The past year has been challenging to say the least. Hopefully the COVID-19 crisis, which affected all of us in some ways, is nearing the end. While it has been difficult to focus attention on much other than the health and safety of our loved ones, tax planning can’t take a back seat forever. In addition to normal midyear planning ideas, legislation enacted by both the current and former administrations may provide opportunities to save a little tax and maybe keep a little more money in your pocket. President Biden has released a plan that, if enacted, would result in higher tax rates for both individual and corporate taxpayers. Time will tell, but there is certainly a possibility that that the rates in effect today could increase in the near future. At this time, it’s too soon to say what the new rates will be or when they will be effective, if at all. As always, I am monitoring these developments and will alert you as soon as new legislation is signed into law. For now, it’s a good time to get a handle on what your 2021 income might look like, so that, if legislation is passed, I will be able to project how it affects you.
Here are some ideas to think about over the summer.
Consider Adjusting Your Tax Withholding or Estimated Payments
No taxpayer likes to be surprised with a large tax bill (or a smaller-than-anticipated refund) come tax filing season. In many cases, this occurs because individuals didn’t adjust their tax withholding or estimated payments to account for changes in income. For those accustomed to receiving refunds every year, an unexpected tax bill can be a real hardship. Fortunately, there’s still time to make sure the right amount of federal income tax is being withheld from your paycheck for 2021.
IRS Form W-4 is used to tell your employer how much tax to withhold from each paycheck. Many taxpayers simply don’t have the correct amount of tax withheld. The IRS has a tool to assist taxpayers in completing Form W-4. If you haven’t reviewed your withholding recently, you should consider using the IRS’s “Tax Withholding Estimator,” available at www.irs.gov/individuals/tax-withholding-estimator. You will need your most recent pay stubs (for both spouses if married filing a joint return), details of other sources of income, and a copy of your most recent tax return. However, keep in mind that the calculator isn’t perfect. If you want more precise results, we would be happy to put together a 2021 tax projection for you.
If you make estimated tax payments throughout the year (if you’re self-employed, for example), we can take a closer look at your tax situation for 2021 to make sure you’re not underpaying or overpaying.
Take Advantage of Lower Tax Rates on Investment Income
Income from an investment held for more than one year is generally taxed at preferential capital gains rates. Those rates are 0%, 15%, and 20% for most investments. (Higher-income individuals may be subject to an additional 3.8% net investment income tax.) The rate that applies is determined by your taxable income. For example, the 0% rate applies if your 2021 taxable income doesn’t exceed $80,800 (for joint filers), $54,100 (for heads of household), or $40,400 (for other individuals). The 20% rate doesn’t kick in until your taxable income exceeds $501,600 (for joint filers), $473,750 (for heads of household), $250,800 (for married filing separate), or $445,850 (for other individuals).
If your taxable income hovers around these threshold amounts, there are ways to reduce your income to take advantage of a lower capital gains rate. For example, you could make deductible IRA contributions or reduce taxable wages by deferring bonuses or contributing to employer retirement plans. If you’re over the age of 70½, making contributions to a qualified charity with a direct distribution from your IRA also is a good way to lower income. If you own a business and use the cash method of accounting, you can wait until the end of the year to send out some client invoices. That way, you won’t receive payments until early 2022. Also, you can postpone taxable income by accelerating some deductible expenses this year. If possible, you should get your income low enough to qualify for the 0% rate. But, if you are subject to a higher tax rate next year, strategies that defer tax, like delaying billing, can push income into a higher bracket. Hopefully, we will know more before year-end.
If your income is too high to benefit from the 0% rate, consider gifting investments (like appreciated stock or mutual fund shares) to children, grandchildren, or other loved ones. If these individuals will be in the 0% or 15% capital gains tax bracket when they later sell the investments, any gain will be taxed at the lower rates, as long as you and your loved one owned the investments for more than one year. This strategy has two risks, however. First, there are gift tax consequences if you transfer assets worth over $15,000 during 2021 to a single recipient. Second, all children under age 18 and most children age 18 or age 19–23 who are full- time students are subject to the Kiddie Tax rules. Kiddie Tax rates are tied to the parent’s tax bracket. The Kiddie Tax limits the opportunity for parents to take advantage of the 0% capital gain rate by gifting appreciated property to their children, including college age children.