Year-End Tax Planning
With the end of the year rapidly approaching, it is important to have a plan to implement any strategic year-end tax planning that can still be accomplished. There are many strategies and elections that can not only help reduce current-year tax bills but can also help minimize future tax liabilities. The items listed below are some of the most effective tax planning strategies that can still be accomplished before the end of the year. For reference and convenience, the appendix to this Insight also includes charts containing the tax brackets and other important tax information for tax years 2021 and 2022, which you can find in the PDF version here.
Minimize Capital Gains
A timely review of a taxpayer’s portfolio can uncover hidden tax savings. Tax loss harvesting is the process of selling underperforming investments at a loss and using those capital losses to offset taxable capital gains elsewhere in the taxpayer’s portfolio. In a year when a taxpayer’s capital losses outweigh their gains, the IRS will allow the taxpayer to apply up to $3,000 in net capital losses against ordinary income. Any unused capital losses can be carried forward to be used in future tax years. On top of the tax benefits of loss harvesting, the strategy can also help rebalance a portfolio that is out of alignment.
Reinvesting capital gains into a qualified opportunity zone (QOZ) fund before the end of 2021 could also give taxpayers additional tax savings. Investing in a QOZ allows a taxpayer to defer the realization of capital gains in an amount equal to the QOZ investment until 2026. Additionally, if a taxpayer invests 2021 realized gains in a QOZ fund by the end of 2021 and holds the QOZ investment until the end of 2026, the taxpayer’s basis in the reinvested gain is increased by 10%, effectively excluding 10% of the initial 2021 realized gain from the taxpayer’s income. This additional tax incentive would be lost if 2021 capital gains are not invested in a QOZ fund by December 31, 2021.
Annual Exclusion Gifts
For tax year 2021, the IRS permits an individual to gift up to $15,000 ($30,000 for a married couple) to an unlimited number of individuals, without the donor having to use any of his or her $11,700,000 lifetime gift exemption or paying any gift tax.
A married couple that has a taxable estate could therefore save $12,0001 in federal estate taxes for every individual they gift $30,000 to each year. Electing to front load the funding of a 529 plan (up to $75,000 per donee or $150,000 per donee for a married couple), is another great way for taxpayers to reduce their taxable estates, without the donor having to use any of his/her lifetime gift exemption. On top of the gifted money no longer being included in the taxpayer’s estate, the appreciation on those gifted assets is also not subject to estate tax in the donor’s estate.
For tax year 2022, the annual exclusion amount will be increased to $16,000 per person ($32,000 for a married couple). As a result, married taxpayers could give $30,000 in December and another $32,000 in January to the same individual without any gift tax consequences.
Due to the increased standard deduction ($25,100 for married couples filing jointly in 2021) and the $10,000 cap on the state and local tax deduction, taxpayers may have to be more strategic with their charitable gifting to realize any tax benefit. Depending on a taxpayer’s “traditional” annual gifting and other circumstances, they may not gift enough in a given year to exceed the standard deduction. As a result, a taxpayer may get no tax benefit in that year for their charitable contributions.
As the end of the year approaches and taxpayers have a better idea of their income for the year and potentially future years, it may make sense for taxpayers to “bunch” and accelerate their charitable giving for this year, as opposed to sticking with their “traditional” yearly gifting pattern now and in the future. In addition, one special charitable gifting provision, the ability to deduct up to 100% of cash gifts directly to public charities, is scheduled to expire at the end of 20212.
An ideal recipient for accelerated charitable gifting is a donor-advised fund (DAF). If a taxpayer establishes a DAF, they can make a large donation to the DAF in the current year and receive the tax deduction in the current year, but the taxpayer is not forced to decide which individual charities he or she would like to benefit right away. Instead, the taxpayer can advise that the DAF make distributions to charities of his or her choosing over any number of years. Please note, however, that the 100% deductibility provision for tax year 2021 does not apply to cash gifts to DAFs.
Income Tax Surcharge Planning
President Biden’s Build Back Better Act proposes “Surcharge(s)” on high-income individual taxpayers and non-grantor trusts, that would begin in tax year 2022. The Surcharge(s) would apply to the extent a taxpayer’s modified adjusted gross income (MAGI) exceeds a certain threshold3. As a result, it may be advantageous for taxpayers to accelerate income, including capital gains, into 2021 to avoid the imposition of the Surcharge(s) in future years. It is notable that the Surcharge(s) would apply based on MAGI and not taxable income, as this means a taxpayer would not be able to avoid the additional tax through strategic planning with itemized deductions, such as charitable contributions.
Retirement Plan and IRA Year-End Checklist:
Required Minimum Distributions: If you are age 72 or older, you may be required to take distributions from your retirement accounts. These distributions are known as “required minimum distributions” (RMDs) and are applicable to all employer sponsored retirement plans, including 401(k) plans, Roth 401(k) plans, 403(b) plans, 457(b) plans and profit-sharing plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs and Simple IRAs. The RMD rules do not, however, apply to Roth IRAs while the owner is alive.
If a taxpayer is age 72 or older, he or she must take their RMD by December 31st of the current year or face substantial penalties. There is, however, an exception for taxpayers who turned age 72 in 2021. Such a taxpayer can delay taking their RMD until April 1, 2022, which can provide an opportunity for tax deferral if the taxpayer does not need the RMDs this year.
Qualified Charitable Distributions: Another strategic tax planning item with IRAs is a qualified charitable distribution (QCD). A QCD allows individuals to donate up to $100,000 annually to one or more charities directly from a taxable IRA, in lieu of all or a portion of their RMD (up to the $100,000 limit) being distributed to the individual. There are several tax advantages to a QCD. First, because the QCD goes directly to a charity, the amount of the QCD will not be included in and increase the taxpayer’s taxable income. This may help a taxpayer remain in a lower tax bracket and avoid phase-outs and special rules based on the adjusted gross income or taxable income of the taxpayer. Additionally, depending on their state of residence, a taxpayer might not receive a state income tax benefit for charitable contributions claimed as an itemized deduction but could benefit at the state level from excluding the RMD from income all together through a QCD.
The manner in which the QCD rules are drafted by the IRS provide another tax planning opportunity for taxpayers. The QCD rules allow individuals aged 70 ½ or older to make QCDs in a given year, up to 18 months before they are required to start taking RMDs. This window could allow individuals to make QCDs and lower the value of their IRAs, which could reduce the amount of their future RMDs.
President Biden’s Build Back Better Act proposes to prohibit Roth conversions of “after-tax” dollars held in retirement accounts (both IRAs and employer-sponsored retirement plans), beginning in 2022. While it is not certain to be passed, taxpayers who have “after-tax” dollars in their traditional retirement accounts should take a fresh look at whether they should convert them to a Roth before year-end, as the choice may soon be now or never.
The Build Back Better Act would also prohibit the Roth conversion of all dollars (not just “after-tax” dollars) for high-income taxpayers, beginning in 2032. If a taxpayer is considering a Roth conversion and may be subject to the Surcharge(s) discussed above in future years, it may be advantageous to complete the Roth conversion before the end of 2021.
Non-Grantor Trust Income Tax Planning
The income taxation of a non-grantor trust may provide another income tax planning opportunity. Non-grantor trusts reach the top tax bracket (including the imposition of the additional 3.8% net investment income tax) at a much lower threshold than individuals4. However, tax law provides that these trusts will generally receive a tax deduction equal to the amount of income that is distributed to the beneficiaries (“income distribution deduction”).
As a result, if the trust permits discretionary distributions of income to the beneficiaries, there may be an opportunity to minimize the overall tax liability of the trust and the beneficiaries by making distributions of income to the beneficiaries. Because a non-grantor trust’s MAGI (on which the Surcharge thresholds are based) is net of any income distribution deduction the trust is entitled to, this strategy may become even more advantageous if the Surcharge(s) discussed above are passed.
Of note, the IRS permits additional flexibility here by allowing a Trustee to elect to treat distributions made during the first 65 days of the current tax year as distributions made during the immediately preceding tax year5. For tax year 2021, a trustee will have until March 6, 2022, to decide to make distributions to beneficiaries that could be treated as distributions made during 2021 for tax purposes.
While the past several months have been filled with proposals to dramatically change the United States individual tax regime, in the end, it appears that 2021 year-end planning may remain relatively unchanged from the past. Of course, there could be nuance surrounding the proposed “Surcharges” and the proposed changes to the rules surrounding retirement accounts, as well as the opportunity for strategically timed QOZ investments. However, with the limited scope of the new Build Back Better bill, many conventional techniques remain relevant. If we’ve learned anything from the tumultuous environment of late, perhaps it is that planning early, for the right reasons, always smooths out the ride. With legislative volatility here to stay, we will do well to remember that lesson for many years to come.
As always, we encourage clients to reach out to their advisors to continue the discussion and determine if any of the strategies discussed in this piece are right for them.
- Assumes a 40% federal estate tax rate and assumes no further appreciation on the gifted amount.
- Resuming in 2022, charitable deductions for cash gifts will be capped at 60% of adjusted gross income.
- The Surcharge would be equal to 5% of the amount over $10MM of MAGI for single and married filing joint taxpayers and 5% of the amount over $200,000 of MAGI for non-grantor trusts. An additional 3% Surcharge would apply to the amount over $25MM of MAGI for single and married filing joint taxpayers and 3% of the amount over $500,000 of MAGI for non-grantor trusts.
- For tax year 2021, a non-grantor trust reaches the top 37% tax bracket at $13,050 of taxable income.
- The election is permitted under IRC Section 663(b).