With year-end rapidly approaching, it’s time to consider making some moves that will lower your 2021 federal income tax bill — and potentially position you for future tax savings. Unfortunately, tax planning is particularly challenging this year because the tax rules for 2022 aren’t yet certain. In fact, they may not even be certain for 2021.
Here are nine planning tips for you to consider making before year end. But you also may want to be ready to take last-minute corrective actions if Congress works out a deal on the proposed Build Back Better Act and the Bipartisan Infrastructure Bill before year end.
1. Game the Standard Deduction
The 2017 Tax Cuts and Jobs Act (TCJA) almost doubled the standard deduction amounts. For 2021, the standard deduction allowances are:
- $12,550 for single people and married individuals who file separate returns,
- $18,800 for people who use head-of-household filing status, and
- $25,100 for married couples who file jointly.
If your total itemizable deductions will be close to your standard deduction allowance, consider making enough additional expenditures for itemized deduction items before year end to exceed the standard deduction. Those additional expenditures will lower this year’s tax bill. Next year, your standard deduction will be bigger thanks to an inflation adjustment, and you can claim it then if you’re unable to itemize next year.
The easiest deductible expense to prepay is included in the mortgage payment due on January 1. Accelerating that payment into this year will give you 13 months’ worth of itemized home mortgage interest deductions in 2021. Speak to an R+R tax advisor to determine whether you’re affected by limits on mortgage interest deductions under current law.
Other ways to increase your itemized deductions for 2021 include:
- Making bigger charitable donations this year and smaller donations next year to compensate, and
- Accelerating elective medical procedures, dental work and expenditures for vision care if you think you can qualify for a medical expense deduction.
You can claim an itemized deduction for medical expenses to the extent they exceed 7.5% of your adjusted gross income (AGI) for 2021.
2. Manage 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.
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 rates of up to 37%.
3. Donate to Charity
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 tax-smart 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 any federal income tax.
4. Gift Assets to Loved Ones
The principles for tax-smart gifts to charities also apply to gifts to relatives. That is, you should sell losing 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. When they sell the shares, they’ll probably pay a lower tax rate than you would.
5. Donate to Charity from Your IRA
IRA owners and beneficiaries who have reached age 70½ are permitted to make cash donations totaling up to $100,000 annually 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 2021, you’ll need to arrange with your IRA trustee or custodian for money to be paid out to one or more qualifying charities before year end.
6. Prepay College Tuition Bills
If paid for you, your spouse or a dependent to attend college, you may be eligible for one of the following tax credits for higher education costs:
American Opportunity credit. This credit equals 100% of the first $2,000 of qualified postsecondary 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.
Lifetime Learning credit. This credit equals 20% of up to $10,000 of qualified education expenses. The maximum credit is $2,000.
For 2021, both higher education credits are phased out 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 jointly.
Numerous rules and restrictions apply to these higher education credits. If you’re eligible for either credit, consider prepaying college tuition bills that aren’t due until early 2022 if it would result in a bigger credit this year. Specifically, you can claim a 2021 credit based on prepaying tuition for academic periods that begin in January through March of next year.
7. Defer Income into Next Year
It may pay to defer some taxable income from this year into next year if you optimistically believe you’ll be in the same or lower tax bracket in 2022 than in 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.
Note: Congress is currently discussing possible tax increases for some higher-income individuals to help fund various spending initiatives.
8. Convert a Traditional 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 as you are in today. If you think you might be in a higher tax bracket in the future due to proposals being discussed by Congress, now might be a good time to consider a conversion.
However, 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 2022 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.
9. Schedule a Tax Planning Meeting
Given the uncertainties about future federal income taxes, year-end tax planning for 2021 is a tricky business. Schedule a meeting with an R+R tax advisor as soon as possible to stay atop the latest developments and to discuss any last-minute moves that may be needed before December 31st.
Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve.
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