Below are ideas for individuals with investment income, retirement income, and estate and gift planning needs.
Capital Gains and Losses
Frequently, investors time sales of assets like securities at year-end to produce optimal tax results. For starters, capital gains and losses offset each other. If you show an excess loss for the year, it offsets up to $3,000 of ordinary income before being carried over to the next year. Long-term capital gains from sales of securities owned longer than one year are taxed at a maximum rate of 15% or 20% for certain high-income investors. Conversely, short-term capital gains are taxed at ordinary income rates reaching up to 37% in 2020.
YEAR-END MOVE: Review your investment portfolio. Depending on your situation, you may harvest capital losses to offset gains realized earlier in the year or cherry-pick capital gains that will be partially or wholly absorbed by prior losses.
Be aware of even more favorable tax treatment for certain long-term capital gains. Notably, a 0% rate applies to taxpayers below certain income levels. Furthermore, some taxpayers who ultimately pay ordinary income tax at higher rates due to their investments may qualify for the 0% tax rate on a portion of their long-term capital gains.
However, watch out for the “wash sale rule.” If you sell securities at a loss and reacquire substantially identical securities within 30 days of the sale, the tax loss is disallowed. A simple way to avoid this harsh result is to wait at least 31 days to reacquire substantially identical securities.
Note: The 0%/15%/20% rate structure for long-term capital gains also applies to qualified dividends you have received in 2020. These are dividends paid by U.S. companies or qualified foreign companies.
Net Investment Income Tax
In addition to capital gains tax, a special 3.8% tax applies to the lesser of your “net investment income” (NII) or the amount by which your modified adjusted gross income (MAGI) for the year exceeds $200,000 for single filers or $250,000 for joint filers. (These thresholds are not indexed for inflation.) The definition of NII includes interest, dividends, royalties, capital gains and income from passive activities, but not Social Security benefits, tax-exempt interest and distributions from qualified retirement plans and IRAs.
YEAR-END MOVE: Assess the amount of your NII and your MAGI at the end of the year. When it is possible, reduce your NII tax liability in 2020 or avoid it altogether.
For example, you might add municipal bonds (“munis”) to your portfolio. Interest income generated by munis does not count as NII, nor is it included in the calculation of MAGI. Similarly, if you turn a passive activity into an active business, the resulting income may be exempt from the NII tax. These rules are complex, so obtain professional assistance.
Required Minimum Distributions
As a general rule, you must receive “required minimum distributions” (RMDs) from qualified retirement plans and IRAs after reaching age 72 (70½ for taxpayers affected prior to 2020). The amount of the RMD is based on IRS life expectancy tables and your account balance at the end of last year. If you do not meet this obligation, you owe a tax penalty equal to 50% of the required amount (less any amount you have received) on top of your regular tax liability.
YEAR-END MOVE: Take RMDs in 2020 if you need the cash. Otherwise, you can skip them this year, thanks to a suspension of the usual rules by the CARES Act. There is no requirement to demonstrate any hardship relating to the pandemic.
However, if you already received an RMD this year and did not return the money to a qualified plan or IRA by August 31, the distribution is generally taxable in 2020.
Typically, retirees wait until late in the year to arrange RMDs. If you still intend to take any of your RMDs in 2020, make sure you complete the arrangements in time to have this accommodated by the financial institution.
Note: RMDs are not treated as NII for purposes of the 3.8% tax. Nevertheless, an RMD may still increase your MAGI used in the NII tax calculation.
If you receive a distribution from a qualified retirement plan or IRA, it is generally subject to tax unless you roll it over into another qualified plan or IRA within 60 days. In addition, you may owe a 10% tax penalty on taxable distributions received before age 59½. However, some taxpayers may have more leeway to avoid tax liability in 2020 under a special CARES Act provision.
YEAR-END MOVE: Take your time redepositing the funds if it qualifies as a COVID-19 related distribution. The CARES Act gives you three years, instead of the usual 60 days, to redeposit up to $100,000 of funds in a plan or IRA without owing any tax. Also, the taxes on a COVID-19 related distribution may be spread over three years for any amounts not redeposited.
To qualify for this tax break, you (or your spouse, if you are married) must have been diagnosed with COVID-19 or experienced adverse financial consequences due to the virus (e.g., being laid off, having work hours reduced or being quarantined or furloughed).
Note: This may be a good time to consider a conversion of a traditional IRA to a Roth IRA. With a Roth, future payouts are generally exempt from tax, but you must pay current tax on the converted amount. Have a tax professional help you determine if this makes sense for your situation.
Estate and Gift Taxes
The TCJA doubled the federal estate tax exemption from $5 million to $10 million for 2018 through 2025, inflation-indexed to $11.58 million in 2020. The following table shows the progression of the estate tax exemption and top estate tax rate during the last decade.
|Tax year||Estate tax exemption||Top estate tax rate|
YEAR-END MOVE: The increased exemption amount shown above for 2018-2020 is scheduled to end in 2025, but there could be changes in the law before then. This, along with other factors such as historically low interest rates, provides incentive for engaging in planning soon to take advantage of this.
Under the “portability provision” for a married couple, the unused portion of the estate tax exemption of the first spouse to die may be carried over to the estate of the surviving spouse. This tax break is now permanent, so incorporate it into your estate planning decisions and make sure your estate plan reflects this change.
Note: With the gift tax exclusion, you can give each recipient, like a young family member, up to $15,000 in 2020 without paying any federal gift tax. This exclusion is effectively doubled to $30,000 for joint gifts made by a married couple. These gifts reduce the size of your taxable estate.
* Contribute up to $19,500 to a 401(k) in 2020 ($26,000 if you are age 50 or older). If you clear the 2020 Social Security wage base of $137,700 and promptly allocate the payroll tax savings to a 401(k), you can increase your deferral without any further reduction in your take-home pay.
* Sell real estate on an installment basis. For payments over two years or more, you can defer tax on a portion of the sales price. This may effectively reduce your overall tax liability, but consideration should also be given to the potential for increases in tax rates in future years.
* Consider investing in a Qualified Opportunity Fund (QOF) to take advantage of the opportunity to defer paying tax on eligible capital gains realized during the year that are reinvested into a QOF. Additional tax breaks are available for QOF investments, so consult your tax advisor to discuss the tax savings opportunities as well as eligibility restrictions associated with QOFs.
* Invest in passive income generators (PIGs). Generally, you can only use losses from passive activities (e.g., most real estate investments) to offset income from other passive activities, with limited exceptions. With a PIG, you can absorb more of your passive activity losses but watch out for the NIIT rules discussed above.
* From a tax perspective, it is often beneficial to sell mutual fund shares before the fund declares dividends (the ex-dividend date) and buy shares after the date the fund declares dividends.
* Consider a qualified charitable distribution (QCD). If you are age 70½ or older, you can transfer up to $100,000 of IRA funds directly to a charity. Although the contribution is not deductible, the QCD is exempt from tax. This may benefit your overall tax picture.