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Fall Tax Planning May Be Wise

Article Highlights:

Taxes are like vehicles in that they sometimes need a periodic check-up to make sure they are performing as expected, and if ignored, can cost you money. That is true of taxes as well, especially for 2021, as the pandemic benefits begin to wane and President Biden’s tax proposals loom.

The following is a list of potential tax strategies that you might benefit from. Every taxpayer’s situation is unique, and not all the tax strategies suggested here will apply to you. However, opportunities for tax planning are available for all income levels and a variety of tax circumstances, some of which may apply to your situation. But waiting too late in the year may not give you the time needed to take advantage of some of these strategies.

Maximize Education Tax Credits

There are two things to check for if you qualify for the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC). Check to see how much you have already paid for qualified tuition and related expenses during the year. Suppose it is not the maximum allowed for computing the credits. In that case, you can prepay 2022 tuition for an academic period beginning in the first three months of 2022 and use the expense for the 2021 credit.

Employer Health Flexible Spending Accounts

If you contributed too little to cover expenses this year, you might wish to increase the amount you set aside for next year. As a reminder, amounts paid after 2019 for over-the-counter medicine (whether or not prescribed) and menstrual care products are considered medical care and are considered a covered expense. The maximum contribution for 2021 is $2,750.

Maximize Health Savings Account Contributions

Become eligible to make health savings account (HSA) contributions late this year. You can make an entire year’s worth of deductible HSA contributions, even if you were not eligible to make HSA contributions for the whole year. This opportunity applies even if you first become eligible in December. In brief, if you qualify for an HSA, contributions to the account are deductible or nontaxable if made by your employer (within IRS-prescribed limits); earnings on the account are tax-deferred. Distributions are also tax-free if made for qualifying medical expenses. Amounts paid after 2019 for over-the-counter medicine (whether or not prescribed) and menstrual care products are considered medical care and are considered a covered expense. However, only medical expenses you incur after you establish an HSA are eligible for tax-free distribution. An HSA can become a supplemental retirement plan if the funds are left to accumulate.

Convert Traditional IRAs to Roth IRAs

Suppose your income is unusually low this year or even negative. In that case, you may wish to consider converting your traditional IRA to the more favorable Roth IRA. Converting your account provides tax-free accumulation, and the distributions are tax-free at retirement. The lower income results in a lower tax rate, which gives you an opportunity to convert to a Roth IRA at a lower tax amount.

Don’t Forget Your 2021 Minimum Required Distributions

If you are age 72 or older, you must take required minimum distributions (RMDs) from your IRA, 401(k) plan, and other employer-sponsored retirement plans (but if you are still working, distributions from your current employer’s plan can be postponed in some circumstances). Failure to take a required withdrawal can result in a 50% penalty of the amount of the RMD not withdrawn. If you turned age 72 in 2021, you could delay the first required distribution to the first quarter of 2022, but if you do, you will have to take a double distribution in 2022, the one for 2021 and the 2022 RMD. One must carefully consider the tax impact of a double distribution in 2022 versus a distribution in both this year and next.

Bunching Deductions

Suppose your tax deductions usually fall short of needing to itemize. In that case, the standard deduction you are allowed is greater, or even if you can itemize. Still, only marginally, you may benefit from adopting the “bunching” strategy. To be more proactive, you can time the payments of tax-deductible items to maximize your itemized deductions in one year and take the standard deduction in the next.

Take Advantage of the Zero Capital Gains Rate

There is a zero long-term capital gains rate for those taxpayers whose taxable income is below the 15% capital gains tax threshold. This may allow you to sell some appreciated securities you have owned for more than a year and pay no or very little tax on the gain.

Defer Deductions

When you itemize your deductions, you may claim only the deductions you paid during the tax year (the calendar year for most folks). Suppose your projected taxable income will be negative, and you are planning on itemizing your deductions. In that case, you might consider putting off some of those year-end deductible payments until after the first of the year and preserving the deductions for next year. Such payments might include house of worship tithing, year-end charitable giving, tax payments (but not those incurring late payment penalties), estimated state income tax payments, medical expenses, etc.

Increase IRA Distributions

Depending upon your projected taxable income, you might consider taking an IRA distribution to add income for the year. For instance, if the projected taxable income is negative, you can withdraw up to the negative amount without incurring any income tax. Even if projected taxable income is not negative and your normal taxable income would put you in the 24% or higher bracket, you might want to take out just enough to be taxed at the 10% or even the 12% tax rates. Of course, those are retirement dollars; consider moving them into a regular financial account set aside for your retirement. Also, be aware that distributions before age 59½ are subject to a 10% early withdrawal penalty.

Defer Capital Gains by Investing in an Opportunity Zone Fund

A unique tax benefit is the ability to defer any capital gain into a qualified opportunity fund (QOF). QOFs are funds that invest in areas in need of development. Suppose you have a capital gain from selling property to an unrelated party. In that case, you may elect to defer that gain by investing it into a QOF within 180 days of the sale or exchange. The gain won’t be recognized (i.e., you won’t be taxed on the gain) until your return for the earlier of the year of sale of the QOF or 2026. You can get up to 10% of the deferred gain forgiven entirely by holding the investment for the required time period, and you will pay no tax on any additional gain if the investment is held for ten years.

Sell Loser Stocks

Although the stock market has been performing well recently, you still may have stocks that have declined in value. If you sell them before the end of the year, you can use any losses to offset other gains for the year or produce a deductible loss. The net capital loss deductible on a tax return is limited to $3,000 ($1,500 if filing married separate) for the year. Still, any excess loss carries over to future years. You can repurchase stock in the same company for which you sold shares at a loss after 30 days have passed and avoid the wash sale rules.

Take Steps to Avoid Underpayment Penalties

If you are going to owe taxes for 2021, you can take steps before year-end to avoid or minimize the underpayment penalty. The penalty is applied quarterly, so making a fourth-quarter estimated payment only reduces the fourth-quarter penalty. However, withholding is treated as paid ratable throughout the year, so increasing withholding at the end of the year can reduce the penalties for the earlier quarters. This can be accomplished with cooperative employers or by taking a non-qualified distribution from a pension plan. This will be subject to a 20% withholding and then returning the gross amount of the distribution to the plan within the 60-day statutory rollover limit. Please consult this office to determine if you will be subject to underpayment penalties (there are exceptions) and if so, the best strategy to avoid or minimize them.

Prepay State and Local Taxes

You probably know that if you are not subject to the alternative minimum tax and you itemize your deductions, you are eligible to deduct both your property taxes and your state income tax. But did you know that you can increase the amount that you deduct on your 2021 tax return by prepaying some taxes? You can ask your employer to boost your state withholding by a reasonable amount. If you are self-employed, pay your 4th-quarter state estimate due in January in December and increase your deduction. The same is true for your real estate taxes: if you pay your first 2022 installment in 2021, you can take it as part of your 2021 deduction.