By Anita Mahamed, CPA, CFP®, Wipfli LLP and Anthony Perillo, CFP®, Wipfli Financial Advisors, LLC
There have been a lot of tax law changes enacted over the last couple of years — with potentially more ahead. In times like these, your most effective tax strategy can practically flip from year to year.
Is your approach keeping up with the latest tax legislation? What’s coming down the pike — and how that could impact the decisions you make today? Is now the time for income acceleration or income deferral?
Tax wise, we’re in a somewhat fast-paced environment. That’s why it’s good to have annual check-ins with a CPA and a financial advisor who know your situation. These advisors can keep you current on new opportunities so you can live your most tax-efficient financial life.
Here are five tax-saving strategies:
- 401(k) planning
Waiting until spring to do your tax planning? That could mean missed opportunities, particularly if you’ve had a big income year. Some savings vehicles like IRAs and HSAs can be implemented after year-end, but the deferral limits are relatively low.
Generally, the primary opportunity for deferring income is in your employer-sponsored 401(k) plan, and those contributions need to be made by December 31. Be aware, your 401(k) limit may be higher than you think. Beyond the $19,500 limit for pretax contributions, some plans have a maximum contribution limit of $58,000 in 2021 ($64,500 if you’re 50 or older). That limit includes pretax, after-tax and employer contributions.
And, if your 401(k) plan allows you to move your after-tax money, you could boost your tax advantages with an in-plan Roth rollover. It’s a way to get your funds into a Roth IRA, even if your income exceeds the standard milestone. This can be a valuable strategy if you’re in a lower income year and/or expect your tax bracket to be significantly higher in the future.
- Charitable planning
Right now, a lot of people are making charitable donations and not seeing any tax benefit. Ever since the Tax Cuts and Jobs Act raised the standard deduction in 2018, fewer people benefit from itemizing their charitable gifts.
But if your household is near the standard deduction threshold ($24,000 filing jointly, $12,000 as an individual), there may be tax advantages to doubling your donations one year, then skipping the next.
Let’s say you donate $5,000 to charity every December. Under an every-other-year strategy, you might hold your 2021 gift to January 2022 and then make your regular contribution in December that year. By deferring your gift just one month, your combined donations may tip you over the standard deduction, creating a tax benefit where previously there was none.
Donor-advised funds (DAFs) are another strategy with increasing popularity. With a DAF, you can make a financial contribution today but distribute those funds to a charity at a later date. It’s another way to bunch your contributions together to create a tax-advantaged gift that exceeds your standard deduction. Because they are designated for charity, your gifts can also grow tax-free until they are disbursed in the form of grants.
One way to further increase the tax-efficiency of your charitable giving is to donate appreciated securities (stocks, mutual funds, ETFs, etc.) that you have held for longer than a year. These types of gifts can either be made to a DAF or directly to a charity, presuming they are willing to accept securities (most are). By donating appreciated securities, you are able to avoid capital gains tax on the appreciation and get a deduction equal to the fair market value, as long as you itemize your deductions.
- Expanded spending options for 529 plans
A 529 plan is a tax-favored savings account you can use for educational expenses. These accounts have federal tax benefits, with many states (including Wisconsin) offering state tax deductions as well. In Wisconsin, contributions reduce your state taxable income, dollar for dollar, up to $3,380 per beneficiary per year. Any contributions you make above that amount will carry forward into the next year.
Originally designed to help families save for college, 529 plans can now be used for elementary and high school tuition. And, as of December 2019, those funds can also be applied to apprenticeship programs registered with the federal Labor Department. Eligible apprenticeship expenses include fees, textbooks, equipment and other required supplies.
Another relatively new change allows 529 funds to be used for student debt, up to $10,000 per year. That can be a helpful strategy to optimize a grandparent-owned 529 account without impacting a student’s financial aid eligibility. Or, if one student doesn’t use all their allocated funds, money can be used to pay down a sibling’s school debt.
- Tax management for your investment portfolio
If you have a taxable investment portfolio, there are strategies you can use to mitigate income taxes on your returns.
Using tax-efficient investment vehicles, like ETFs and tax-managed mutual funds, can boost your after-tax returns. In a conventional mutual fund with a high level of portfolio turnover, capital gains distributions and non-qualified dividends can eat away at your returns on an after-tax basis. The structure of ETFs can provide some tax advantages over mutual funds, and tax-managed mutual funds are administered in a way that minimizes taxes. Those strategies may include holding an investment for longer than a year, tax lot accounting, managing for qualified dividends and more. (If tax minimization is not an explicit strategy listed in a fund’s prospectus, it’s probably not being managed that way.)
Another strategy: Generally, if your federal tax bracket is around 24% or higher, consider investing in municipal bonds. Interest on these bonds is not taxed at the federal level. In some states, certain bonds may be tax-free for both state and federal.
Tax-loss harvesting is an investment strategy that involves selling an investment at a loss and buying a similar, substitute investment simultaneously. By using this strategy, you can “lock in” an otherwise unrealized, paper loss to offset gains on your tax return, but the overall composition of your investment portfolio essentially remains the same. Almost everyone had losses at some point in 2020 in their portfolios when we experienced a significant market downturn due to the COVID-19 pandemic. Did you take advantage of the opportunity to harvest losses?
- Potential tax rate increases
At this point, we don’t know if and when federal tax rates will increase, but bills are underway. We could be seeing a higher tax rate for individuals making over $400,000, new gifting rules, higher corporate tax rates and higher capital gains rates for gains over $1 million.
In a typical year, tax planning often involves deferring income and maximizing deductions. But if tax changes come to pass, your best strategy may be doing the opposite — accelerating income into the 2021 tax year and deferring deductions into future years when the tax value will be greater.
Similarly, if you’re a business owner, you might decide to opt out of the new bonus depreciation rules in order to spread depreciation out over several years. Those deductions would be worth more in future years if tax rates increase.
In times of rapid tax law changes, your best strategy is to stay flexible. What makes sense for your situation one year can change considerably the next.
But whether tax laws shift or not, there are a lot of tax planning and wealth planning strategies you can implement to optimize your financial life. Exploring what those are for your individual situation can really move the needle — regardless of what may happen in Washington. Reach out to learn more.
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