It's time to implement strategies to help reduce your 2020 federal income tax bill and position yourself for future tax savings. Here are some ideas to consider before year-end.
Gaming the Standard Deduction
The Tax Cuts and Jobs Act (TCJA) almost doubled the standard deduction amounts. For 2020, the standard deduction allowances are:
- $12,400 for single people and married couples who file separate returns,
- $18,650 for people who use the head-of-household filing status, and
- $24,800 for married couples who file joint tax returns.
If your total itemizable deductions for 2020 will be close to your standard deduction amount, consider making enough additional expenditures for itemized deduction items before year-end to exceed the standard deduction. Those prepayments will lower your tax bill for 2020. Next year, your standard deduction might be a bit bigger thanks to an inflation adjustment, and you can claim it then. Or the standard deduction might be smaller, depending on possible tax law changes.
The easiest itemizable expense to prepay is included in home mortgage payments due on January 1, 2021. Accelerating that payment into 2020 will give you 13 months' worth of itemized home mortgage interest deductions for this year. Beware: The TCJA limits these deductions, so consult with your tax advisor before prepaying your mortgage.
Other items to consider prepaying are state and local income and property taxes that are due early next year. Prepaying those bills before year-end can decrease your 2020 federal income tax bill because your total itemized deductions will be that much higher. However, the TCJA decreased the maximum amount you can deduct for state and local taxes to $10,000 ($5,000 for married couples who file separate returns).
Important: Prepaying state and local taxes can be a bad idea if you'll owe the alternative minimum tax (AMT) this year. That's because write-offs for state and local taxes are completely disallowed under the AMT rules. Therefore, prepaying those expenses may do little or no good for people who are subject to the AMT. Fortunately, the TCJA eased the AMT rules, so most people are no longer at risk.
To maximize your itemized deductions for 2020, you also could make bigger charitable donations this year and then make smaller donations next year to compensate. Or you might consider accelerating elective medical procedures, dental work and expenditures for vision care. If you itemize for 2020, you can deduct medical expenses to the extent they exceed 7.5% of your adjusted gross income (AGI). Next year, the deduction threshold is scheduled to rise to 10% of AGI.
Managing Gains and Losses in Taxable Investment Accounts
If you hold investments in taxable brokerage firm accounts, consider the tax advantage of selling appreciated securities that have been held for over 12 months. The federal income tax rate on long-term capital gains can be as high as 20%, plus the 3.8% net investment income tax (NIIT) can also apply at higher income levels. (See "Current Individual Federal Income Tax Rate Scene" at right.)
To the extent you have capital losses from earlier this year or capital loss carryovers from prior years, selling appreciated investments this year won't result in a tax hit. In particular, sheltering net short-term capital gains with capital losses is a tax-smart move because net short-terms gains would otherwise be taxed at higher ordinary income rate of up to 37%.
Conversely, if you have some loser investments — that are currently worth less than what you paid for them — you might want to unload them. Taking the resulting capital losses this year would allow you to shelter capital gains, including high-taxed short-term gains, from other sales this year,
If selling some loser investments would cause your 2020 capital losses to exceed your 2020 capital gains, the result would be a net capital loss for the year. It can be used to shelter up to $3,000 of 2020 income from salaries, bonuses, self-employment income, interest income and royalties ($1,500 for married couples who file separate returns). Any excess net capital loss can be carried forward indefinitely.
A capital loss carryover can be used to shelter short- and long-term gains recognized next year and beyond. This can give you extra investing flexibility in those years because you won't have to hold appreciated securities for over a year to get a lower tax rate. You'll pay 0% to the extent you can shelter gains with your loss carryover. Depending on future tax rate changes, these loss carryovers can be quite valuable.
Donating to Charities
You can also make gifts to your favorite charities in conjunction with an overall revamping of your investments in taxable brokerage firm accounts. But there are two principles to keep in mind.
First, don't give away investments that are currently worth less than what you paid for them. Instead, sell the shares and book the resulting tax-saving capital loss. Then you can give the cash sales proceeds to favored charities — plus, if you itemize, you can claim the resulting tax-saving charitable write-offs.
The second principle applies to investments in appreciated securities. These winning investments should be donated directly to a preferred charity. Why? Because, if you itemize, donations of publicly traded shares that you've owned for over a year result in charitable deductions equal to the full current market value of the shares at the time of the gift. Plus, when you donate appreciated shares, you escape any capital gains taxes on those shares. Meanwhile, the tax-exempt charitable organization can sell the donated shares without owing federal taxes.
Gifting to Family Members
The principles for tax-smart gifts to charities also apply to gifts to relatives. That is, you should sell loser investments and collect the resulting tax-saving capital losses. Then give the cash sales proceeds to loved ones.
Likewise, you should give appreciated shares directly to relatives. In many cases, they'll pay a lower tax rate than you would if you sold the same shares.
Making Charitable Donations From Your IRA
IRA owners and beneficiaries who have reached age 70½ are permitted to make cash donations totaling up to $100,000 to IRS-approved public charities directly out of their IRAs. You don't owe income tax on these qualified charitable distributions (QCDs), but you also don't receive an itemized charitable contribution deduction.
The upside is that the tax-free treatment of QCDs equates to an immediate 100% federal income tax deduction without having to worry about restrictions that can delay itemized charitable write-offs. Contact your tax advisor if you want to hear about the benefits of QCDs. If you're interested in taking advantage of this strategy for 2020, you'll need to arrange with your IRA trustee for money to be paid out to one or more qualifying charities before year-end.
Prepaying College Tuition Bills
The TCJA retains two valuable tax credits for higher education costs.
1. American Opportunity credit. This credit equals 100% of the first $2,000 of qualified post-secondary education expenses, plus 25% of the next $2,000 (assuming the phaseout rule explained later doesn't affect you). So, the maximum annual credit is $2,500.
For 2020, the American Opportunity credit is phased out (reduced or eliminated) if your modified adjusted gross income (MAGI) is between:
- $80,000 and $90,000 for single people, or
- $160,000 and $180,000 for married couples filing joint returns.
2. Lifetime Learning credit. This credit equals 20% of up to $10,000 of qualified education expenses. The maximum credit is $2,000.
For 2020, the Lifetime Learning credit is phased out if your MAGI is between:
- $59,000 and $69,000 for single people, or
- $118,000 and $138,000 for married couples filing jointly.
Numerous rules and restrictions apply to these higher education credits. If you're eligible for either credit, you might consider prepaying college tuition bills that aren't due until early 2021 if it would result in a bigger credit this year. Specifically, you can claim a 2020 credit based on prepaying tuition for academic periods that begin in January through March of next year.
If your MAGI is too high to be eligible for the Lifetime Learning credit, you might still qualify to deduct up to $2,000 or $4,000 of college tuition costs for 2020. If so, consider prepaying tuition bills that aren't due until early 2021 if that would result in a bigger deduction this year. As with the credits, your 2020 tuition and fees deduction can be based on prepaying tuition for academic periods that begin in the first three months of 2021.
Important: The higher education tuition and fees deduction is scheduled to expire after 2020 unless Congress passes legislation to extend it.
Deferring Income Into Next Year — or Not
If you expect to be in the same or lower tax bracket next year, you might want to defer some taxable income from 2020 into 2021. For example, if you operate a small business that uses the cash method of accounting, you can postpone taxable income by waiting until late in the year to send out some invoices. That way, you won't receive payment for them until early 2021. Small business owners can also defer taxable income by accelerating some deductible business expenditures into this year.
Both moves will postpone taxable income from this year until next year when it might be taxed at lower rates. Deferring income can also be helpful if you're affected by unfavorable phase-out rules that reduce or eliminate various tax breaks, such as the child tax credit and the higher-education tax credits.
On the other hand, if you expect to be in a higher tax bracket in 2021, consider accelerating income into this year (if possible) and postponing deductible expenditures until 2021.
Converting an IRA to a Roth IRA
The best scenario for converting a traditional IRA into a Roth account is when you expect to be in the same or higher tax bracket during retirement. Currently, tax rates are low by historical standards, but there's been discussion of increasing taxes in the future to fund COVID-19 financial relief measures and various spending priorities. So, now might be a good time to consider a conversion.
Beware: There's a current tax cost for converting. A conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth account. If you wait to convert your account until 2021 or later, the tax cost could be higher, depending on future tax rates.
After the conversion, all the income and gains that accumulate in the Roth account, and all qualified withdrawals, will be federal-income-tax-free. In general, qualified withdrawals are those taken after:
- You've had at least one Roth account open for more than five years, and
- You've reached age 59½, become disabled or died.
With qualified withdrawals, you (or your heirs if you die) won't be required to pay higher tax rates that might otherwise apply in future years. While the current tax hit from a Roth conversion is unwelcome, it could be a relatively small price to pay for future tax savings.
Current Individual Federal Income Tax Rate Scene
Here's an overview of the current tax situation under the Tax Cuts and Jobs Act (TCJA). Many of its provisions that affect individuals will expire in 2026 unless Congress extends them.
Federal Income Tax Rates
The 2020 federal income tax rate picture for individuals is the same as last year, except the tax rate brackets have been adjusted slightly for inflation. Currently, there are seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. For 2020, the top rate applies to:
- Single people with taxable income above $518,400,
- Married couples who file jointly with taxable income above $622,050, and
- Heads of households with taxable income above $518,400.
Long-Term Capital Gains Rates
For most individuals, the 2020 federal income tax rate on long-term capital gains and qualified dividends is either 0% or 15%. However, the maximum rate on long-term capital gains and dividends rises to 20% for:
- Single people with taxable income above $441,450,
- Married couples who file jointly with income above $496,600, and
- Heads of households with income above $469,050.
Net Investment Income Tax
Higher-income individuals can also see all or part of their net investment income, including long-term capital gains and dividends, hit with a 3.8% net investment income tax (NIIT). However, the NIIT strikes only if your modified adjusted gross income (MAGI) exceeds:
- $200,000 if you're unmarried, or
- $250,000 if you're married and file jointly.
The NIIT applies to the lesser of:
- Your net investment income, or
- The amount by which your MAGI exceeds the applicable threshold.
MAGI refers to adjusted gross income increased by certain tax-exempt income from outside the United States.
Additional Medicare Tax
Higher-income individuals can also get hit by the additional 0.9% Medicare tax on wages and self-employment (SE) income. The 0.9% tax is charged on salary and/or net SE income above:
- $200,000 for unmarried individuals, and
- $250,000 for married couples who file jointly.
Expiring Tax Breaks
Be aware that these popular federal tax breaks for individuals are scheduled to expire at the end of 2020.
1. Higher education tuition and fees deduction. This write-off can range from $0 to $4,000, depending on your income. This deduction is "above-the-line," meaning that you don't need to itemize to benefit.
2. Tax-free treatment for forgiven principal residence mortgage debt. Forgiven debts generally count as taxable cancellation of debt (COD) income. However, a temporary exception applies to COD income from canceled mortgage debt that was used to acquire a principal residence. Under the temporary rule, up to $2 million of COD income from principal residence acquisition debt that's canceled in 2020 is treated as a tax-free item.
3. Credit for energy-efficient home improvements. Homeowners can claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence. The $500 cap must be reduced by any credits claimed in earlier years.
President-elect Joe Biden has said he would like to repeal parts of the TCJA, including raising the top individual federal income tax rate on ordinary income and net short-term capital gains back to 39.6%. However, he's promised to refrain from raising taxes for people who earn less than $400,000.
It's important to remember that the president doesn't make legislation. Any post-election federal tax law changes would first have to pass in the House and Senate, before going to the president to sign into law — or to veto.
Meet With a Tax Pro
The future of federal income taxes for individuals is uncertain. But at least you know the rules that will apply for 2020. Contact your HK tax advisor to discuss ways to best position yourself for this year and beyond. 330-453-7633