percent of adjusted gross income (AGI). This itemized deduction was eliminated. For taxpayers who relied on this deduction in prior years, they should see to renegotiating their employment contract with their employer to avoid losing valuable deductions. Employers can still deduct documented reimbursements from their employees such as miles and other costs as part of their employees’ jobs.
Business Owner – Income and Expenses:
- As mentioned earlier, under the cash method of accounting, expenses are deducted in the year they are paid. Manage your year-end expenses and consider accelerating expenses (such as repair work and the purchase of supplies and equipment) in the current year to lower your tax bill if cashflow is available to do so. In some cases, even using your line-of-credit may make sense to pay expenses. However, use caution in driving up debt if your AR collection cycle is not short enough to immediately reset your line-of-credit in the following year because the interest charged might outweigh the benefit received.
- Increase your employee withholding of state and federal taxes to help avoid exposure to estimated tax underpayment penalties.
- The 80% Limitation rule for Net Operating Losses under the Tax Cuts and Jobs and the Excess Business Losses has been suspended for tax years 2018, 2019, and 2020 under the new Coronavirus Aid, Relief, and Economic Security (CARES) Act. There’s a mandatory Amended Tax Return requirement. The Tax Cuts and Jobs Act of 2017 eliminated the ability to carryback net operating losses for years after 2017 to prior years. Furthermore, the new law has added an excess business loss limitation for non-corporate taxpayers (S Corps and Partnerships and Single-Member LLCs and Sole Proprietors) of $250,000 for single filers and $500,000 for joint filers on their tax returns. Any losses not utilized in the current year will be carried forward to future years.
- In certain circumstances, it may be possible for the full cost of last-minute purchases of equipment to be deducted currently by taking advantage of Section 179 deductions. The new tax law has expanded the Section 179 deduction and increased the Bonus Depreciation deduction amount to 100% for 2020. However, even though these benefits offer larger deductions, you may want to spread out your depreciation over several years to take full advantage of the 199A qualified business deduction for businesses taxes (as part of the Tax Cuts and Jobs Act for Business) as Partnerships, S Corps, and Disregarded Entities such as Single Member LLCs and Sole Proprietorships. Visit with your tax advisor and run the numbers to strategize on the best approaches to purchasing depreciable equipment. More importantly, never buy to just get a deduction. Make sure your purchase makes economic sense.
- There is a new business deduction available to pass-thru businesses such as S Corps, Partnerships, Single Member LLCs, and Sole Proprietors. Section 199A was added under the new law to bring down the effective tax rate for pass-thru business to compete against the new 21% flat tax rate for corporate taxpayers. There are many nuances to this new deduction and strategies that taxpayers need to be aware of when planning at year-end to ensure they receive this valuable benefit. For example, using defined benefit plans to fund your retirement can give you large deductions that lower your taxable income below the phaseout requirements of 199A. It’s important to work with an experienced tax professional who understands this new benefit because the calculation and formula to receive your 20% benefit are not simple to derive and not all businesses qualify and have more restrictions such as specified services businesses like lawyers, doctors, accountants, and financial advisors to name a few.
- Under the Tax Cuts and Jobs Act of 2017, your interest expense deduction for your business could be limited. If your business is leveraged and operates on a lot of debt, these new limitations could impact your tax bill. If you have a lot of debt in your business, make sure your CPA applies these complicated and technical rules accordingly.
- There are new IRS Regulations on audits that you and your legal team should consider for Partnerships and LLCs. Make sure you have visited with your attorney to update your business documents to refer to the requirements and how to address the new rules on audited changes.
- Generally, you can contribute to your retirement plan at any time up to the filing deadline, including extensions. You must have a plan in place to do so, and not all plans can be set up after the prior year has ended.
- For small businesses or independent contractors, you can consider setting up a retirement plan (401k, SEP-IRA, SIMPLE IRA, or a Defined Benefit Plan). These plans allow you to defer taxes on income from $13,500 to $57,000 in 2020 and more for Defined Benefit (or Cash Balance) plans. In 2020, the range will increase to $13,500 and $58,000. Catchup contributions remain the same for those over 50 years of age at $6,500 for 2020.
- If you own an interest in a partnership or S corporation, know your tax basis. If you don’t have any basis in your business, you cannot deduct a loss this year. If you are planning on taking distributions, don’t over distribute in excess of your basis or you could end up paying unintended taxes on excess basis distributions.
- Beware of aggressive tax strategies for shifting income to other businesses or recharacterizing W-2 employees to 1099 contractors. The IRS is aware of all the possible “games” that can be played with trying to benefit more from the new laws. Proceed with caution.
- The IRS recently published Notice 2018-76 which provides taxpayers guidance on the deductibility of Meals and Entertainment expenses. The Tax Cuts and Jobs Act of 2017 eliminated the ability to deduction any entertainment expenses such as event tickets. However, the IRS notice provides guidance that meals, food, and beverages, are still able to be deducted at 50% as long as the taxpayer maintains the appropriate record of the expense (who, what, where, when, and why).
Financial Planning and Investments:
- Pay attention to the changes in the capital gains tax rates for individuals and try to sell only assets held for more than 12 months. Capital gains rates are no longer determined by your marginal tax rate, but rather your income levels and don’t forget about the Net Investment Income Tax of 3.8% for those who make over $250,000 of income.
- Review your Adjust Gross Income (AGI) and then review your passive and portfolio investment income to see if you are going to get “hit” with the Net Investment Income Tax, commonly referred to as the 3.8% Obamacare Tax. There may be ways you can reduce your AGI below that threshold that triggers this tax.
- Consider selling stock if you have capital losses this year that you need to offset with capital gain income (sometimes called “tax-loss harvesting”).
- If you plan to sell some of your investments this year, consider selling the investments that produce the smallest gain.
- If you are having a lower-income year and expect to be in a lower tax bracket, consider converting a portion of your Traditional IRA to a Roth IRA. Conversions will create taxable income, but the goal is to lock in permanent tax savings at lower rates when you previously received a tax deduction in prior years at higher rates. Important observation – if you are a business owner who is eligible for a 199A qualified business deduction, be sure to run the analysis of the conversion before pulling the trigger to ensure the conversion doesn’t end up reducing or eliminating your otherwise business deduction.
- Other possible ROTH conversion tax consequences could include increasing Medicare premiums, triggering the Net Investment Income Tax, the Alternative Tax (AMT), phaseouts of deductions, and Roth contributions thresholds. Always complete a tax analysis first before converting it. You don’t want any surprises.
- You may also want to consider breaking up your conversion amount by making smaller conversions throughout the year to dollar average the taxable income. For example, if you convert lump sum at the beginning of the year, versus converting a little each month, and the markets are higher at the beginning of the year and slowly decline through the year, dollar averaging will result in a lower tax than the lump sum method.
- As stated in the prior point, the new 199A deduction needs to be balanced and coordinated with all other income items like W-2 wages, retirement distributions or conversions, or your deductions for pensions or other qualified plans or IRAs. A multifactor analysis is needed to maximize your 199A deduction.
- If you made any IRA Rollovers during the tax year, make sure you didn’t make any common IRA rollover mistakes like forgetting to complete your 60-day rollover in a timely manner.
- Make sure you take ALL required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retirement plans). RMDs from IRAs must be taken no later than April 1st of the year following the year in which you reach the age of 72 (due to the SECURE Act). If you don’t take your RMDs timely, the penalty can be 50%! Also, don’t forget to withhold the appropriate amount for taxes and/or make sure that you make an estimated tax payment to cover your RMD to avoid underpayment and interest penalties. Any turning 70 ½ under the old rules prior to December 31st, 2019 would continue under the old rules.
- If you are over age 70 ½ and charitably inclined, consider taking advantage of a Qualified Charitable Distribution (QCD) that will result in a tax-free distribution from your IRA directly to a charity. This type of distribution will NOT be added to your adjusted gross income that may affect other deductions due to phaseouts or potentially cause your Medicare premiums to increase. For those that will no longer itemize given the tax law changes, a QCD is an excellent way to give to charity.
- Don’t forget to split inherited IRAs before the end of the year. If an IRA owner, died during the year and had multiple individual beneficiaries named on a beneficiary form, they can each use their own life expectancy for calculating required minimum distributions (the stretch IRA) if the inherited IRAs are split into separate shares before the end the year. If this is not done timely, the beneficiaries will be stuck using the age of the oldest beneficiary, even if they split their shares in a later year. Again, the split must be done by the end of the year after the IRA owner’s death.
- The SECURE ACT has passed. Inherited IRAs are no longer stretched for the beneficiary’s life known as the “STRETCH.” This was replaced with a mandatory 10-year distribution rule where the entire IRA must be distributed within 10 years. Please see the linked SECURE Act Article view the attached webinar on alternatives to consider due to the elimination of the lifetime stretch IRA.
- Net Unrealized Appreciation or NUA. It may be beneficial to roll out low basis employer stock, pay tax on the original cost basis, and receive capital gains treatment on the appreciated gain when you sell your stock; however, don’t forget to complete this transaction before year-end by taking a lump-sum distribution. You keep the employer stock and roll over the rest to an IRA so you’re only taxed on the original cost basis this year. Failing to complete the transition (leaving no remaining funds in your employer plan) by year-end will result in disqualifying the NUA transaction.
- If you lived in a disaster area, pay attention to Tax Relief Acts from future natural disasters allowing you can access more of your IRAs without penalties. Here are some tips I wrote about related to Hurricane Harvey (but it may benefit you if you lived in another Federally Declared Disaster Area).
Personal Residence and other Real Estate Deductions:
- Under the new tax law, bunching itemized deductions doesn’t have the impact as it once did; however, it’s still a great strategy. If you bunch deductions together every other year, the better your overall tax bill we are over the same two-year period.
- Make your early January mortgage payment (i.e., payment due no later than January 15 of next year) in December so that you can deduct the accrued interest for the current year that is paid in the current year.
- Under the new law, the limit of your mortgage interest deduction for principal amounts of $1M has been reduced for new mortgages to $750K. Mortgages in effect prior to the new act are still grandfathered. If you are considering refinancing or taking on new mortgages, be sure to remember this new rule.
- Did you know that your RV, if mortgaged, may qualify for an interest deduction? Check with your tax professional to see if your RV qualifies because you can deduct up to two mortgages on your tax return.
- Under the new tax law, State and Local Taxes, also known as SALT taxes, are now limited to $10,000 max per tax year itemized. This change will affect taxpayers who once were able to itemize versus taking the new standard deduction amount.
- If you looking to sell your principal residence, you may qualify to exclude all or part of the capital gain from the sale on your federal income tax. If you meet the requirements, you can exclude up to $250,000 ($500,000 for married couples filing jointly). Generally, you can exclude the gain only if you used the home as your principal residence for at least two out of the five years preceding the sale. In addition, you can generally use this exemption only once every two years. However, even if you don’t meet these tests, you may still be able to qualify for a reduced exclusion if you meet the relevant conditions. Taxpayers must have lived at the residence to qualify. For example, just because you marry your spouse and they move in doesn’t mean they automatically are fully entitled to their $250,000 capital gain exclusion. More rules apply if you use the residence in a trade or business or as a rental prior to the sale. Speak to a tax professional before selling your home that has greatly increased in value since your purchase.
- Consider structuring the sale of investment property as an installment sale to defer gains to later years.
- If you are looking to sell real estate other than your primary home, consider the tax benefits of utilizing a 1031 Exchange to defer, and possibly eliminate, both the capital gains taxes and the recapture of any depreciation taken.
- Maximize the tax benefits you derive from your second home by modifying your personal use of the property in accordance with applicable tax guidelines.
Retirement Planning and Contributions:
- Make the maximum deductible contribution to your IRA or consider a Roth IRA if you are eligible. Even if you are not eligible for a Roth IRA, you may still be able to contribute through a “Back Door” ROTH IRA contribution by contributing to a nondeductible IRA and then converting it to a Roth IRA. For our best strategies on Roth IRA Conversions, see this article on Roth IRA conversion strategies post-2018 (due to the changes in the Tax Cuts and Jobs Act).
- Try to avoid premature IRA payouts to avoid the 10 percent early withdrawal penalty unless you meet an exception. Exceptions may include first time home buyers, higher education expenses, disability, or medical need. For more exceptions, visit with your tax advisor.
- Even if your spouse is not working, make the maximum deductible contribution to their IRA or ROTH, if eligible. If you meet all the requirements, you may be able to deduct annual contributions of $6,000 to your traditional IRA and $6,000 to your spouse’s IRA for 2020. If you’re at least age 50, make a catch contribution of $1,000 as well. Keep in mind, however, if you are covered by an employee plan, your Traditional IRA deduction may be limited depending on your income.
- Set up a retirement plan for yourself if you are a self-employed taxpayer such as a solo 401K, SEP IRA, or Simple IRA to contribute even more to your retirement.
- If your children work for your business or somewhere else, consider making IRA contributions on their behalf. Consider a Roth IRA over Traditional IRAs for your children as it may be more beneficial than a Traditional IRA because they will have a longer deferral period AND they won’t have RMDs later in life or distributions that are taxed. Make sure you coordinate this strategy with your estate gifting strategy as this will be considered a completed gift. If your children are at least 18 years old, and no longer your dependent or a full-time student, they may even qualify for the Savers Tax Credit worth up to $1,000.
- If possible, minimize the income tax on Social Security benefits by lowering your income below the applicable threshold.
- You can minimize the tax drag on your qualified plans by fully funding in January your contributions and waiting until the last possible moment to take any RMDs. This is a time-sensitive and tricky strategy, so be careful.
Charitable Planning and Donations:
- As previously stated, the tax deduction bunching strategy isn’t as impactful as it once was because of the SALT $10,000 limitation, Mortgage Interest Limitation, and elimination of Miscellaneous Itemized Deductions. However, the strategy does still benefit those who are charitably inclined or have large mortgages. Bunch all charitable donations (cash or even old clothes) into one year if you are able. Remember to keep all your receipts from the recipient charity.
- Higher-income taxpayers can pre-fund their charitable giving in one year to maximize their tax benefits. Use investment accounts like Donor Advised Funds to assist with the logistics of receiving larger charity contributions to be distributed to 501(c)(3)s at later dates.
- Give appreciated stock and property rather than cash when giving to charities. This may help you permanently eliminate income tax on the built-in gain of your stocks or property, while at the same time, maximizing your charitable deduction.
- Use a credit card to make contributions to ensure that they can be deducted in the current year.
- If you are over age 70 ½, you can also consider doing a Qualified Charitable Distribution (QCD) that will be a tax-free distribution from your IRA to a charity that will NOT hit your tax return (and possibly impact other deductions). For those that will no longer itemize given the new tax law changes, a QCD is an excellent tax-efficient way to give to charity.
- For a brief discussion on charitable giving, check out this link on Tax-Efficient Charitable Planning.
Miscellaneous Tax Matters:
- Take advantage of the adoption tax credit for any qualified adoption expenses you paid. In 2020, you may be able to claim up to $14,300 per eligible child. If the child has “special needs,” you may qualify for the full credit regardless of the amount of adoption expenses paid. The credit begins to phase out once your modified AGI exceeds $214,520 and it’s eliminated when your modified AGI reaches $254,520.
- Under the new law, itemized miscellaneous deductions have been eliminated. You can no longer deduct your tax prep fees or even your investment advisor fees. However, these fees may still be deductible as part of your business. Unreimbursed employee expenses are no longer allowed. Even casualty losses unless deemed a federal disaster may no longer be allowed. It’s much harder to itemize under the new law, but again, don’t forget to bunch deductions if you are able.
- Medical expenses are still deductible under the new law and you might maximize them by bunching such expenses in the same year, to the extent possible, to meet the threshold percentage of your AGI.
- The “bunching” strategy for itemized deductions still may benefit taxpayers. If you can double up on your itemized medical, charitable, SALT, investment interest, and mortgage interest expenses in a tax year, you may achieve a higher deduction than the new standard deduction amounts.
- Under the new law, Alimony will no longer be deductible for NEW divorces starting in 2019. Although the deduction will be allowed for older divorce decrees, some divorced taxpayers may find it worthwhile to change their decrees.
- Although you may hear politicians say that the individual mandate has been eliminated, however, it technically still exists in law and only the penalty has been reduced to ZERO starting in 2019.
- Consider investing in Qualified Opportunity Zones (QOZ). These QOZ’s (many times in funds) can provide tax deferral and a partial tax exclusion benefit when investors use their gains from earlier investment transactions and reinvest the gains into QOZ’s. These rules are complex and the funds from other gains need to be re-invested within 180 days of the prior transaction. When done properly, investors receive a 15% step-up in basis and thus exclude some of their prior gains after 7 years (only 10% after 5 years). When investing in QOZ’s, make sure to evaluate the investment on its own merits and not solely on the tax benefits. If invested by the end of 2019, you will receive the full 15% (10% + 5%) step up in basis under current law, and if held for 10 years or more, any gain on the new QOZ will be excluded from taxes. Alert: Congress is aware of the short timeframe on the opportunity zones. They are considering extensions to give investors more time to meet the 7-year requirement.
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