Want to be smart about your income tax liability for 2020? Don’t wait till it is too late. Now is the best time to think about it, before the 2020 tax year ends. In this article we discuss a variety of tax planning tips for Business Owners & High Net-Worth Individuals. Looking for help with business taxes? We will publish a similar post on business tax planning strategies next week.
General Income Tax Planning for Individuals
Where possible postpone income until the following year and accelerate deductions. Many individual taxpayers and small businesses report their taxable income on the cash basis. If you are a cash basis taxpayer and have the ability to control timing on income and expenses, consider this strategy each year to shift a portion of your income to the next year.
This year has been full of economic surprises and stock market ups and downs. As we approach yearend look at realized capital gains and losses from your brokerage accounts, crypto currency holdings, sales of real estate and other capital assets. If you have realized capital gains or losses, there may be steps you can take now to improve your tax position by selling other assets.
Capital gain tax rates should also be considered. Depending on your taxable income, your long-term capital gain from sales of assets you have held for more than a year will be taxed at 0%, 15% or 20%. If you have appreciated long-term holdings and expect to be in a higher capital gain tax rate next year, consider selling some of them this year to make use of your lower long-term capital gain tax rate.
The 3.8% NII tax is a special extra tax on investment income for high income taxpayers. You can minimize your tax liability in two ways: consider deferring some of your net investment income for the year or seek ways to reduce applicability of the NII by reducing your income overall.
You are subject to a 0.9% additional Medicare tax on wages or self-employment income when it exceeds a threshold amount.
For 2020, the threshold amount is $250,000 for joint filers and $200,000 for single taxpayers. Regardless of your filing status or the level of other income, your employer is required to withhold the additional Medicare tax from your wages when total wages exceed $200,000.
Individuals and joint filers can explore tax planning possibilities by deferring income to the following year if future wages are expected to be below the threshold amount.
Filing status | 2020 tax year | 2021 tax year |
Single | $12,400 | $12,550 |
Married, filing jointly | $24,800 | $25,100 |
Married, filing separately | $12,400 | $12,550 |
Head of household | $18,650 | $18,800 |
Should you opt for standard deduction or itemized deductions? Like many things in tax — that depends. The easy route is to take the standard deduction as you do not have to worry about collecting and saving the documents necessary for itemized deductions. The relatively high amount of the standard deduction today and the various limits applied to itemized deductions make the standard deduction appropriate for most taxpayers.
However, if you are reading this you are likely a sophisticated high-income taxpayer.
Consider the following in itemizing your deductions:
- Interest paid on home mortgage debt. If you have a mortgage or home equity loan, check whether itemizing would save you money. The interest you paid on home mortgage debt (subject to a grandfathering rule) can be deducted to the extent of debt up to $750,000.
- Your state and local taxes (SALT). Only up to $10,000 of state and local taxes may be deducted when itemizing. If you are a high earner and own a home or pay state income tax, then you will likely have $10,000 deduction for state and local taxes.
- Gifts to charity. If you have made cash gifts to charity or in-kind gifts these can be added to your itemized deductions.
- Investment interest expense. If you have a margin loan with your brokerage or have borrowed funds to invest in a business activity the interest may qualify for the investment interest itemized deduction.
If you are still unsure whether to itemize or take the standard deduction, try running the numbers both ways. If total itemized deductions are greater than your standard deduction, then you will itemize when filing. If you are close and want to make additional charitable contributions consider delaying until January 1, 2021 to improve your itemized deduction position for next year.
Due to COVID-19 the government encourages your charitable giving even more than before. Two provisions under the Coronavirus Aid, Relief, and Economic Security (CARES) Act are important for your tax planning.
New charitable deduction limit for 2020
Individuals can now deduct charitable donations up to 100% of their 2020 adjusted gross income. And your contributions do not have to be COVID related.
A new deduction for non-itemizers
Those who take the standard deduction, can now deduct up to $300 in annual charitable contributions. This adjustment reduces your adjusted gross income and the taxable income.
This is a special provision available for 2020 only. If you typically take the standard deduction and are considering a charitable contribution you should make it before the year end.
Charitable distributions by IRA account holder over age 70 ½
The CARES Act eliminated the requirement for required minimum distributions (RMD) for 2020. However, if you are an IRA account holder over age 70 ½, you may still make distributions directly to charities up to $100,000 in 2020 and keep those distributions out of your adjusted gross income.
Donate highly appreciated securities
You may find tax savings by contributing your highly appreciated securities such as public traded stock outright instead of donating cash.
Bunching refers to paying two years of deductible expenses in a single tax year, as far as you can manage it and within limits. Bunching significantly increases the total amount of your itemized deductions in one tax year, while causing a significant decrease the following year. For tax planning purposes, this means itemizing your deductions in years where you have relatively higher expense levels. And you can then use the standard deduction in the years when your itemized expenses are at a lower level.
Bunching deductions and then alternating between itemizing and using the standard deduction, you may be able to potentially save thousands of dollars in taxes. Using the bunching strategy requires a lot of planning ahead, since you must consider your taxes and expense levels two years ahead.
Generally, bunching can work for property taxes, charitable contributions, and medical expenses.
Health and Education Saving
Health Savings Accounts (HSAs) let you set aside money on a pre-tax basis to pay for qualified medical expenses. By using pre-tax dollars in a HSA to pay for your copayments, deductibles, coinsurance and certain other expenses, you can reduce your overall health care costs. HSA funds cannot be used to pay premiums.
Unspent HSA amounts roll over year to year. The interest earned in an HSA is not taxable. Think of an HSA as a bank account just for health expenses.
You must have a high-deductible health plan (HDHP) to contribute to an HSA. Those with individual coverage in 2020 can deduct up to $3,550 ($7,100 with family coverage) for the year. An eligible taxpayer who is at least 55 years of age is permitted to make an additional $1,000 contribution.
If you change your health plan to a non-high-deductible health plan in the future, you can still use your HSA funds for qualified medical expenses. Bottom line, if you have a HDHP and have not contributed to an HSA you should make a contribution before the end of the year and reduce your taxes!
Consider adjusting what you aside for 2021 in your employer’s health flexible spending account (FSA), especially if you set aside too little or too much for 2020. FSA funds are use-it-or-loose-it. So, plan carefully for amounts contributed.
If you are self-employed, you may be eligible to deduct amounts you have paid for medical, dental, vision, and/or long-term care insurance for yourself and your family.
General eligibility criteria are:
- Reporting net profit on Schedule C
- You are a partner in a partnership with net earnings from self-employment reported on Schedule K-1
- Received wages in 2020 from an S corporation where you were a more than 2% shareholder
If you are self-employed, you may be eligible to deduct amounts you have paid for medical, dental, vision, and/or long-term care insurance for yourself and your family.
General eligibility criteria are:
- Reporting net profit on Schedule C
- You are a partner in a partnership with net earnings from self-employment reported on Schedule K-1
- Received wages in 2020 from an S corporation where you were a more than 2% shareholder
529 plans authorize tax-free status for qualified tuition programs. Earnings in 529 plans grow on a federal tax-deferred basis. Distributions are not subject to federal tax when used for qualifying education expenses.
In addition to covering college tuition, qualifying education expenses now also include up to $10,000 per year per person in K-12 tuition for private, public or religious elementary and secondary schools.
If you are a resident of a state with a state income tax, there may be a state income tax benefit for contributions to a 592 plan.
Flexibility of 529 plans allow you to change investment options and rollover funds to another 529 plan. They are low maintenance, with simplified tax reporting and give you control of your account. You may withdraw funds at any time for any reason. However, the earnings portion of non-qualified withdrawals will result in a 10% penalty tax plus income tax on the earnings.
529 plans have no income limits, age limits or annual contribution limits. The lifetime contribution limits vary by plan and range between $235,000 to $529,000.
529 plans and gift tax
Contributions to a 529 plan are considered a gift for gift tax purposes. For 2020 the annual gift tax exclusion is $15,000 per recipient. If you have the means and are interested in front loading contributions to a 529 plan, you may elect to contribute up to 5 years’ worth of gifts to the plan in a single contribution by moving $75k into a plan in one shot. If both parents or grandparents make 5-year contributions the amount can double to $150k. If you can make large contributions like this when your child is young and let it grow tax free for an extended period, the payoff will be impressive. This is a very powerful planning technique.
Retirement Planning
- 401(k) Retirement Plan
- Traditional IRA Plan
- SIMPLE IRA Retirement Plan
- Simplified Employee Pension Plan (SEP Retirement Plan)
- Defined Benefit Plans
Sometimes it makes sense to pay taxes on retirement savings sooner rather than later. This is when you may want to consider converting an Individual Retirement Account (IRA) to a Roth IRA.
Roth Individual Retirement Accounts (Roth IRAs) are funded with after-tax dollars. Qualified withdrawals from them are tax-free. Roth IRAs aren’t subject to required minimum distributions (RMDs), offering you greater control in managing your taxable income levels in retirement.
To be eligible to contribute to a Roth IRA, in 2020, your modified adjusted gross income (MAGI) needs to be less than $139,000 for single filers and $206,000 for couples filing jointly.
Roth IRA conversion is a workaround for this limitation. With such conversion, regardless of income level, you may convert all or part of your funds in traditional IRA accounts to a Roth IRA. You are subjected to income taxes on the converted funds in the year of the conversion. The rules can be complex so make sure to consult a tax professional before taking action.
Here’s when it makes sense to use Roth IRA conversion in 2020 for tax planning purposes:
- You believe your tax bracket will be higher in retirement. This is not as unusual if you have yet to reach your peak earning levels or have amassed significant savings in your retirement accounts. If this is the case, paying taxes at the current tax rate is a smart move than paying at a higher rate upon retirement. If you fall into this group, it may make sense to convert all or some of your funds in a traditional IRA to a Roth now, and pay tax on it at a lower tax rate applicable at present.
- You wish to maximize the value of your estate you pass on to your heirs. Some don’t need to tap into their IRA funds during their lifetime, due to other sources of income. If such is the case, consider leaving more to your heirs by taking a Roth IRA conversion. This allows the savings to grow undiminished. And your heirs can also benefit from tax-free withdrawals in their lifetimes.
- When most of your assets are in tax-deferred accounts. For better tax planning in retirement, it is worthwhile to have at least some of your assets in accounts that are not taxable on withdrawal. This is another scenario in which a Roth IRA conversion can help be better prepared for retirement, tax wise.
- If your income streams are irregular and lower than usual this tax year, you may want to convert some funds held in IRA accounts to a Roth IRA with a low tax impact.
If you are self-employed, you may want to establish and contribute to qualified retirement plan like the Simplified Employee Pension (SEP).
A SEP allows employers to contribute to a retirement plan for employees and provides a deduction of up to 25 percent of net earnings from employment. For 2020, this can be up to $57,000. There are pros and cons of SEP vs 401(k). If you are interested in learning more, consult your tax advisor.
Gift and Estate Tax Planning
If you are concerned about your exposure to the estate tax, now is a great time to review your options and devise a plan.
The annual federal gift tax exclusion allows you to give away up to $15,000 to as many people as you wish and not have those gifted amounts count against your $11.58 million lifetime exclusion. For married couples, the annual gift exclusion can be doubled with a gift-splitting election. If you think you will have a taxable estate proper use of the annual gift exclusion is a great tool to reduce exposure to the estate tax and transfer wealth during your lifetime.
For 2020, the lifetime unified gift and estate tax exclusion is $11.58 million per person, and the highest it has ever been. This amount will be reduced by about 50% to $6.8 million in December 31, 2025 when many of the provisions of the Tax Cuts and Jobs Act expire.
Due to the pending law change you may want to consider using your lifetime exclusion for estate and gift tax planning before it expires. The IRS has clarified that large gifts made with the elevated exemption between 2018 and 2025 will not harm estates after 2025 when the exclusion drops to pre-2018 levels.
Read our article on Estate and Gift Tax for more details (coming soon).
The AFR or the Applicable Federal Rate is the minimum interest rate that the IRS allows for private loans. AFR is at historically lows due to the low global interest rate environment. For estate tax and gift tax purposes, this means you can offer highly favorable terms to execute intrafamily asset sales, loans and gifts. Use this opportunity now, before the economy improves, and interest rates rise.
Qualified Business Income (QBI) Deduction – Save 20% on Small Business Income
If you are self-employed or a small-business owner, see whether you are entitled to the qualified business income (QBI) deduction. If you qualify, you may be able to deduct up to 20% of your QBI, reducing your income and effective tax rate.
To qualify for the QBI deduction, you must have “pass-through income”, that is business income that you report on your personal tax return. If your business is a sole proprietorship, partnership, S corporations and Limited liability company (LLCs), you may be entitled to QBI deductions.
To qualify for a full QBI deduction not subject to special limitations, your total taxable income in 2020 must be under the following thresholds:
| FILING STATUS | 2020 | 2021 |
| Married filing jointly | $326,600 | $329,800 |
| Married filing separately | $163,300 | $164,900 |
If your income exceeds these limits, complex IRS rules determine whether your business income qualifies for either full or partial deduction.
Because QBI deduction limits apply at the individual taxpayer level planners need a holistic view of your business and personal tax positions to optimize for the 20% pass-through deduction.
Learn More About Year End Tax Planning
These are some of the ways in which you can use tax planning to minimize your tax liability.
At AccountFWD, we guide entrepreneurs and businesses on how best they can optimize their tax position. If you have questions about tax planning or want to take a deep dive into planning for QBI send us a note, schedule a time to connect, or give us a call 954-686-8687.
