This is the time to assess your tax outlook for 2021. By developing a comprehensive year-end plan, you can maximize the tax breaks currently on the books and avoid potential pitfalls. Be aware that the concepts discussed in this article are intended to provide only a general overview of year-end tax planning. It is recommended that you review your personal situation with a tax professional.
Traditionally, investors time sales of assets like securities at year-end for optimal tax results. For starters, capital gains and losses offset each other. If you show an excess loss for the year, you can then offset up to $3,000 of ordinary income before any remainder is 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 as high as 37% in 2021.
TAX TACTIC: Review your portfolio. Depending on your situation, you may want to harvest capital losses to offset gains or realize capital gains that will be partially or wholly absorbed by losses. For instance, you might sell securities at a loss to offset a high-taxed short-term gain.
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, such as young children. 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.
Tip: The preferential tax rates for long-term capital gains also apply to qualified dividends received in 2021. These are most dividends paid by U.S. companies or qualified foreign companies.
Required Minimum Distributions
Normally, you must take “required minimum distributions” (RMDs) from qualified retirement plans and traditional 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.
The CARES Act suspended the RMD rules for 2020—but for 2020 only. The RMD rules are reinstated for this year.
TAX TACTIC: Make arrangements to receive RMDs before January 1, 2022. Do not procrastinate. If you wait too long, you may miss the December 31 deadline if the financial institution cannot accommodate you quickly enough or you run into other complications.
As a general rule, you may arrange to receive the minimum amount required, so you can continue to maximize tax-deferred growth within your accounts. However, you may decide to take larger distributions—or even the full balance of the account—if that suits your needs.
Tip: The IRS has revised the tables for 2022 to reflect longer life expectancies. This will result in smaller RMDs in the future.
Net Investment Income Tax
Moderate-to-high income investors should be aware of an add-on 3.8% tax that applies to the lesser of “net investment income” (NII) or the amount by which 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, capital gains and income from passive activities, but not Social Security benefits, tax-exempt interest and distributions from qualified retirement plans and IRAs.
TAX TACTIC: After a careful analysis, estimate both your NII and MAGI for 2021. Depending on the results, you may be able to reduce your NII tax liability or avoid it altogether.
For example, you might invest in municipal bonds (“munis”). The 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. Caution: These rules are complex, so obtain professional assistance.
Tip: When you add the NII tax to your regular tax plus any applicable state income tax, the overall tax rate may approach or even exceed 50%. Factor this into your investment decisions.
Section 1031 Exchanges
Beginning in 2018, the TCJA generally eliminated the tax deferral break for Section 1031 exchanges of like-kind properties. However, it preserved this tax-saving techniques for swaps involving investment or business real estate. Therefore, you can still exchange qualified real estate properties in 2021 without paying current tax, except to the extent you receive “boot” (e.g., cash or a reduction in mortgage liability).
TAX TACTIC: Make sure you meet the following two timing requirements to qualify for a tax-deferred Section 1031 exchange.
- Identify or actually receive the replacement property within 45 days of transferring legal ownership of the relinquished property.
- Have the title to the replacement property transferred to you within the earlier of 180 days or your 2021 tax return due date, plus extensions.
Note that the definition of “like-kind” is relatively liberal. For example, you can exchange an apartment building for a warehouse or even raw land.
Tip: Proposed legislation would eliminate the tax break for real estate. If this technique appeals to you, start negotiations that can be completed before the end of the year.
Estate and Gift Taxes
Going back to the turn of the century, Congress has gradually increased the federal estate tax exemption, while establishing a top estate tax rate of 40%. At one point, the estate tax was repealed—but for 2010 only—while the unified estate and gift tax exemption was severed and then subsequently reunified.
Finally, the TCJA doubled the exemption from $5 million to $10 million for 2018 through 2025, with inflation indexing. The exemption is $11.7 million in 2021.
TAX TACTIC: Develop a comprehensive estate plan. Generally, this will involve various techniques, including trusts, that maximize the benefits of the estate and gift tax exemption. The table below shows the progression of the exemption and top estate tax rate for the last ten years.
Furthermore, you can give gifts to family members that qualify for the annual gift tax exclusion. For 2021, there is no gift tax liability on gifts of up to $15,000 per recipient ($30,000 for a joint gift by a married couple). This reduces the size of your taxable estate.
Tip: You may “double up” by giving gifts in both December and January that qualify for the annual gift tax exclusion for 2021 and 2022, respectively.
- Contribute up to $19,500 to a 401(k) in 2021 ($26,000 if you are age 50 or older). If you clear the 2021 Social Security wage base of $142,800 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. Also, this may effectively reduce your overall tax liability.
- Weigh the benefits of a Roth IRA conversion, especially if this will be a low-tax year. Although the conversion is subject to current tax, you generally can receive tax-free distributions in retirement, unlike taxable distributions from a traditional IRA
- 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 improve your overall tax picture.
This year-end tax-planning article is based on the prevailing federal tax laws, rules and regulations. Of course, it is subject to change, especially if additional tax legislation is enacted by Congress before the end of the year.
You may be interested in the other year-end articles:
- Click here for the 2021 Year-End Individual Tax Planning article
- Click here for the 2021 Year-End Business Tax Planning article
Finally, remember that this article is intended to serve only as a general guideline. Your personal circumstances will likely require careful examination. We would be glad to schedule a meeting with you to assist with all your tax-planning needs.