The end of this very strange year is right around the corner — and not a moment too soon, many people would say. The coronavirus pandemic has altered so many things about our normal lives this year, so it’s probably no surprise that it has also altered year-end tax and financial planning strategies.
Here are 5 questions to ask as you plan your 2020 year-end tax strategies over the next couple of weeks.
- Should you accelerate, instead of defer, income this year? One common year-end strategy is to lower taxable income by deferring earned income into the next year. But this strategy only makes sense if you don’t anticipate being in a higher tax bracket the following year. Income tax rates are currently at their lowest level in a long time but they could rise as soon as next year, especially for high-income individuals and couples.
In this scenario, it might make sense to do just the opposite and accelerate income into tax year 2020. This may be especially true if you expect to have less income this year due to a COVID-related job loss or not taking required minimum distributions (RMDs) from a traditional IRA. A few ways to accelerate income into this year are to exercise stock options, realize deferred compensation, recognize capital gains or perform a Roth IRA conversion (see below).
- Should you convert a traditional IRA to a Roth IRA? Converting a pre-tax traditional IRA to an after-tax Roth IRA can offer several benefits, such as tax-free distributions in retirement and no requirement to take RMDs annually. But there’s one big drawback: You’ll have to pay income tax on the fair market value of the IRA assets at the time of conversion.
However, if your IRA contains assets that have declined in value, or you’re in a lower tax bracket this year due to a COVID-related job loss or reduced work hours, this could be a good opportunity to lower your tax burden on a Roth IRA conversion. As an added bonus, if the assets increase in value, the appreciation will be tax-free if the assets are held in a Roth account.
- Can you give more money away to charity? The limit on charitable deductions for cash contributions has been raised from 60% to 100% of adjusted gross income (AGI) for tax year 2020 only. If you’re charitably inclined, this provision could enable you to significantly reduce, or maybe even completely offset, your taxable income for this year.
You might be able to reap even more tax benefits from charitable giving by “stacking” cash contributions on top of contributions of gifts that are subject to limits. For example, donations of appreciated securities are limited to 20% or 30% of AGI, depending on certain factors. So you could donate long-term capital gain assets that you’ve held for more than one year in an amount equal to 20% of your AGI and then donate 80% of your AGI in cash on top of this. In doing so, you would avoid paying capital gains taxes on the appreciated securities.
- Can you harvest some tax losses? This is a strategy that involves selling underperforming assets and using the losses to offset investment gains. The amount of losses you book before the end of the year will offset up to $3,000 in taxable investment gains and ordinary income (if you don’t have this much in gains) on a dollar-for-dollar basis.
If you have any unused investment losses this year, they can be carried forward to offset capital gains or ordinary income in future years. So if you had $5,000 in investment losses in 2020, you could use $3,000 to offset capital gains and ordinary income this year and carry $2,000 forward to offset capital gains and ordinary income next year. Also, you can buy back any investments you sell at a loss 30 days after you sell them.
- Can you sock away more money for retirement? For tax year 2020, you can contribute up to $19,500 to your 401(k), or $26,000 if you’re 50 years of age or over. And you can contribute up to $6,000 to a traditional IRA this year, or $7,000 if you’re 50 years of age or over.
Keep in mind that 401(k) and IRA contributions don’t have to be made before December 31 to count toward tax year 2020. You have until April 15, 2021, or your tax-filing deadline (including extensions) to make these contributions for the current tax year. And remember: Contributing to tax-advantaged retirement plans like these can also reduce your current income or provide a tax deduction.
Be sure to consult with your tax professional and financial advisor about these and other year-end financial and tax planning strategies.