YES – tax season is upon us once again!
As we approach year-end, it’s time to think about steps you can take to help reduce your 2021 tax bill. In what appears to be the new normal, 2021 is shaping up to be a year with plenty of tax law changes. COVID-related disaster relief signed into law last December made several favorable (mostly temporary) changes to the 2021 rules. Then, in March, the American Rescue Plan Act, with another set of tax law changes, was enacted. We’ll highlight some of the planning opportunities these provide.
In addition to all the known changes impacting 2021, it looks like we may end the year with some other big (and probably not so favorable) tax law changes. As you undoubtably know, President Biden has proposed raising the ordinary income and capital gains tax rates on individuals. The ordinary income tax rate increase is proposed to take effect in 2022. We talk about the timing for the proposed increase in the capital gains rate later. A corporate tax rate hike has also been proposed for tax years beginning after 2021. Currently, the House is negotiating to come up with a bill based on the President’s proposals.
Even though we don’t know yet what, if anything, will become of President Biden’s proposals, there are still many things you might consider doing before year-end to minimize your 2021 tax bill. We’ll point out some strategies and things to consider in light of potentially higher tax rates in 2022. Clearly, uncertainty makes tax planning challenging, but putting it off until we know the fate of these proposals may leave you with too little time to make any moves before year end. It’s best to have a plan in case of a tax increase, so that you can pull the trigger if need be.
Year-end Planning Moves for Individuals
Make Your Plan for Possible Higher Income Tax Rates. Here’s what we know: President Biden, a Democrat, has proposed raising individual ordinary income and capital gains tax rates on individuals with income over certain thresholds. The Democrats have slim majorities in both the House of Representatives and the Senate. The rest, at this point, is speculation. Tax hikes could pass, but both the increased rates and the income thresholds at which they kick in may be different than the proposals—or nothing could change. But, we think it’s safe to say that any planning you do should consider the possibility, depending on political outcomes and your level of income, that you will be paying a higher rate of tax in 2022 than in 2021.
If you think that you will be in a higher tax bracket in 2022 than in 2021, the conventional wisdom of deferring income and accelerating deductions is flipped upside down. Instead, you generally should try to accelerate income into 2021 (where it will be taxed at the lower rate) and defer deductions until 2022, when they will generate a bigger tax benefit. Of course, whenever you accelerate income, you have to keep the time value of money in mind and realize that you are giving up some deferral to have the income taxed at a lower rate. We can help you determine whether the tax savings associated with accelerating income into 2021 to have it taxed at a lower rate exceeds the cost of giving up the tax deferral.
With those caveats in mind, some strategies for accelerating income and deferring deductions include:
- If you have a small business, get all your billings done and collect as much of them as you can before year-end. If possible, progress bill for work in process at year-end. If you are a cash-method taxpayer, wait until after year-end to pay your bills, to the extent possible.
- Gain on the sale of business or investment property is generally taxed at the long-term capital gain rate, provided you have held the property for more than a year. If you are thinking about selling such property, get the sale closed before year-end. If you will receive payments in 2021 and later years, you might consider electing out of the installment method, which, fortunately, doesn’t have to happen until you file your 2021 return, when the picture should be much clearer. Bear in mind, if you elect out of the installment method, your 2021 tax bill on the sale may be more than the payments you receive by the time the tax is due. So, you might need cash from another source to pay the tax.
- If you have or will have long-term capital gains in 2021, defer selling stocks or other investments that have declined in value until 2022. That way, you can use the loss in 2022 (or later) to offset capital gains that will potentially be taxed at a higher rate than in 2021. Be careful, though, that you don’t let taxes drive your entire decision. If you think an investment will continue to lose value, it might be best to sell it in 2021, regardless of the tax consequences. But, if you think most of the decline has already happened, you might want to wait until 2022 to sell some losers.
- Wait until 2022 to make charitable contributions, pay your real property taxes (to the extent possible) or to have elective medical procedures, dental work, routine physicals or to purchase glasses, contact lens, hearing aids, etc. Of course, don’t delay any medical procedure or purchase if that would be detrimental to your health.
At this point, we think the best advice is to wait and see what happens. In the meantime, give these ideas some thought. Look at your investment portfolio to identify winners and losers so that, if you want to trigger a gain or loss in a particular year, you’ll have an idea of which investments to sell. Of course, we will keep you informed of any developments on the proposed tax rate increases as soon as we know them.
Bunch Itemized Deductions to Maximize Their Worth. For 2021, the standard deduction amounts are $12,550 for singles and those who use Married Filing Separate (MFS) status, $25,100 for Married Filing Joint (MFJ) couples, and $18,800 for Heads of Household (HOH). If your total annual itemizable deductions for 2021 will be close to your standard deduction amount, consider bunching your expenditures so that they exceed the standard deduction in one year, and then use the standard deduction in the following year.
For example, assume your filing status is MFJ and your itemized deductions are fairly steady and around $25,000 per year. In that case, you would end up claiming the standard deduction each year. But, if you can bunch expenditures so that you have itemized deductions of $30,000 in 2021 and $20,000 in 2022, you could itemize in 2021 and get a $30,000 deduction versus a $25,100 standard deduction. In 2022 your itemized deductions would be below the standard deduction (which adjusted for inflation will be at least $25,100), so for that year, you would claim the standard deduction. If you manage to exceed the standard deduction every other year, you’ll be better off than if you just settle for the standard deduction each year.
Probably the easiest deductible expenses to bunch are charitable contributions. Note that even if you implement this strategy and decide to take the standard deduction in 2021 (and bunch itemized deductions in 2022), you can still take an “above the line” deduction for charitable contributions in 2021, up to $300 ($600 if MFJ).
Also, consider state and local income and property taxes. In many cases, property tax bills are sent out before year-end, but can be paid after year-end. Likewise, you can make your fourth quarter installment of state income tax (generally due in January) before year-end. Choosing the year in which you pay your state and local income and property taxes is another way to get the itemized deductions into the year you want them. Remember, barring any tax law changes, the maximum amount you can deduct for state and local taxes is $10,000 ($5,000 if MFS) per year. But that limit doesn’t apply to property taxes on property held for investment or in a trade or business.
You can also choose when you make your house payment that is due on January 1. Accelerating that will give you 13 months’ worth of interest in any given year. Remember that mortgage insurance premiums for eligible taxpayers also are deductible in 2021, but not in 2022.
Decide Whether Selling Investment Assets before Year-end Makes Sense. Regardless of whether you think you will be in a higher tax bracket in 2022, you should look at your investment portfolio and see if selling before year end could make tax sense. (This doesn’t apply to investments held in a retirement account or IRA, where the gains and losses are not currently taxed.)
To the extent you have capital losses that were recognized earlier this year or capital loss carryovers from pre-2021 years (or you have some capital losses you can trigger), selling winners before year-end will not result in any tax hit. Triggering short-term capital gains that can be sheltered with capital losses is a sweet deal because net short-term gains would otherwise be taxed at higher ordinary income tax rates.
If some of your investments have declined in value, you might want to bite the bullet and take the resulting capital losses this year. Those losses would shelter capital gains, including high-taxed short-term gains, from other 2021 sales. Even if you don’t have capital gains to shelter this year, selling some losers could make sense, especially if you think they will continue to decline in value. The result would be a net capital loss for the year, which can be used to shelter up to $3,000 of 2021 ordinary income from salaries, bonuses, self-employment income, interest income, royalties, and whatever else ($1,500 if you file MFS). Any excess net capital loss from this year is carried forward to next year and beyond.
In fact, having a capital loss carryover into 2022 could work to your advantage. The carryover can be used to shelter both short-term and long-term gains recognized next year and beyond. This can give you extra investing flexibility in those years because you won’t have to hold appreciated securities for over a year to get a preferential tax rate. And if your capital gains are subject to a higher tax rate in 2022, having a capital loss carryover into next year to shelter those gains could be a very good thing.
Take Advantage of Tax Credits Extended through 2021. Several credits for purchasing or installing energy efficient property were scheduled to expire after 2020 but have been extended through 2021 (2023 for residential energy efficient property). Credits are still available for: (1) energy-efficient home improvements, (2) residential energy efficient property (including solar energy equipment), (3) fuel-cell vehicles, (4) electric motorcycles, and (5) alternate fuel vehicle refueling equipment. If you’re thinking about purchasing any of these, let us know. We can help you determine whether your expenditure qualifies for a credit. If it does, and you purchase before year-end, you will effectively be letting Uncle Sam pay for a portion of your new energy-saving property.
Consider a Roth IRA Conversion. This may be the perfect time to make that Roth conversion you’ve been thinking about, especially if you think you will be in a higher tax bracket in 2022. Although you will pay tax as if the assets had been distributed from the traditional IRA, your future Roth IRA distributions can potentially be tax-free. And, unlike traditional IRAs, Roth IRAs don’t have minimum distribution requirements during the account owner’s lifetime.
Contribute to a Traditional IRA. Individuals over the age of 70½ who are still working in 2021 can contribute to a traditional IRA. However, if you’re over age 70½ and considering making a charitable donation directly from your IRA (known as a Qualified Charitable Distribution or QCD) in the future, making a deductible IRA contribution for years you are age 70½ or older will affect your ability to exclude future QCDs from your income. Please contact us for further explanations of QCDs and how they can be an effective way to give to charity and reduce your taxable income.