2020 Year-End Tax Planning

2020 Year-End Tax Planning: Walking into the Great Abyss?

2020 is likely turning out to be a year we will never forget. Even though we might wish to forget it, our clients still need us to help them plan for the (hopefully) inevitable tomorrow.

With that in mind, let’s consider some year-end planning ideas or thoughts as to what may lie ahead for our clients:

1. Are income taxes going to be higher in the future? Regardless of your political persuasion, at some point, our country will have to come to grips with crippling debt, unfunded pensions, a looming social security funding crisis, and state budget defaults. These issues make the likelihood for future higher taxes a near certainty. While most of the tax professional community has nearly always sought ways to defer paying taxes until a later time (myself included), is it time now to consider:
   1. Accelerating income into 2020?
   2. Cashing out and paying tax on deferred compensation arrangements now?
   3. Exercise stock options before year-end?
   4. Generating capital gains sooner than anticipated?
   5. Converting traditional IRA accounts into ROTH IRAs?
2. Will future administrations make passing wealth to heirs more expensive? The 2020 unified gift and estate tax exemption is $11,580,000. This increase was made under the Tax Cuts and Jobs Act (TCJA). The change is scheduled to “ratchet” back to the pre-TCJA level of $5 million in 2026, adjusted for inflation. In addition, the law provides for step-up (or step down) of inherited assets to the fair market value as of the date of death of the property owner, assuming the assets are part of the decedent’s gross estate.
   1. Might clients consider maximizing the exemption by making taxable gifts now (current value of more than $15,000)? The IRS told us back in November 2019 with the issuance of IR-2019-189 that if future unified credit amounts are reduced, there will be no “clawback” for taxable gifts made during the higher credit years under TCJA. We may have a window with the sizeable unified credit to remove assets from taxpayer’s estates before the credit is potentially reduced.
   2. How about establishing marital trusts or grantor retained annuity trusts while the credit is still high? Establishing certain types of trusts may still provide the grantor access to the assets contributed while using the high unified credit amounts to avoid paying tax currently on taxable gifts.
   3. Should complex trust arrangements make distributions to lower tax rate beneficiaries?  In a complex trust, distributions are at the discretion of the trustee.  Trusts reach the maximum tax rate of 37% at $12,950 of taxable income in 2020. Assuming the trust document’s terms are not violated, trustees might consider taxable income distributions to lower income beneficiaries rather than having the trust pay the tax.  Trusts are not always established with a goal of minimizing income tax, nor should they be in the opinion of this author.
   4. Be prudent when advising clients to transfer assets to their young children. The “kiddie tax,” as it is called, was changed under TCJA to mirror trusts and estate tax rates. That was recently changed and reverted to the pre-TCJA rules of the child’s unearned income being taxed at the parent’s highest tax rate. Therefore, the strategy of shifting income-producing assets from the parents to young children (under age 18 or under age 23 and a full-time student) may end up just being a circle back exercise and not save any tax.
3. In the first discussion point listed above, I noted the possibility of generating capital gains earlier than later. With proper planning and some calculations, we could see scenarios where long-term capital gains may result in your client not owing any tax at all. For example, a single person has a 0% long-term capital gain rate on income (including the capital gain recognized) up to $40K; married couples have that same 0% rate on income up to $80K. Above those amounts, the long-term capital gain rate is currently capped at 15% up to $441,450 for single taxpayers and $496,600 for married couples. However, I want to caution you that while it might make sense to “harvest” long-term capital gains now in the event these rates increase later, you need to examine the taxpayer’s entire tax picture. For example, while the capital gain may be at 0%, the additional income being reported may cause up to 85% of social security benefits to be includable as ordinary income, which might defeat the client’s goal in the first place.
4. Here’s a tough decision: fund traditional IRAs and 401(k) accounts or consider ROTH options instead. If I were to have been asked this question 20 years ago, I would have answered quickly by stating that a taxpayer should never give up a tax deduction for a federal government promise. During my entire adult life, the concept has always been to defer paying taxes until later in life when you are making less money, and therefore taxes will be lower. What’s the reality? Retirees are making as much or more than they were during their working years, and it’s almost a sure bet that income tax rates must increase. The tough question to answer is when. Without stepping into the arena of a financial advisor, my advice is to have a mix of pre-tax and post-tax investments. That way, when retirement comes, your client has options to go to, which may not all be fully taxable at the time withdrawn. Regardless of the tax savings, money needs to be put aside for their ultimate retirement date. Not many people are able to work right up to the day they die. Save money for the future; don’t let the tax result drive the saving decision.
5. How about charitable contributions for 2020? Should taxpayers do more in 2020 than in the future?  Both the SECURE and CARES Acts provide for taxpayers to make cash contributions of up to 100% of their taxable income. The SECURE Act provisions are more limited as to the charities being involved in disaster area relief efforts, but no such limitation exists under the CARES Act. TCJA increased the annual limitation of taxable income to 60%, so the CARES Act 100% provision may be short-lived. Taxpayers who make annual contributions to their favorite charity may consider making multiple year contributions now because of the 100% provision. If the taxpayer can get past the higher standard deductions created by TCJA, this deduction window may be worth advising your client to consider.  Think about a client who might be making a multi-year pledge to their church for a building project. 2020 might be the year to accelerate the pledge and reap a tax benefit.
6. Convert Traditional IRA to ROTH? In the opening part of our discussion, I mentioned this idea as the fifth bullet point. 2020 was indeed a challenging year. Is it possible your taxpayer has had one of their lowest-income years ever? Could they even have sustained a net operating loss in 2020? I’m willing to bet many restaurant and bar owners may have. With that net operating loss potential, could a conversion from a traditional IRA to ROTH result in $0 tax for the client?

Run the numbers, my friends, in darkness may be the light of opportunity.

by Tom O’Saben, EA