Year-End Tax Planning Strategies for 2020
COVID-19 seems like it has upended the universe. Halloween has been reimagined, Thanksgiving is a Zoom call for many this year, and Christmas presents might now come in an Amazon cardboard box. But you can count on one thing, and that’s taxes. So, while you’re waiting for the UPS truck, take a moment to consider the following year-end tax planning strategies before December 31, 2020.
Roth Conversions
This year could prove a most opportune time to convert a portion of your traditional IRA to a Roth IRA. Unlike a traditional IRA, a Roth IRA is funded with money that has already been taxed. You don’t get a tax deduction on your income tax return for contributions, but funds are allowed to grow tax-free. Withdrawals are also tax-free if you are 59½ or older and have satisfied the five-year holding period.
The Tax Cuts and Jobs Act that went into effect January 1, 2018, reduced the highest bracket marginal income tax rate for individuals from 39.6% to 37%. But that’s only until 2025, when rates go back to pre-2018 levels. And considering that the $2 trillion CARES Act pushed the deficit even higher, taxes may climb as soon as next year.
So, 2020 might just be the year of the Roth. Consider taking advantage of the lower rates today because you may not have the opportunity next year—but you must have a game plan. Converting a Roth could push you into a higher tax bracket, and you need to have enough money to pay the taxes due on a Roth conversion come April 15.
If you have questions about whether a Roth conversion is right for you, consider talking with a fiduciary financial advisor who will advise you on your overall financial situation and goals.
Top Off Your Retirement Accounts
If you are financially able, consider contributing the maximum to retirement accounts such as your 401(k) or traditional IRA. Not only will you be saving toward your future, you can help get a tax break on your 2020 return.
For 2020, you can help reduce your taxable income by contributing up to $19,500 to a 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan. If you are 50 or older, you can contribute an additional $6,500. You have until December 31, 2020, to contribute.
For an IRA, you can contribute up to $6,000, plus the $1,000 catchup contribution if you are 50 or older. With an IRA, you have longer to max out your contributions—until April 15, 2021. Make sure you understand how IRA income phase-out rules will affect your potential tax deduction, and make sure you specify that the contribution is for 2020.
Stimulus Checks and Unemployment
The IRS issued over 150 million stimulus payments to Americans, and over 20.5 million have filed for unemployment. How will this affect your tax return come April 2021? Good news for Californians, unemployment compensation is exempt from state taxes—but it is subject to federal taxes.
You do not have to pay taxes on your stimulus check. It is considered a refundable tax credit. The stimulus payment is an advance on a refundable 2020 tax credit that the government created but is already distributed. The recovery rebate will be applied to your 2020 tax return but was already paid out in the stimulus check.
Charitable Giving
Because the Tax Cuts and Jobs Act increased the standard deductions, it reduced the number of itemizers. Thus charitable contributions were less of a factor in tax returns. But the CARES Act allows for a $300 deduction ($600 filing jointly) on top of the standard deduction. If you itemize, you can deduct up to 100% of your adjusted gross income (AGI)—up 40% from last year’s 60% of AGI.
Qualified charitable distributions (QCDs) are a tax-saving technique for those taking required minimum distributions (RMDs). As a retiree age 70 ½ or older, you can make gifts up to $100,000 per year directly from the IRA custodian to a qualified charity—a gift that counts toward your RMD.
Donor-advised funds and private foundations do not qualify, and you must donate through your IRA custodian to be considered a QCD.
This technique is useful in a few ways: It lowers your AGI, you won’t have to pay income tax on the distribution, and it reduces your RMD for next year by decreasing your tax-deferred IRA balances. However, be aware that the CARES Act waived the RMD requirement for 2020.
HSAs and FSAs
If you are nearing retirement, then a health savings account (HSA) is the Triple Crown. Your contributions are tax-free, your investment earnings are tax-free, and your distributions are tax-free.
While you are still working, your employer may offer an HSA as a benefit if they have a high-deductible health insurance plan. HSAs are a way to save pre-tax money for medical costs, and there is no use-it-or-lose-it clause, as a flexible savings account (FSA) has. You can also open an HSA on your own as long as you are covered by a high-deductible health plan.
An HSA is an excellent and underutilized way to save for medical expenses in your retirement plan. If you are 65 or older, you can use the money for nonmedical expenses, but withdrawals will be taxed as ordinary income.
If it’s open enrollment at your company, then consider opening an HSA now, even if you aren’t close to retirement. The limits for a single person in 2021 are $3,600 and $7,200 for those filing jointly.
If you have an FSA, you may be able to carry over up to $550 of your 2020 balance into 2021—check with your Human Resources department or FSA documentation. Also check to determine if there is a grace period for spending the balance (usually up to 2 1/ months).
If you need to spend down your health care FSA, consider your potential medical needs, such as:
A dental procedure you’ve been putting off
An eye exam and new contact lenses
Refills on your prescription drugs
Estate Planning
This year has been challenging for many people, and you may be in a position to help your loved ones through cash or other gifts. Your gifts to family members won’t help your 2020 tax return, and there are some important tax considerations to consider:
The Tax Cuts and Jobs Act doubled the number of assets exempt from estate taxes. The estate and gift tax exemption is $11.58 million per person in 2020 and $11.7 million in 2021. However, the exemption amount could be lowered (either by expiration in 2025 or sooner via presidential election results)—in 2017, the exemption was just $5.5 million.
The IRS has indicated that even if the exemption is lowered, gifts made over that amount before the exemption is changed will be protected. Talk to a financial advisor or CPA to determine whether you should take advantage of the current exemption in light of your financial situation, long-term goals, and potential changing regulations.
Don’t forget the annual gift tax exclusion as well. This year you can give up to a $15,000 gift ($30,000 filing jointly) in cash or assets to family and friends. (Be mindful that if you go over the limits, you can end up owing taxes.)
You can also pay an unlimited amount of tuition and medical expense if the money is paid directly to the provider. This is on top of the gift exclusion.
Don’t Leave Yourself Scrambling
Get organized before December 31 because you don’t want to scramble on the last day of the year to do a Roth conversion or give a charitable donation or a gift to your family or friends. Our Roseville, California financial planning firm can help you facilitate these year-end strategies and work with your tax professional to get it done to give you the most tax savings for 2020.
Schedule a complimentary, 15-minute call with a fee-only, fiduciary financial advisor today to discuss your personal situation.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.
Parkshore Wealth Management is a family-owned, independent, fee-only Registered Investment Advisor serving the greater Sacramento area with an office in Roseville, CA. We partner with financially responsible individuals and families who are eager to take positive steps that will allow them to use their money to build the life they desire. The firm is led by Harold Anderson, CFP®, and Daniel Andersen, CFP®, both members of NAPFA, the country's leading professional association of fee-only financial advisors.