Year-end planning is always important, but upcoming tax changes make planning even more important this year. Missing out could cost you real money. I’m going to discuss a few of the upcoming changes, how they can affect you, and ways to mitigate their impact. Past that, I’ll show you several planning items that you can’t afford to miss.
Let’s talk politics for a minute if we can do that without becoming partisan. Democrats have a razor thin majority in the House and the Senate, along with holding the Presidency. They have the ability to pass major legislation without the help of Republicans, but they can’t lose any Democratic senators along the way. Centrist Senators Kyrsten Sinema and Joe Manchin have been major roadblocks to passing several infrastructure bills in the Senate, while the progressive wing has pushed against compromise. This has led to an interesting showdown, in which the majority party hasn’t really been able to accomplish much of anything. With midterm elections just around the corner, Democrats are looking to the future and realizing that they need to pass some sort of legislation on which they can justify holding onto the house.
This brings us to the current situation: Democrats have put forth several potential tax plans as means to pay for infrastructure spending. These plans have ranged from moderate changes to a wealth tax focused on approximately 700 billionaires. I’m not going to waste your time going over every single proposal, but I do want to touch on the major changes that I expect will make it to the final draft.
· The top marginal tax rate will be raised from 37% to 39.6%. This just moves the rate to its pre-TCJA level, so I’m not particularly worried.
· Top capital gains rates are also increasing, from 20% to 25%. This too, only affects those with incomes above $400,000. Not great, but it isn’t a huge hit.
· The Net Investment Income Tax will be applicable to all income above $400,000 (for single filers). In the past, this only applied to investment income, now it will apply across the board.
· Backdoor Roth contributions, and mega-backdoor Roth IRA’s, will be disallowed. This provision will probably affect more people than any of the previously mentioned changes.
There are also several estate planning changes.
· The estate tax exemption is being lowered from $11.7 million per person to just over $5 million per person. You need to plan ahead if you’re above that level now, but there are plenty of investors who will cross that level in the next few years.
· Grantor trusts will be considered part of the taxable estate.
· There will be a required minimum distribution for IRA accounts with balances above $10 million, with the RMD being 50% of the amount above $10 million. This is under estate planning because it won’t affect many until the death of the second spouse, after all household retirement accounts have been consolidated.
Let’s start with the elephant in the room. Do you need to worry about estate taxes? I’ll break this down a couple ways.
· Do you have more than $11.7 million (or $23.4 million if you’re married) in assets? If so, you almost certainly have estate tax concerns, even under the current law.
· Do you have more than $5 million (or $10 million if you’re married) in assets? If so, you will probably have estate tax concerns if the exemption is lowered.
The more interesting question, and less straightforward answer, is for those who don’t fit into either of these categories. Like a gentleman I spoke to recently who was in his early 60’s and had assets of $7-8 million. A sizeable amount, no doubt, but not an amount that is taxed under current law or under proposed changes. That said, I recommended to him that he begin planning now anyway, because it’s likely that his assets will grow over his lifespan to the point that he will be subject to estate taxes. My reasoning is that with an average annual return of 6%, investments will double in a 12-year period. For someone in their early 60’s, it’s very likely that they live another 12 years, at which point they’ll almost certainly be looking at estate taxes. The answer then, is to plan ahead and consider moving some of those assets outside of the estate.
So how do you plan ahead to minimize / eliminate estate taxes? The short answer is that you call a professional to walk you through the process. Generally, you will need a team including a CPA, an estate planning attorney, and a financial planner. This team will look at your situation and find the best course of action for you. Depending on your motivations, that could include using charitable strategies like charitable lead trusts or charitable remainder trusts. Maybe it makes more sense to use a grantor retained annuity trust or an irrevocable defective grantor trust. Going through the various types of trusts is beyond the scope of this piece, so just know that there are many options and the right one really depends on a number of considerations.
Getting away from estate taxes, one item that everyone should do on an annual basis is review your beneficiaries. This can be on retirement accounts like 401(k)’s or IRA’s, or it can be on taxable accounts like brokerage accounts. Every account, unless a joint account, should have a beneficiary. This ensures that the funds will pass to your intended beneficiaries without going through probate, which can be a headache. The other consideration is that sometimes your beneficiaries change. I can’t tell you how many times I’ve discovered ex-wives and husbands still listed as beneficiaries. That can create an awkward situation with your current spouse, so just update your beneficiaries.
You can update your estate plans whenever you like but when the year is over, your tax planning options are gone too. That means it’s important to make sure that you take advantage where you can. The items I’ll be covering with my clients this year are:
· Tax-Loss Harvesting in taxable accounts, to minimize capital gains.
· Run a tax-projection for 2021. Depending on taxable income, it can make sense to harvest long-term capital gains at the 0% and 10% capital gains rates.
· Fill up low income tax rate buckets with Roth conversions.
· Sweep 401(k) accounts for after-tax contributions and roll them into an outside Roth IRA. This is most likely being taken away after 12/31/2021, so make sure to do it this year.
· Take your Required Minimum Distribution. If you’re over 72, or if you have an inherited IRA, you have to take an RMD this year. Distributions were suspended last year, but this year is back to normal. Make sure to take your full RMD to preclude a 50% excise tax on the undistributed amount.
This could be an entire piece, considering charitable giving is one of my favorite soapboxes. If you’re charitable, you could probably be getting more from your giving by maximizing the tax benefits. I’ve said for years that you should give because you want to make a difference, but you should still maximize the tax benefits of your gifts. So, what’s the best way to maximize your giving?
If you’re over 72, then you should consider making gifts to charity directly from your IRA. These gifts, called Qualified Charitable Distributions, count towards your RMD, but aren’t considered taxable income. You won’t be taxed on these withdrawals, but you don’t have to itemize the deduction either, which can be a headache. QCD’s are one of the most often missed strategies that I see.
If you give substantially every year, but you don’t give enough to itemize your deductions, consider gift bunching. This means giving multiple years of gifts in one year, so that you can itemize your deductions that year, then you can take the standard deduction after that. It keeps you from missing out on the deduction from your gifts. For example, it’s hard to itemize more than the standard deduction of $27,700, even if you give $10,000 to charity each year. Instead, what you can do is give $30,000 in year one, deduct the full amount, then take the standard deduction in the following two years.
If you want to maximize gift bunching, you can pair it with a Donor Advised Fund. DAF’s are essentially a checking account that is technically a charity. You donate money into it and get the deduction immediately, then you can send money from the account to specific charities when you want. So to the previous example, you could make the $30,000 contribution to the DAF in year one, immediately take the deduction, and send $10,000 to the charity of your choice. In years two and three, you could send them the same $10,000 contribution as usual, just from the DAF instead of from your checking account. DAF’s allow you to frontload contributions, without affecting the cashflow of your favorite charity.
Donor Advised Funds can also be really powerful tools if you have highly appreciated assets. You aren’t limited to donating cash. You can also donate stocks, mutual funds, or even cryptocurrency. This can be a great option if you have a concentrated position that you would like to diversify. You can donate the asset into the DAF and take a deduction for the fair market value of the gift. You can then use the deduction to either lower your taxable income or you can do something like offset a Roth conversion. There are a lot of tools in the toolbox.
I’ve mentioned a lot of options so far, but they’re all just tools in the toolbox. The important thing is knowing how to pick the right tool for the job. If you have questions, or maybe your situation is getting complicated and you want a second opinion, let’s chat. I would love to set up a strategy call, which you can do at the Schedule button at the top right of this page.