Although the legislative landscape changed rapidly during the COVID-19 pandemic, when it comes to tax planning, many individuals are now looking at how potential changes may impact their 2021 tax return.
Will Congress raise the top marginal income tax rate from 37% to 39.6%? Will it raise the capital gains tax of high-income individuals from 20% to 37%? Will the lifetime estate tax exemption decrease? And will these changes be retroactive?
While we don’t yet know what actions Congress will take this year, there are tax planning strategies that individuals can leverage now to help prepare. We recommend talking them over with your CPA and financial advisor to help ensure you leverage the best strategies for your unique situation.
1. Convert traditional IRAs into Roth IRAs
If you’re anticipating that tax rates will go up, converting traditional IRAs into Roth IRAs will allow you to take advantage of lower current tax rates. Unlike a traditional IRA, a Roth IRA does not have required minimum distributions when you reach age 72, and the distributions are not taxed when you take a withdrawal in retirement. When planning for your Roth conversion, be mindful of where you lie within your tax bracket. If you’re on the lower end, you have room to make a Roth conversion without getting bumped into the next tax bracket.
If you’re a business owner and experienced business losses due to the pandemic, this may be a good year to make a Roth conversion because you can net the business loss against the Roth conversion to offset how much you have to pay in taxes. Remember that starting in 2021, there are limits on the amount of business losses that can be claimed with excess amounts being carried forward.
2. Make charitable contributions
The CARES Act extended the suspension of the 60% adjusted gross income (AGI) limit, allowing individuals to deduct cash charitable contributions made in 2021 up to 100% of their AGI.
However, if tax rates do go up, deductions become more valuable in a future year at that higher rate. Talk to your tax advisor about which scenario makes more sense for your situation, as well as what other limitations may apply to the charitable contributions you make.
3. Use your estate tax exemption
Many people are concerned that the lifetime estate and gift tax exemption of $11.7 million ($23.4 million for a married couple) will decrease to $5 million, $3.5 million or potentially as low as $1 million. If you have a sizable estate, gifting assets to your children or into a trust this year can allow you to use the exemption while it’s still at $11.7 million. Gifts made under current law would be grandfathered in, even if the exemption does decrease.
Note that on January 1, 2026, the exemption will automatically decrease to $5.49 million (albeit adjusted for inflation) unless Congress takes action, which makes it critical to begin planning your gifting strategy now.
4. Pull income into 2021
The Tax Cuts and Jobs Act allows a 20% deduction for qualified business income from pass-through entities. Certain proposals aim to reduce or eliminate this deduction. If you’re a small business owner and you believe this deduction may decrease, you might consider whether you can pull income — such as any business contracts you negotiate through the remainder of the year — into 2021 at a lower tax rate and higher deduction.
Talk to your tax advisor, as there are numerous rules and limitations in determining what business income qualifies for the 20% deduction.
5. Set up a SEP-IRA for your business
Small business owners should also consider setting up a retirement account for their business. A SEP-IRA allows employers to contribute to traditional IRAs set up for employees — including the business owner — up to the lesser of 25% of the employee’s compensation or $58,000 for 2021. This amount is much higher than the $6,000 limit ($7,000 if age 50 or older) individuals are allowed to contribute annually to a traditional or Roth IRA, making them a very attractive tool for retirement savings.
One more added benefit? As the employer, SEP-IRA contributions are deducted before you calculate your AGI, which may result in an overall lower tax bill.
6. Introduce your advisory team to each other, and communicate early and often
When your advisory team works together, things run faster and smoother, and strategies are easier to identify and execute upon. This includes tax planning, financial planning and estate planning. We recommend introducing your CPA to your financial advisor and attorney so they can share critical documents, collaborate and set you up for greater financial success.
Your advisory team is there to give you advice and recommendations. Strategies can also take time to implement, so working through them now can help put you in the best position to react to potential tax changes.
If you need assistance talking through or implementing the above strategies, Wipfli is here to help. We provide financial services that grow and protect accumulated wealth. Click here to learn more.
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