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Worried about Higher Taxes? 5 Tax-Smart Moves to Make Now

Will taxes go up under President Joe Biden? That’s a question we’ve been hearing from our wealth management clients, so we thought it would be worth looking at what changing tax laws might mean for you.

The tax hikes with the best chance of passing may be those that reverse the tax cuts of 2017, which would increase taxes for the highest earners and corporate tax rates.

But there’s no way to know what part of Biden’s tax plans that Congress will be able to pass. Most tax experts think stimulative measures to ease tax burdens on low and middle income families are more likely.

Most tax experts and economists do not expect tax laws to change for at least a year, which would give investors time to plan for these changes. However, if you’re concerned about your future tax returns, we’ve run through a few possible scenarios, below.

3 potential 2021 tax changes 

Tax planning is complex, and we recommend getting professional help with your financial planner and CPA to assess what your unique tax and estate plan should look like for the coming years before making moves based on future forecasts.

What to do if income taxes rise

If the 2017 tax bill is reversed, the top income tax bracket (for taxpayers with income over $400,000) would go back to 39.6% versus the current 37%, although it’s unclear if this income level would be based on adjusted gross income (AGI) or taxable income.

If you think this change might take place in 2021, then you’d likely want to do what you can to increase your income in 2020 by taking cash bonuses, exercising stock options, and converting assets to a Roth IRA, where it can grow tax-free in the future. 

What if capital gains and dividend taxes increase

 The current top tax rate for long-term capital gains and qualified dividends is 20% (plus 3.8% for Medicare tax)and that could rise to 39.6% for individuals who have over $1 million in income.

Although unlikely next year,  it could be beneficial to sell investments that have substantially appreciated before the end of 2020, so you can pay the current capital gains tax rate. You could also potentially repurchase the shares to reset the cost basis.

What if tax deductions are limited or phased out

Itemized deductions could be limited to 28% of their value and some deductions could be phased out for income earners over $400,000.

If this were going to change in 2021, then it would be beneficial to increase your deductions and donations in 2020.

5 tax-smart moves to make before the end of 2020

Here at FundX, we’re focused on what we can do now to reduce taxes for our wealth management clients. As the Schwab Center for Financial Research noted “while investment selection and asset allocation are still the most important factors affecting your returns, minimizing taxes and other costs isn't very far behind.”

December is an opportunity to make tax-smart investment decisions and do some year-end financial planning. Here are a few things to consider before the end of 2020:

1. Managing mutual fund distributions

If you own mutual funds in a taxable account, then you should be focused on year-end distributions right now. Some funds are making substantial payouts this month, these are taxable to you, so you’ll want to try to avoid buying into a tax liability this month and try to use distributions as a way to trim your taxes. In some cases, you may be able to use a fund’s distribution to effectively turn a short-term gain into a long-term gain for tax purposes.

Deciding what to do about a distribution can be complex. It’s something FundX advisors have been doing for our wealth management clients for decades, and it still takes time and careful consideration to determine the best course of action, but it’s often worth making the effort.

2. Consider a Roth conversion

Last month’s discussion of Roth conversions prompted many questions from investors. (Click here to read more about why 2020 could be a good time for a conversion.) If you haven’t assessed if it’s right for you, there is still time.

Since required minimum distributions (RMDs) aren’t mandatory this year, you can still choose to convert that amount for simplification or change to a different amount. You’ll pay taxes on it now, but then have it grow tax-free in a Roth IRA for future years. Under current rules, you’d never have to pay taxes on those assets again. Check with your accountant regarding how any conversion affects your own tax bill.

3. Make tax-smart trades

Review your taxable accounts and see if there are any losses you can take before year-end. These can be used to offset other capital gains. Read more on tax-loss harvesting here.

If you have already realized sizable gains in 2020, you might want to postpone making trades that will trigger capital gains. Is your income forecasted to change from 2020 to 2021? That can be an important factor in deciding whether to realize gains.

4. Make year-end donations and gifts

A special measure in the CARES Act, which Congress passed in March, includes an extra incentive to give to charitable organizations in 2020. "Under this new change, individual taxpayers can claim an 'above-the-line' deduction of up to $300 for cash donations made to charity during 2020. This means the deduction lowers both adjusted gross income and taxable income – translating into tax savings for those making donations to qualifying tax-exempt organizations," the IRS explained.

Even if you take the standard deduction, you can still claim up to $300 in donations. If you itemize, the deductibility of cash contributions was raised from 60% to 100% of your adjusted gross income (AGI). This is only applicable to charitable organizations, not gifts to family members.

Remember that it also may be advantageous to gift appreciated securities instead of cash. This way, you’re supporting the people or causes that matter to you, and also lowering your tax bill. Talk to your advisor about which shares are best to pass along; it may not be your best-performing position.

You can also use 529 plans for annual gifting. You can make up to five years' worth of contributions to a 529 plan in a single year (up to $75,000 per beneficiary) without incurring federal gift taxes, as long as you don’t give any more to the plan for the next five years.

5. Maximize your IRA and 401(k) contributions

The limit for individual retirement accounts is $6,000 in 2020; for 401(k) plans, it’s $19,500. If you are 50 or older, you can make an additional catch-up contribution of $1,000 to an IRA or $6,500 for your workplace plans.

Many employers offer health savings accounts (HSA) as well, and you can contribute up to $3,550 to your HSA if you have single coverage or up to $7,100 for family coverage. If you're 55 or older, you can contribute an extra $1,000. Funding your HSA can be more beneficial than adding to your IRA or 401(k) because you get the same tax deduction, but you can withdraw from your HSA tax-free to pay for medical expenses.

To learn more about how our advisors and financial planners might help you manage your investment taxes, click here and let’s set up a time to talk.

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