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.
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.
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.
But be careful, the state and local tax deduction for any year is limited to a maximum of $10,000, so any amount more than $10,000 would be wasted as a tax deduction.
Don’t Waste the 2021 Annual Gift Tax Exemption
Part of President Biden’s tax plan is to reduce the lifetime gift and estate tax exemption. Whether for that reason or you want to limit your estate’s exposure to inheritance taxes, you can give $15,000 each to an unlimited number of individuals in 2021. Still, you can't carry over unused exclusions from one year to the next. Taxpayers and their spouses can use their gift tax exemptions together to give up to $30,000 per beneficiary. For example, if you are married, have four children, and have four grandchildren, you can remove $240,000 from your estate tax-free this year. The transfers also may save family income taxes when income-earning property is given to family members in the lower income tax brackets and are not subject to the kiddie tax.
Not Needing to File May Be an Opportunity
If your income and tax situation is such that you do not need to file for 2021, don’t overlook the opportunity to bring in some additional income to the extent it will be tax-free. For instance, if you have appreciated stock that you can sell without incurring any tax, consider selling it. Further, you can also take a tax-free IRA distribution if you are 59½ or older or younger and qualify for an exception to the “early withdrawal” penalty.
Utilize IRA-to-Charity Transfers
If you are age 70½ or over, you can request that your IRA trustee directly transfer funds from your IRA to a charity. Although not deductible as an itemized charitable deduction, the distribution is not taxable. Suppose you are age 72 or over when the IRA to charity direct transfer is made. In that case, the distribution can count towards your required minimum distribution for the year. This also reduces your AGI, which can reduce the amount of taxable Social Security income in some circumstances. There is no minimum charitable distribution, but the maximum amount per individual is limited to $100,000 per year. There are some complications if you are age 72 or older, have earned income, and contribute to the IRA. Check with our office for the details.
Maximize Tax-Deductible Medical Expenses
For example, suppose you have outstanding medical or dental bills. In that case, paying the balance before year-end may be beneficial, but only if you already meet the 7.5% of the AGI floor for deducting medical expenses, or if adding the payments would put you over the 7.5% threshold are itemizing your deductions. You can even use a credit card to pay the expenses. Still, you would only want to do so if the interest expenses you’d incur if you don’t pay off the card right away would be less than the tax savings.
Make Business Purchases
You can reduce taxable income if you make last-minute business purchases such as:
vehicles and write them off using the 100% bonus depreciation
Sec. 179 expensing, provided you place the item(s) into business service by the end of the year. However, you must consider the impact of expensing the items on your taxable income and the Sec. 199A 20% pass-through deduction. It may be appropriate to contact this office in advance of any last-minute business acquisition.
Divorced or Separated During the Year
A divorce or separation can have a significant impact on a couple’s tax filings. Filing joint or separate returns, who claims the children, the tax rules related to whether to take the standard deduction or itemize, how income and tax prepayments are allocated and more are issues to be considered. Best to figure that all out in advance.
Disaster Loss Planning
2021 has had some significant declared disasters, including Hurricane Ida and the wildfires in the West. Any losses incurred because of a federally declared disaster can be claimed on the current year’s tax return or, at the taxpayer's election, on the prior year’s return (2020 for 2021 disasters), generally providing quicker access to a tax refund. However, care must be exercised to ensure a disaster loss is claimed on the year's return that will provide the greatest benefit. In addition, after insurance reimbursement is accounted for, the result may not be as expected. It should be determined before deciding which year to claim a loss.
Increased Charitable Giving Opportunities
2021 is the final year that the normal 60% of AGI limit on cash contributions has been increased to 100%. Giving those with the means and the desire to increase their normal charitable contributions and deduct them as an itemized deduction. The normal 5-year carryover applies to any excess over 100% of AGI.
Those who don’t itemize (currently about 90% of income tax return filers) can claim a deduction of up to $300 ($600 on a joint return) for cash charitable contributions made in 2021. Normally, only itemizers can deduct their charitable contributions.
Take Advantage of Energy Credits
Two of the major green credits are the solar tax credit and the electric vehicle credit. The solar credit for 2021 is 26% of the cost of the installed solar system, but the system must be complete and functional before year’s end to claim the credit in 2021. The credit is not refundable, and any excess has a limited carryover. The credit for electric vehicles must be determined from the IRS website since credit begins to phase out once 200,000 of the vehicle type by the manufacturer has been sold.
If you have obtained your medical insurance through a government marketplace, employing some of the strategies mentioned could impact the amount of your allowable premium tax credit.
Residents of states that have an income tax will also need to consider the impact of some of these strategies on their state return.
If you would like to discuss how these strategies and others not included in this article might provide you tax benefits based upon your tax circumstances, or would like to schedule a tax planning appointment, please give the office a call.