As the end of the year approaches, it’s time to consider ways to save money on your 2020 taxes. Year-end planning can seem like a daunting task, especially considering the recent events of this challenging year. To help minimize the financial burden brought on by the 2020 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed by Congress and signed into law by President Donald Trump in March of this year. The CARES Act has provided important tax changes designed to deliver prompt relief to individuals struggling due to the COVID-19 pandemic. Specifically, charitable contributions limits increased for 2020, the 10% early withdrawal penalty from retirement accounts has been removed if the withdrawal is coronavirus-related, and required minimum distributions (RMDs) have been waived.
We want to ensure that you are taking the appropriate actions in order to fully maximize the benefits associated with the newly introduced CARES Act and the previously passed Tax Cuts and Jobs Act (TCJA). In this year-end planning article, we discuss several strategies that should be addressed prior to 2021.
The CARES Act created two temporary changes to the tax treatment of donations. One is to incentivize those who itemize their deductions, and the other is targeted primarily to those who take the standard deduction.
Raising the Charitable Donation Cap
Individuals who itemize their deductions in 2020 can now deduct their charitable cash contributions up to 100 percent of adjusted gross income (increased from 60 percent). The substantial change in the tax treatment of donations theoretically means that individuals could have zero taxable income if they chose to make a large enough donation. For example, if John has an AGI of $200,000, he can now deduct up to his full AGI of $200,000 if he gives that much to charity in 2020. Please note that donations to a Donor Advised Fund and Private Foundations are excluded from the deductibility cap.
Universal Deduction for Donations Up to $300
For individuals who do not itemize their deductions, the CARES Act will allow an above-the-line deduction of up to $300 for charitable contributions, even though the standard deduction was taken. Married filing jointly taxpayers will get a deduction of up to $600.
Waiver of Required Minimum Distributions & Qualified Charitable Distributions
Traditionally, if you are a taxpayer who has reached the age of 72 or older, you will be required to begin taking distributions from your Traditional IRA. However, the CARES Act signed this year waives the Required Minimum Distributions (RMD) rules for certain defined contribution plans and IRAs during 2020.
For those taxpayers participating in a defined benefit plan (pensions) or other plans where the CARES Act waiver does not apply, these distributions are considered ordinary income and are taxed at your applicable federal income tax rate. There is an alternative to exclude these distributions from ordinary income. In order to accomplish this, you can make a direct donation from your IRA to a charitable organization up to $100,000 per tax year. The donation must be made to a charitable organization other than a private foundation or donor advised fund, and the charitable organization must provide an acknowledgement letter stating the value received and that no goods or services were provided in return. One of the benefits of the direct charitable donation from your IRA is that the distribution counts towards your Required Minimum Distribution and by being excluded from your ordinary income, it reduces your Adjusted Gross Income (AGI). This direct contribution from your IRA to the charity is not tax-deductible since you already excluded the distribution from income.
Because the CARES Act raised the charitable giving cap on cash contributions for 2020, there is an opportunity for individuals in the maximum tax bracket to take a lump sum IRA distribution and contribute directly to a qualified public charity. For 2020, a taxpayer intending to make a QCD in excess of $100,000 may realize a benefit by capping the QCD at $100,000 and, for the remaining amount, taking an IRA distribution and using it to make a 100% deductible charitable contribution. While the QCD exclusion is limited to $100,000, there is no similar limitation on the itemized deduction for eligible charitable contributions for 2020. If you are not itemizing deductions but taking distributions, a QCD will result in the best tax benefit.
Waiver of Early-Withdrawal 10% Penalty from Retirement Account
Under the CARES Act, the 10% penalty on an early withdrawal from a retirement account is waived for up to $100,000 of distributions for coronavirus-related purposes made on or after Jan. 1, 2020. A distribution is coronavirus-related if made to an individual:
- Who is diagnosed with COVID-19 by a test approved by the Centers for Disease Control and Prevention;
- Whose spouse or dependent is diagnosed with COVID-19; or
- Who experiences adverse financial consequences because of being quarantined, being furloughed or laid off, having work hours reduced, or being unable to work due to lack of child care or the closing or reducing hours of a business the individual owns or operates.
A taxpayer who takes a coronavirus-related distribution can either report the distribution as ordinary income ratably over a three-year period beginning in 2020 or can recontribute the funds to a retirement plan within three years to avoid tax on the withdrawal altogether.
Converting Traditional IRAs into Roth Accounts
While the stock market has had a blended return and provided that we are experiencing some of the lowest federal tax rates in history, this might be an ideal time to consider taking advantage of a ROTH conversion strategy. Converting your Traditional IRA into a ROTH IRA is a simple, tax-efficient strategy that can reduce your tax burden upon retirement. The idea is to pay taxes on your contributions now, while in a lower tax-bracket, to avoid a higher tax burden later. ROTH IRAs are ideal for taxpayers who believe they will be in a higher tax bracket with less disposable income to pay taxes upon retirement. The current tax hit from a conversion completed this year may turn out to be a relatively small price to pay for avoiding potentially higher future tax rates on the account’s earnings.
Unlike Traditional IRAs, ROTH IRAs include two tax advantages:
- Qualified ROTH IRA withdrawals are federal income tax-free, and
- Required Minimum Distributions (RMDs) are not required after reaching age 72.
As always, consult your tax advisor when converting to avoid common pitfalls such as paying early withdrawal penalties, paying unnecessary taxes on your social security benefits, or being shifted into a higher tax bracket. The maximum benefit is achieved if the income tax on the conversion is paid with other available funds, rather than from the IRA.
Tax-Loss harvesting is an effective planning strategy to be considered by individuals who own taxable investment accounts. Taking this proactive approach is beneficial as it allows for the offsetting of large capital gains realized in 2020. This strategy will benefit you by reducing income taxes and allowing your investments to grow at a faster rate by eliminating any potential earnings withdrawals required to pay income taxes.
Although it may seem that losses reap no direct financial benefits, they allow the reduction or prevention of capital gains related income taxes. Tax-loss harvesting can involve both short-term (held one year or less) and long-term (held longer than one year) investments. It is important that your broker and CPA work together to implement this strategy.
Looking ahead, no matter your political affiliation, the potential changing of the guard could result in increased taxes to higher net worth individuals. Harvesting losses could save you a marginal amount in taxes now but could potentially yield much larger savings in years to come.
2020 Long-Term Capital Gains and Qualified Dividend Rates
|Single||$0 – $40,000||$40,001 – $441,450||over $441,450|
|Married Filing Jointly||$0 – $80,000||$80,001 – $496,600||over $496,600|
|Head of Household||$0 – $53,600||$53,601 – $469,050||over $469,050|
Health Savings Accounts
If you have a Health Savings Account (HSA), be sure to maximize your contributions for the year. Contribution limits for 2020 are $3,550 for an individual, $7,100 for a family, and an additional $1,000 for those 55 or older. You must have a high deductible health insurance plan to contribute to an HSA. Contributing to your HSA qualifies you to take an “above the line deduction” for your health care costs without having to incur medical expenses in excess of the AGI threshold. Any contributions you make to the HSA will remain in your account, and any unused funds roll over to the following year.
An HSA is one of the most desirable tax vehicles available for taxpayers, as it provides more than just the deduction for your contributions. Most HSA accounts offer the flexibility to invest the funds in your account while they are not being used. Over time, these investments will have tax free growth, and once the funds are needed for medical expenses, the withdrawals are tax free.
Gift Tax Exclusion
For 2020, the lifetime exemption was raised to $11.58 million per person. The 2020 annual exclusion allows you to give up to $15,000 each to an unlimited number of recipients without counting against your lifetime exemption. An important point to remember is that federal gift tax applies only to the person making the gift, not the gift recipients.
Utilizing a 529 Plan for Estate Planning
Traditionally, 529 college savings plans have been popular savings methods for post-secondary education. However, the TCJA expanded the 529 savings plan to include expenses for private, public, and religious education from Kindergarten through 12th grade. Contributions to these plans are considered gifts for gift tax purposes, which means they qualify for the $15,000 annual gift exclusion. You can also elect to treat a 529 plan contribution of $75,000 as if it were made over a five calendar-year period and completely avoid gift tax. As a result, these plans are often used as estate planning tools – allowing parents and grandparents to shelter assets from estate taxes – in addition to creating an education-savings fund. Note that if you contribute more than $15,000 per donee per year, you must file a gift tax return to elect to spread the gift over the five years.
Similar to HSA plans, invested funds in a 529 plan will have tax free growth, and once funds are needed for educational expenses, the withdrawals are tax free.
Changes Important to Year-End Planning
It is imperative to notify your tax advisor if any life changing events have occurred in 2020 that may impact your taxes. Below are just a few examples:
- Change in filing status: marriage, divorce, death, or head of household status
- Birth of a child
- Known large capital gains
- Changes in medical expenses
- Employment changes
- Large inheritance
- Large income events in 2020 or upcoming
As opportunities are still available with the CARES Act and TCJA, now is the time to capitalize. Careful planning with your tax advisors at LBMC can help you make the most of the 2020 tax year and beyond.