Timing of Income
To the extent that you can smooth income and not jump into a higher bracket, you will pay less tax. Under the current tax rates and brackets, individuals will be in the 37% tax bracket when their income reaches $523,601 (single)/$628,301(joint).
There is an advantage to timing your income if you are:
- In a different tax bracket in 2021 than in 2022.
- Subject to the Alternative Minimum Tax (AMT) in 2021, but not in 2022.
- Subject to the 3.8% Net Investment Income tax in 2021, but not in 2022.
- Subject to the 0.9% Medicare Tax on earned income in 2021, but not in 2022.
- An individual that is at least 70½ years old and you want to make a qualified charitable donation from your IRA. Up to $100,000 of your required minimum distribution can be directed to the charity of your choice by instructing your IRA trustee to send money directly to this charity. This is a great planning opportunity if you are claiming the standard deduction.
- A beneficiary of a trust. If so, you should talk to your trustees to see if distributions could be made to minimize overall taxes. Trust rates are normally higher than individual rates.
When to Claim Your Deductions
Remember that prepaying certain itemized deductions might not lower your overall tax due to AMT or the deduction limitations set by the tax, but this can be a helpful strategy for reducing taxes. Please contact us to help you analyze the tax effects of prepaying tax-deductible items. The following expenses are commonly paid as part of year-end tax planning:
- Charitable contributions—Cash contributions to qualified charities can be deducted up to 100% of your adjusted gross income (AGI), a temporary increase by the CARES Act from 60%. When noncash gifts are made, the limit is based on 50% of your AGI. Gifts of appreciated property held over one year can be deducted up to 30% of your AGI (20% for gifts to private operating foundations). Avoid paying capital gains tax by gifting the securities, rather than gifting the sales proceeds. Also, consider using a donor advised fund to utilize a bunching strategy for making charitable contributions.
- Mortgage interest—Your ability to deduct prepaid interest is limited and the IRS is matching the information on the bank’s Form 1098-INT. Home loan interest is allowed for loans up to $1 million for pre-December 15, 2017 loans and after that date for loans up to $750,000.
- Medical expenses—Qualified unreimbursed medical expenses must exceed 7.5% of your AGI to be deductible.
Timing Your Capital Gain Recognition
Short-term capital gains are taxed at your ordinary income tax rate. If you hold a capital asset for more than one year, your capital gain is considered “long-term”. Depending on your tax bracket, long-term capital gain is taxed at 0%, 15%, or 20% (see table below):
|Capital Gains Rate||Single||Joint||Head of Household|
|0%||$0 – 40,400||$0 – 80,800||$0 – 54,100|
Remember: capital gains might be subject to an additional 3.8% net investment income tax if AGI is over $200,000 (single)/$250,000 (joint).
Capital losses, including worthless securities, will offset capital gains. If there is a net overall capital loss, only a $3,000 loss can be claimed per year ($1,500 if married filing separately) and the excess losses carry forward into the future. Be careful not to violate the “wash sale” rule by buying an asset nearly identical to the one you sold at a loss within 31 days before or after the sale. Otherwise, the wash sale rule will prevent you from claiming the loss immediately.
If you sell your principal residence before year end, up to $250,000 of your gain is exempt from tax under current law ($500,000 for joint filers). The IRS requires you to have used the property as your main home for at least two of the last five years to qualify for this treatment.
Contribute to a Retirement Plan to Save Taxes
You or your spouse must have earned income to contribute to a retirement plan. Generally, taxpayers with modified AGI below certain thresholds are permitted to contribute up to $6,000 to a Roth IRA for 2021. (Taxpayers aged 50 or older are allowed an additional $1,000 contribution.) These amounts begin to reduce for single filers and married couples filing jointly who reach modified AGI of $125,000 and $198,000, respectively.
Planning Point: If you would like to contribute to a Roth IRA, but your income exceeds the threshold, consider contributing to a traditional IRA for 2021 and then converting the IRA to a Roth IRA in 2022. Be aware, however, that current law prevents the taxpayer from “unwinding” this Roth conversion.
Self-employed individuals can have a Simplified Employee Pension (SEP) plan, contributing up to 25% of their net earnings from self-employment. The maximum contribution limit is $58,000. The self-employed may set up a SEP plan as late as the due date, including extensions. A 401(k) plan is another option for the self-employed. For 2021, a self-employed individual, as an employee, may defer up to $19,500 ($26,000 for age 50 or older) of annual compensation. Acting as the employer, the individual may contribute 25% of net profits, excluding the deferred $19,500, up to a maximum contribution of $58,000.
You may make only oneIRA rollover by beneficiary per year. This does not limit direct IRA rollovers from trustee to trustee, but only those distributions to the IRA beneficiary who, within 60 days, deposits it into an IRA account. Nor does this rule apply to conversions from traditional to Roth IRAs.
The first IRA distribution and rollover will be tax free, but any subsequent rollovers will be subject to regular tax. If the deposit exceeds the IRA contribution limits, it will be subject to a 6% annual excise tax until corrected.
Revisit Your Estate and Gift Planning Strategies
Taxpayers are permitted to make annual tax-free gifts of up to $15,000 per recipient ($30,000, if married) without filing a gift tax return. By making these gifts annually, taxpayers can transfer significant wealth out of their estate without using any of their lifetime exclusions.
Gifts can be made for more than $15,000. A gift tax return must be filed to track the amount of estate/gift lifetime exclusion used, which is currently $11.7 million per person ($23.4 million for married couples) for 2021. Washington State’s 2021 exemption is $2,193,000. Since the Federal Estate rules have changed, and because Washington State has its own set of estate rules, we recommend that you review your current estate documents.
Review Your Withholding/Estimated Tax Payments
Review your federal income tax withholding between now and the end of the year to avoid the penalty for underpaying your 2021 taxes. Underpayment penalties can be avoided by individuals if they timely pay the lesser of 90% of their current tax or 100% of their prior year tax liability. If your AGI exceeded $150,000 in 2020, then the safe harbor for 2021 tax payments is 110% of your total 2020 tax assuming your 2021 income is more than 2020.
Increasing your final estimated tax deposit due January 17, 2022, may reduce some of the penalty but is unlikely to eliminate it entirely. However, withholding payments, even if they are made on the last pay day of the tax year, are deemed as withheld ratably throughout the tax year. You can check your withholding using the IRS Withholding Tool and then updating your Form W-4 if needed. Both the tool and form can be found on the IRS website.