Year-End Tax Planning in Light of Proposed Tax Changes
Update as of 12.19.21
With the end of the year rapidly approaching, the Build Back Better Act still faces significant disagreements in the Senate that appear likely to stretch into 2022. It remains to be seen what effect this delay will ultimately have on the tax changes included in the bill, but the longer that the process is stretched out, the greater the opportunity for stakeholders who will be adversely impacted by the bill to exert their influence.
The question at the front of everyone’s minds is whether or not this bill will be retroactive to the beginning of 2022. While Speaker Pelosi has indicated that it will likely be retroactive if passed in January, a further delay may ultimately push back the effective date.
From a planning perspective, our guidance remains largely unchanged. Even if the Build Back Better Act is delayed, or ultimately defeated, we see it as prudent to review the aforementioned strategies and determine if any of them are applicable to your circumstances.
Original Post 11.30.21
Year-end tax planning is tricky when there is still uncertainty about how tax laws may change next year. However, the Build Back Better bill passed by the House on November 19th gives us the clearest indication of what changes may be ahead. Interestingly, many of the changes proposed in the initial version of the bill, including the increase in capital gains rates and the decrease in estate tax exemption amounts, are no longer included. Instead, the tax changes focus on new surtaxes for very high-income taxpayers, and changes to retirement accounts. The bill will go on to the Senate where additional negotiations and modifications will undoubtedly be made. With so little time between now and year-end, here are some key actions to take to prepare for the potential changes:
Convert after-tax dollars to Roth:
Confirm whether your 401k has any after-tax contributions included in the balance. (Generally, the 401k website should have a section that breaks out contributions by “source”). If this is a 401k plan from a former employer, this is a critical opportunity to roll those after-tax dollars into a Roth IRA tax-free. If you are currently contributing to your 401k, some plans still allow you to roll out the after-tax dollars and convert to your Roth IRA, or at a minimum, do an in-plan Roth conversion. The benefit of these strategies is that you may be able to move a substantial amount into your Roth IRA tax-free. It is critical to do this prior to year-end as the ability to convert after-tax dollars in a 401k or IRA may no longer be available if the Senate approves the bill as currently written.
Maximize your after-tax contributions into your 401k:
For calendar year 2021, the IRS lets employees set aside as much as $58,000 a year in a 401(k) account, a number that rises to $64,500 for those 50 or older. To get to the $58,000 annual limit, a worker can put $19,500—or $26,000 if 50 or older—in either a traditional pretax 401(k) or a Roth 401(k). If the plan allows, you can also make an after-tax contribution of as much as $38,500, less the amount contributed by your employer. Then you can convert these after-tax dollars to your Roth IRA, typically tax-free. For 2022, the IRS has announced the new maximum employee contribution to a 401(k) plan will be $20,500. The maximum contribution between employee and employer has increased to $61,000 per year. For taxpayers who are 50 or older, an additional $6,500 catch-up contribution is allowed bringing the grand total to $67,500 for 2022. Even if the ability to convert after-tax dollars to Roth is taken away, making sure you max out your pre-tax 401k contributions is an easy way to reduce your tax liability. If you are self-employed, a Solo 401(k) is a fantastic way to defer substantial income.
Confirm whether your Traditional IRA has any after-tax contributions:
Talk to your advisor or CPA to determine if there are any strategies available where you could convert the after-tax dollars in your Traditional IRA to a Roth IRA at little or no tax cost. If so, it may make sense to do so before year-end before you lose the opportunity to do so. Starting Jan. 1, 2022, the bill would eliminate backdoor Roth conversions of after-tax contributions. The strategy is often used by high-income taxpayers who aren’t eligible to make direct Roth IRA contributions. Make sure you have also made your 2021 IRA contribution before you complete any Roth conversion this year.
Be strategic about Roth conversions:
Roth conversions of pre-tax contributions will still be allowed under the new bill. However, starting in 2032, they would be off-limits for individuals with income over $400,000 a year and married couples with incomes above $450,000. We do not anticipate this will impact many clients as we typically recommend Roth conversions as a way to leverage low tax brackets. However, those who retire early often drop into lower tax brackets ideal for doing Roth conversions.
Make your annual IRA contributions while you can:
For 2021, the maximum annual contribution is $6,000 with an additional $1,000 catch up for those over age 50. Starting in 2029, the new tax bill would prohibit contributions to IRAs for single people with incomes over $400,000 and married couples making over $450,000, who have aggregate retirement account balances above $10 million. It would also require higher income people with aggregate retirement-account balances above $10 million to start taking distributions, regardless of their age.
Accelerate income into 2021 to avoid net investment income tax:
Pass-through income from entities like S-corporations would now be subject to the 3.8% NIIT for those with taxable income over $400,000 (single filers) or $500,000 (married taxpayers filing jointly).
Shift income to stay under the new $10M income threshold:
For individuals, the basic tax rates would stay unchanged for all but top earners. Those with Adjusted Gross Income over $10 million would pay a 5% surtax, and those with income over $25 million would pay an additional 3%. If possible, try to accelerate or defer income to stay below these thresholds. Importantly, the surtaxes would apply to Adjusted Gross Income, including wages, dividends, and realized capital gains. That means the top tax rate on ordinary income would rise to 45%, plus 3.8% in other taxes, while the top total tax rate on capital gains would be 31.8%. Note deductions for items such as charitable donations and mortgage interest aren’t included in the calculation of Adjusted Gross Income; thus, donations to charity won’t help avoid this surtax.
Take into account the potential benefit of higher deductions:
Some good news if you live in a state with a high-income tax or pay over $10k in real estate taxes: Included in the bill is an increase in the $10,000 cap on the SALT deduction to $80,000 starting in 2021 through 2030.
Continue making annual exclusion gifts to reduce future estate tax:
Even though the proposal to reduce the Federal estate tax exemption amounts is no longer included in the current version of the tax bill, exemption amounts are still scheduled to come down at the end of 2025 (from the current exemption amount of $11.7M per person to $5.5M). You and your spouse can gift up to $15K/per person ($30K/per couple) to any individual without filing a gift tax return. Gifting to avoid estate tax is even more important if you live in a state that also has an estate tax, such as Washington and Oregon, which have very low state estate tax exemption amounts ($2.193M/per person and $1M/per person respectively).
Given the rise in the stock market this year, we also wanted to highlight a few evergreen tax strategies:
Reduce capital gains exposure:
Harvesting losses in the same year as your gains will reduce your taxable income. If you plan to sell investments or concentrated positions that have appreciated significantly, consider selling others that have lost value. If your losses exceed your gains, you can deduct them on your tax return, up to $3,000 per year. Additional loss amounts can be carried forward indefinitely to offset gains in the future.
Hold securities for at least one year:
Sales before the one-year mark are deemed short-term and any gains will be treated as ordinary income. Marginal tax rates are typically much higher than the long-term capital gains rate. The new capital gains rate in Washington State will only be subject to gains on certain assets held long-term.
Consider gifting appreciated securities to adult children in low tax brackets:
If your children are in grad school or have very little income, consider gifting appreciated stock to them while they can sell and recognize capital gains at the 0% capital gains tax rate. (Talk to your tax advisor before transferring appreciated stock to certain trusts for the benefit of your adult children).
Donate long-term appreciated securities to charity:
Donate stock rather than selling the shares and then donating the proceeds. This will allow you to donate and deduct the full value of the investment without paying capital gains tax. On the other hand, shares that have lost value should be sold before donating them to allow you to record a capital loss, reducing your taxable income.
Set up a Donor Advised Fund (DAF):
Also known as a Charitable Gift Fund, a DAF is a simple and inexpensive option for gifting highly appreciated securities. Contributions to a DAF create an immediate tax deduction. Consider whether 2021 or 2022 will yield the larger tax benefit for your charitable contributions.
Donate your IRA RMD directly to charity:
After reaching age 72, IRA owners must take an annual Required Minimum Distribution (RMD) from their account. By donating that RMD amount directly to charity, you can exclude that money from your taxable income. You can start making ‘Qualified Charitable Deductions’ directly from your IRA as early as age 70 ½.
Maximize your HSA contributions and invest for growth:
The deductible Health Savings Account contribution limit for a family is $7,300 and an individual is $3,650 with a $1,000 catch-up for individuals who are 55 years old and older. Instead of spending these funds on current medical expenses, invest the balance for growth and use this account to fund health expenses in retirement tax-free.
Adjust your portfolio structure:
Different asset classes can be strategically placed in different types of accounts to generate the most favorable after-tax result. Through this practice, known as Asset Location, higher growth-oriented assets are placed in tax-deferred or tax-free accounts, while tax-exempt income sources like municipal bonds are placed in taxable accounts.
Please contact your Coldstream advisory team if you’d like to discuss any of these strategies and which ones might work best with your overall plan. We will keep you apprised as this Bill moves through the Senate and the changes are finalized. In the meantime, please reach out with questions!
Disclosure: Information contained herein is subject to legislative changes and is not intended to be legal or tax advice. Consult a qualified tax advisor regarding specific circumstances. This material is furnished “as is” without warranty of any kind. Its accuracy and completeness is not guaranteed. To ensure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication (including attachments) is not intended or written to be used and cannot be used for (1) avoiding penalties imposed under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein unless the communication contains explicit language that it is a tax opinion in compliance with IRS requirements.
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