Follow these tax-smart principles as you plan your year-end expenses.
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With year-end rapidly approaching and the general election finally over, it’s time to consider moves that will lower your 2020 tax bill and hopefully position you for tax savings in future years too.
This column is Part Two of my list of suggested year-end strategies. In Part One, we addressed the remaining post-election uncertainties and why they matter for individual taxpayers. We also covered proposed changes for individuals in the pre-election Biden tax plan and my take on the outlook for them. In this column, we cover the rest of the year-end tax planning story. Here goes.
If you’re charitably inclined: sell loser shares and give away the resulting cash; give away winner shares
If you want to make gifts to some favorite charities or loved ones, they can be made in conjunction with an overall revamping of your taxable account stock and equity mutual fund portfolios. Make gifts according to the following tax-smart principles.
Gifts to charities
Don’t give away loser shares (currently worth less than what you paid for them). Instead, sell the shares and book the resulting tax-saving capital loss. Then you can give the cash sales proceeds to favored charities.
Sell loser shares and collect the resulting tax-saving capital losses. Then give the cash sales proceeds to favored charities and claim the resulting tax-saving charitable write-offs (assuming you itemize deductions). Following this strategy delivers a double tax benefit: tax-saving capital losses plus tax-saving charitable deductions.
On the other hand, you should donate winner shares instead of giving away cash. Why? Because donations of publicly traded shares that you have owned for over a year result in charitable deductions equal to the full current market value of the shares at the time of the gift (assuming you itemize).
Plus, when you donate winner shares, you escape any capital gains taxes on those shares. So, this idea is double tax-saver: you avoid capital gains taxes, and you get a tax-saving charitable deduction (assuming you itemize). Meanwhile, the tax-exempt charitable organization can sell the donated shares without owing anything to Uncle Sam.
Gifts to individuals
The principles for tax-smart gifts to charities also apply to gifts to relatives and other loved ones.
Give away winner shares. Most likely, the gift recipient will pay a lower tax rate than you would pay if you sold the same shares.
Sell loser shares and collect the resulting tax-saving capital losses. Then give the cash sales proceeds to loved ones.
Make charitable donations from your IRA
IRA owners and beneficiaries who have reached age 70½ are permitted to make cash donations totaling up to $100,000 to IRS-approved public charities directly out of their IRAs. These so-called qualified charitable distributions, or QCDs, are federal-income-tax-free to you, but you get no itemized charitable write-off on your Form 1040. That’s okay, because the tax-free treatment of QCDs equates to an immediate 100% federal income tax deduction without having to worry about restrictions that can delay itemized charitable write-offs.
QCDs have other tax advantages too. Contact your tax adviser if you want to hear about them. If you’re interested in taking advantage of the QCD strategy for 2020, you will need to arrange with your IRA trustee for money to be paid out to one or more qualifying charities before yearend.
Consider a Roth IRA conversion
The best scenario for converting a traditional IRA into a Roth account is when you expect to be in the same or higher tax bracket during retirement. However, there is a current tax cost for converting, because a conversion is treated as a taxable liquidation of your traditional IRA followed by a non-deductible contribution to the new Roth account. If you don’t convert until next year or later, the tax cost could be higher, depending on political developments.
After the conversion, all the income and gains that accumulate in the Roth account, and all withdrawals, will be federal-income-tax-free — assuming they are qualified withdrawals. In general, qualified withdrawals are those taken after: (1) you have had at least one Roth account open for more than five years and (2) you have reached age 59½, become disabled, or died. With qualified withdrawals, you (or your heirs if you pass on) avoid having to pay higher tax rates that might otherwise apply in future years. While the current tax hit from a Roth conversion is unwelcome, it could be a relatively small price to pay for future tax savings.
Prepay college bills
If your 2020 AGI allows you to qualify for the American Opportunity college credit (maximum of $2,500 per eligible student) or the Lifetime Learning higher education credit (maximum of $2,000 per family), consider prepaying college tuition bills that are not due until early 2021 if that would result in a bigger credit on this year’s Form 1040. Specifically, you can claim a 2020 credit based on prepaying tuition for academic periods that begin in January through March of next year.
- The American Opportunity credit is phased out (reduced or completely eliminated) if your modified adjusted gross income (MAGI) is too high. The phase-out range for unmarried individuals is between MAGI of $80,000 and $90,000. The range for married joint filers is between MAGI of $160,000 and $180,000. MAGI means “regular” AGI, from your Form 1040, increased by certain tax-exempt income from outside the U.S. which you probably don’t have.
Like the American Opportunity credit, the Lifetime Learning credit is also phased out if your MAGI is too high. However, the Lifetime Learning credit phase-out ranges are much lower, which means they are much more likely to affect you. The 2020 phase-out range for unmarried individuals is between MAGI of $59,000 and $69,000. The range for married joint filers is between MAGI of $118,000 and $138,000.
If your MAGI is too high to be eligible for the Lifetime Learning credit, you might still qualify to deduct up to $2,000 or $4,000 of college tuition costs. If so, consider prepaying tuition bills that are not due until early 2021 if that would result in a bigger deduction on this year’s Form 1040. As with the credits, your 2020 deduction can be based on prepaying tuition for academic periods that begin in the first three months of 2021.
Defer income into next year — if you dare
It may also pay to defer some taxable income from this year into next year if you believe you will be in the same or lower tax bracket in 2021. For example, if you’re in business for yourself and a cash-method taxpayer, you can postpone taxable income by waiting until late in the year to send out some client invoices. That way, you won’t receive payment for them until early 2021. You can also defer taxable income by accelerating some deductible business expenditures into this year.
Both moves will postpone taxable income from this year until next year when you believe it could be taxed at lower rates. Deferring income can also be helpful if you’re affected by unfavorable phase-out rules that reduce or eliminate various tax breaks (the child tax credit, the two higher-education tax credits, and so on).
The last word
Because we are talking about 2020, nothing is completely certain, including year-end tax planning advice. But I think what we say here and in my earlier column constitutes good stuff, based on what we know now. Fingers crossed!
