Since we are approaching December, I thought it would be a good time to discuss a few 2020 year-end tax planning tips.
This is a challenging year for tax planning because….surprise!…..in unsurprising 2020 fashion, we still have a lot of uncertainty in the horizon.
Why do we have uncertainty?
Well, we know that Joe Biden is the president-elect and that his platform included proposed income tax rate increases for higher earners and corporations, and a reduction in the estate tax exemption.
Does this mean that tax rates will go up next year?
We do not know. The Executive branch does not legislate, Congress does. The president proposes, but he can’t do much without a cooperating Congress.
It’s quite reasonable to assume that if the Republican party retains control of the Senate, which seems the most likely outcome of the upcoming Georgia Senate runoff elections, it will be difficult for the Biden administration to pass any new tax legislation.
We’ll have to wait until January to find out the result of the Georgia runoff. The Republican Party needs to win just one of the two seats up for grabs to retain control. At the moment, they are slightly favored by the polls for both seats. Not that polls have been that accurate lately…..But it is seems more likely than not that they will retain at least one of the two seats, giving them a majority in the Senate and control over proposed legislation.
What should we do in the meantime?
That’s the challenge!
If you are a high income earner, and by high income I mean with annual income of $400,000/year or more, and are worried about potential tax increases in 2021, you may want to accelerate income and delay deductions.
If your estate is in excess of $3.5 million, it may a good idea to work with an estate planner to remove some assets out of your estate to take advantage of the current $11.58 million gift and estate tax exemption before it is reduced.
Given the uncertainty, you should only consider taking measures if you are accelerating actions that make sense for your plans and situation, regardless of what may happen in Georgia in January.
Let me give you a couple of examples of situations in which it may make sense to take action before the end of 2020:
- You are a very high income earner who makes more than $1,000,000/year (humor me please, this is just an example!) and you have saved $500,000 for a down-payment on a new home that you intend to buy in 2021 to take advantage of the super low mortgage interest rates. The $500,000 are invested in a brokerage account. The original investment of $300,000 was made in 2016. This means that you are seating on $200,000 of unrealized (and therefore un-taxed) long term capital gains. If you wait until 2021 to realize those gains, you may have to pay $39,200 MORE in income tax on those gains than if you sell those investments in 2020 if the proposed increase in capital gain tax rates for high earners goes through.
- You worked hard for decades, did very well financially and accumulated $10,000,000 in wealth. You are about to retire to spend time with your spouse of 30 years. You have children and grandchildren. All your assets are in your name. You may want to set up a Spousal Lifetime Access Trust or SLAT with your spouse as the primary beneficiary, and your children as remainder beneficiaries (or even create a dynasty trust). This would move those assets away from your spouse’s estate, and the appreciation of those assets outside of your own estate, before (and in case) the lifetime estate exemption lowered from the current $11,580,000 to the proposed $3,500,000. The estate tax savings could top $3,000,000. That’s a lot of zeroes in tax savings…..
Now, if your income is below $400,000 and you have dependent children, and your wealth is less than $3,500,000, you do not need to be too concerned about the Biden proposed tax plan. Even if his proposed changes go through, to the extent that you notice any changes in your own taxes, it is more likely to be to your benefit than to your detriment.
What’s in the Biden proposed tax plan anyway?
- An increase in social security taxes for US taxpayers with US wages or with US self-employment income above $400,000. Currently, US social security taxes are capped at wages or self-employment income of $137,700/year. Taxpayers with wages and self-employment covered by foreign social security laws need not worry about this one. Under this proposal, the additional 12.4% social security taxes would apply only on the wage amounts above $400,000.
- Remember how the highest marginal income tax rate was reduced from 39.6% to 37% by the TCJA, aka 2017 Tax Reform? Under the Biden Plan, the 37% rate is out, and the 39.6% rate is back in. Who needs to worry about this higher marginal rate? Once again, earners with incomes above $400,000.
- Long term capital gains are currently taxed at preferential rates. Under the Biden plan, this preferential rate is denied to taxpayers with incomes above $1,000,000. At that income level, instead of paying the reduced 20% rate, the gains would be subject to the ordinary 39.6% rate. This practically doubles the tax amount on long term capital gains for those taxpayers.
- Are you charitable and a high-income earner? The tax benefit of your charitable contributions would be limited to a 28% reduction instead of providing a benefit at your marginal tax rate. Currently there are three tax rates above 28%: 32%, 35% and 37%. Taxpayers taxed at any of the three highest tax brackets would see the benefit of their charitable deductions limited.
- You know what else comes back for taxpayers with taxable incomes above $400,000? The Pease limitation. The Pease limitation is a reduction in itemized deductions when income exceeds the $400,000 threshold. The higher your income above $400,000, the more your itemized deductions get reduced.
- There is more for the $400,000 magic number: the qualified business income deduction, which exempts up to 20% of income from certain US businesses from taxation, will be phased for taxpayers with incomes above $400,000.
Are there any goodies for taxpayers with incomes below $400,000?
Well, yes, thanks for asking. The proposed benefits for taxpayers with lower incomes include:
- Expansion of the Earned Income Tax Credit for working workers older than 65.
- Expansion of the Dependent Care Credit to a maximum of $8,000 per child (capped at $16,000 per family) from the current $3,000/$6,000 cap. (Editorial note: About time! Where can you find childcare for $3,000/year anyway?)
- Increases the Child Tax Credit from $2,000 to $3,000 per child under 17, with a $600 bonus for children under 6, and makes it fully refundable, which would be extremely beneficial not just for US resident families with children, but also for US expats who normally do not owe US income tax but are nonetheless raising US citizen children abroad.
- It brings back the First-Time Homebuyer’s Tax Credit for first time homeowners. The maximum proposed credit is $15,000.
The Biden proposal also includes a number of corporate and business tax provisions, which we will not cover in this newsletter but which you can find in this report from the Tax Foundation.
As you can see from this summary, the proposed tax increases for taxpayers with incomes above $400,000 are not insignificant. If you are in this group and expect your high income to continue to increase, you may want to explore possibilities of accelerating income to 2020 and potentially postponing deductions to 2021. This is not always easy, wage earners, for example, generally have little control over the realization of their wages, but some options are always available:
- Accelerating deferred compensation elections
- Accelerating the exercise stock options
- Selling appreciated investments in brokerage accounts to pay capital gains taxes now at lower rates
- Accelerating charitable contributions that you would otherwise make in 2021 and which may be limited by the 28% maximum deduction rate next year
- Delaying the payment of certain deductible state taxes to 2021
- Making Roth IRA conversions to fill out tax brackets to avoid higher taxes in future years
If you are serious contemplating taking action, do not forget that tax is just one of the considerations of any financial decision you make.
You should always think about your tax planning holistically, beyond just the immediate tax benefit. You should always ask yourself questions such as: “Does this decision make sense for me in the long-term?”” Is the potential benefit of taking action today large enough to offset any restrictions or limitations that this action will have on me tomorrow?, ”Do I have enough cash today to pay the taxes I am accelerating or will this cause me a cash-flow problem?”. If you are not sure, the right choice for you may be to do nothing. Doing nothing can be better than doing the wrong thing!
And with this, I leave you until next week.
Be safe and take good care of one another,