A new year brings the opportunity to review current income tax planning and consider an update.
Since the Tax Cuts and Jobs Act of 2017 (TCJA), tax rates remain relatively low. However, most TCJA provisions are set to expire in 2025. In addition, recent federal budget deficits have risen to unprecedented levels, and there is uncertainty around tax policy as a new administration takes office. These factors set the stage for a need for increased revenue, which could translate into higher taxes.
Investors may want to consider certain strategies to hedge against the risk of higher taxes. The current tax environment and potential for higher tax rates in the future create an opportunity for tax-smart planning.
1. Consider Roth IRA conversions
A strategy utilizing Roth conversions can be an effective way to hedge against the threat of higher taxes in the future. Lower tax rates now translate to a lower cost for converting traditional IRA assets to a Roth IRA. It is impossible to predict tax rates in the future, given uncertainty in Congress, or to have a good idea of what your personal tax circumstances will look like years from now. Like all income from retirement accounts, Roth income is not subject to the 3.8% surtax and is also not included in the calculation for the $200,000 income threshold ($250,000 for couples) to determine if the surtax applies. IRA owners considering a conversion to a Roth IRA should carefully evaluate that transaction since the option to recharacterize, or undo, a Roth IRA conversion is no longer available.
2. Explore alternative ways to fund Roth accounts
Taxpayers at higher income levels are prohibited from contributing directly to Roth IRAs. For 2021, income phaseouts begin at $125,000 ($198,000 for married couples filing a joint return). Taxpayers may want to consider funding a non-deductible (after-tax) IRA and then subsequently converting the account to a Roth IRA. There are no income restrictions on Roth IRA conversions. However, adverse tax consequences, referred to as the “pro rata” rule, may apply if the individual owns other pretax IRAs (including SEP-IRA or SIMPLE-IRA). Before considering this strategy, taxpayers should consult with their tax professional. Also, participants in 401(k) plans may be able to make voluntary after-tax contributions into their plan in excess of their salary deferral limit ($19,500 or $26,000 if age 50 or older). When allowed by the plan, after-tax contributions may be directly transferred to a Roth IRA without any income tax consequences upon a plan triggering event.* This may be a strategy for higher-income taxpayers to diversify their tax liability in retirement.
3. Maximize deductions in years when itemizing
With the increase in the standard deduction under recent tax law changes, and the scaling back of many popular deductions, fewer taxpayers are choosing to itemize deductions. Some taxpayers may benefit by alternating between claiming the standard deduction in some years and itemizing deductions in other years. Investors may want to “lump” as many deductions into those years when itemizing. For example, taxpayers may want to consider making a substantial charitable contribution during a tax year when itemizing instead of making regular annual gifts. In addition, with the repeal of the “Pease rule,” there are no phaseouts on itemized deductions at higher income levels.
4. Be mindful of irrevocable trusts and taxes
There is a low income threshold ($13,050 for 2021), that will subject income retained within an irrevocable trust to the highest marginal tax rates and the 3.8% Medicare surtax. For this reason, trustees may want to reconsider investment choices inside of the trust (municipal bonds, life insurance, etc.). Trustees might also consider (if possible) distributing more income out of the trust to beneficiaries who may be in lower income tax brackets.
5. Expand use of 529 accounts for education savings
The use of 529 college savings plans provide several tax advantages. Account earnings are free of federal income tax, and a special gift-tax exclusion allows account owners to treat up to $75,000 of contributions as though they had been made over a five-year period. Qualified education expenses were expanded in recent years to include laptops, computers, and related technology. Recent changes allow families to use up to $10,000 annually for K–12 tuition. Make sure to consult with a tax professional if considering a distribution for K–12 expenses since there may be adverse state income tax consequences.
6. Consider the charitable rollover option for retirees
Retired IRA owners (age 70½ and older) may benefit from directing charitable gifts tax free from their IRA. Since even more retirees will claim the higher standard deduction, they will not benefit tax-wise from making those charitable gifts unless they itemize deductions. Account owners are limited to donating $100,000 annually, which can include the required minimum distribution (RMD), and the proceeds must be sent directly to a qualified charity.
With any tax strategy, it is important to consult with a financial professional or tax expert with knowledge of your personal financial situation. Making changes to tax strategies may have an impact on your overall tax plan. Read Putnam’s “10 income and estate planning strategies” for more information about tax-smart strategies for 2021.
*IRS Notice 2014-54
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.