Along with some COVID-19 related tax changes, the result of the recent Presidential election tends to make tax planning more challenging this year. In looking forward to tax planning beyond 2020, one thing we know for sure is that much depends not only on the outcome of the Presidential election, but also on the results of the Congressional and Senate races. In this article, we will share some year-end tax tips for 2020 to consider in your planning, and point out what some of the proposed changes could be under President-elect Biden’s administration.
Payroll and Withholding
Many taxpayers saw payroll changes during the COVID-19 shutdowns. Because of this, it may be more important this year than in years past to review your projected 2020 income, along with your withholding and estimated tax payments. If you were receiving no paycheck or a reduced income during the shutdown, but were counting on a certain amount of tax withholding to keep you safe from underpayment penalties, there is still time to make any needed adjustments. Keep in mind that withheld taxes are considered to be paid evenly throughout the year, but estimated payments are considered paid on the actual payment date. Therefore, if you find that you have underpaid, it may be better to increase withholding than to boost your fourth quarter estimated payment.
Joe Biden’s tax plan proposes an increase in the top tax rate back to 39.6% from the current 37%. He has also proposed imposing the 12.4% Social Security payroll tax on wages and self-employment income earned above $400,000. The 12.4% tax is split between employers and employees. Because this tax is currently not imposed on wages and self-employment earnings above $137,700, Biden’s plan would create a gap in the Social Security payroll tax, where wages between $137,700 and $400,000 would not be taxed.
Retirement Plan Contributions
Lack of paychecks, distributions and revenue also caused many taxpayers to stop or decrease funding of retirement plans during the shutdown. There is still time to maximize your retirement account contributions prior to year-end. 2020 limits for 401(k) salary deferrals are $19,500 for taxpayers 49 and under and $26,000 for age 50 and over. For taxpayers eligible for Health Savings Account (HSA) contributions, there is still time to maximize those as well. An HSA will allow you to use pre-tax dollars to pay for health care expenses. If your family is covered under your plan, you can contribute up to $7,100 in 2020 plus an extra $1,000 if you are age 55 or over.
If you are over age 70 ½, or have a parent over that age, the CARES Act waived Required Minimum Distributions for 2020 for both account owners and for beneficiaries who inherited a retirement account.
Consider bunching of your itemized deductions for the year. With the current limitations on deduction for state and local income and property taxes ($10,000 maximum deduction), along with increased standard deduction for taxpayers, many find that they are taking the standard deduction vs. itemizing. If so, you may want to consider “bunching” of two years’ worth of charitable contributions into one tax year in order to itemize one year and take the standard deduction the next year. This strategy can also be utilized if you have medical expenses that approach the AGI threshold for deductibility each year, but don’t quite meet it. If so, try to bunch the medical expenses into one year to gain some tax benefit.
President-elect Biden is reportedly in favor of removing the cap on the federal deduction for state and local taxes (SALT deduction), as are Nancy Pelosi and Charles Schumer. Biden proposes capping the value of all itemized deductions to 28% for those taxpayers in the top tax bracket. He would restore the Pease limitations on itemized deductions for those with taxable income above $400,000. These limitations required taxpayers to subtract 3% of certain itemized deductions including mortgage interest, state and local taxes and charitable contributions, if AGI was above certain thresholds.
Harvesting Capital Losses against Gains
Harvesting capital losses is a strategy in which you sell investment assets at a loss in order to offset capital gain income in the same tax year. This allows you to reduce the capital gains tax owed. In 2020, you may have sold investment assets when the market was at a low point during the COVID-19 pandemic. If so, keep in mind that if capital losses exceed capital gains for the year, you can only deduct $3,000 in losses against non-capital gain income, and any remaining capital losses will be carried forward to future tax years.
Biden’s tax proposal includes taxing capital gains at ordinary income tax rates for those earning over $1 million. This current top capital gains tax rate for those in the highest tax bracket is 23.8%. Biden has proposed increasing the top individual income tax rate back to the 39.6% rate that was in effect prior to the 2017 Tax Cuts and Jobs Act.
Qualified Business Income deduction
Specified Service Trades or Businesses (SSTBs), including medical practices, are generally excluded from taking the Section 199A pass-through income deduction. However, since this deduction is taken at the individual level, some business owners and physicians are still able to take the deduction against business/practice income. Individual taxpayers with taxable income less than $326,600 (married) or $163,300 (single) can claim a 20% Section 199A deduction even if the income is from a specified service trade or business. The deduction is phased out until it goes away completely for specified service business income once the taxable income reaches $426,600 (married) or $213,300 (single). You may have other pass-through income that is non-SSTB that qualifies for the deduction. In addition, if you are above the threshold amount, qualified plan contributions and increased charitable contributions may enable you to reduce taxable income to below the threshold amounts.
Biden’s proposal would phase out the Section 199A deduction for taxpayers earning over $400,000. This deduction is currently slated to go away after 2025.
If your business or professional practice is taxed as a C corporation, the owners are likely reducing corporate taxable income by paying themselves reasonable compensation in the form of W-2 wages and bonuses. The current tax rate for C corporations is 21%. Biden has proposed increasing that rate to 28%, which remains below the previous 35% top rate.
While it is hard to determine what the future holds in terms of changes in tax laws, we can act now based on the law as it stands in 2020. Most importantly, review 2020 taxable income and deductions, along with withholding and estimated payments, so you know where you stand. If income for 2020 is lower due to the impact of COVID-19 or for other reasons, you may want to push some of your deductions into 2021 if you expect income to increase next year. Educated planning is often the best defense against future unknowns.