"Now might be a good time to make some savvy financial moves"
2020 has certainly been an outlier year. The government’s response to the Coronavirus pandemic put in-place some special rules for investors via the CARES Act. Additionally, the results of the recent election could make some other financial moves prudent. Bottom line is, for individuals who have the means, now might be a good time to make some savvy financial moves.
Joe Biden is President Elect of the United States. He brings with him a slew of campaign promises regarding the tax code that could affect your financial decisions as 2020 ends. The following items are based on Biden’s tax proposals on his campaign website and an analysis by the Tax Foundation(2). Even though he is elected, there is no assurance as to which, if any, of these campaign proposals become law. Often, campaign proposals are either not implemented or watered down during the legislative process. It is Congress who would have to implement most of them, not the President. It is not clear that Mr. Biden would have enough votes to pass all them even if Democrats controlled the Senate (they already control the House). And that is a big if, at the moment. It looks like Republicans are destined to maintain control in the Senate pending a runoff election in Georgia. That would most certainly mean most of Biden’s proposals would not make it into law without significant changes. For the purposes of this article, let us just assume every campaign promise will become law. You must assess the probabilities of their enactment and base your decisions accordingly, realizing legislative risk plays a major factor. As always, contact your tax, legal and financial advisors before acting on any of these recommendations.
1. Forego your Required Minimum Distribution (RMD). This is old news by now but, if you were still planning on taking your 2020 RMD, you may want to forego doing so. RMD’s are mandatory withdrawals from a qualified plan (IRA, 401k, etc.) for those over age 72. The CARES Act is allowing you to skip them this year(1), thereby reducing your taxable income.
2. Consider a ROTH Conversion. The CARES Act gives special provisions for spreading taxes on IRA withdrawals taken in 2020 over a 3-year period(1). Converting some of your IRA into a ROTH IRA might make sense, especially if your taxable income is lower this year. For more information about this 2020 ROTH conversion strategy, see the article we wrote earlier this year on the Cogent Consumer Blog.
3. Consider Tax-Loss Harvesting. Tax-loss harvesting is the process of selling assets at a loss to realize those losses for tax purposes. Look at any unrealized losses in your taxable investment portfolio and consider selling some or all losers to realize their losses. You can either keep those losses through the end of the year to use as write-offs or use them to offset realized capital gains in Items 4 and 5 below. Discuss with your financial advisor how to invest the proceeds from any sales you make.
4. Consider Realizing Some Long-Term Capital Gains on Investments. Long-term capital gains (LTCG’s) apply to assets you have owned for more than 1-year. They are the difference between the value at time of sale and your cost basis, and are taxed at a lower rate than your ordinary income. Biden is proposing two changes directly affecting tax treatment of LTCG’s(2): 1. Elimination of the step-up in cost basis upon death and, 2. For those making greater than $1 million per year in income, increasing the tax rate on LTCG’s to their ordinary income tax rate. Assets of all types have had a long run of capital appreciation over the last 10 plus years, so it is highly likely you have significant unrealized (not yet having a tax impact) LTCG’s in them. Especially if your tax burden is lower this year, either due to lost wages or to skipping your RMD, you may consider realizing some of these LTCG’s and either paying taxes on them, thereby locking-in today’s tax rules, or potentially deferring them into Qualified Opportunity Zone Funds (See our previous article on Opportunity Zones on the Cogent Consumer Blog). Either way, realizing gains will help increase your cost basis on your winners thereby winnowing down any future tax liabilities.
5. Consider Increasing Cost Basis on Real Estate. To increase your cost basis on an real estate assets, you either must realize capital gains through a sale or make qualified improvements to them. Both of Biden’s proposed changes to LTCG’s could be at play here: The elimination of the step-up in cost basis and the taxing of LTCG’s at ordinary income rates on folks earning $1 million in a year. Most folks are not going to be concerned with the latter, but older folks especially should pay attention to the former: The proposed elimination of the step-up in cost basis. Currently, when a person dies and leaves property to an heir, the cost basis of that property is increased to its fair market value on the date of death. This “step-up” means that heirs have a reduced tax burden compared to if there was not a step-up. If this goes away, the heirs will have the same tax burden as whomever they have inherited it from (i.e., they would inherit the cost basis of the deceased). Increasing your cost basis now will help reduce your heirs’ tax burden and would lock-in today’s tax laws for yourself. For a primary residence in which you meet the IRS’ Eligibility Test(3), you may consider selling your home in 2020 to take advantage of your capital gains exemptions. Those exemptions are $250k for an individual and $500k for a married couple. That means married couples can eliminate up to $500k of long-term capital gains upon the sale(3). It is not clear if your beneficiaries would get any such exemptions if the step-up is eliminated. For investment property, you may consider selling and either paying cap gains taxes at current rates or deferring them by performing a 1031 exchange (also on Mr. Biden’s chopping block)(2).
6. Maximize Your 401k Contribution. One of Biden’s purported proposals (this is not confirmed yet) is to replace the current tax deductibility of 401k contributions at your marginal tax rate with a flat 26% deduction(4), regardless of income. If this happens, those falling into the 32% tax brackets and higher will see the value of their deductions on contributions be less than they are now. Max your 401k contributions this year to lock-in your higher tax deduction.
7. Change your Compensation for 2021 if You Make More Than $400k. Biden’s proposed tax plan has two tax increases aimed at those making greater than $400k per year in ordinary income(2): 1. He proposes raising the top marginal tax rate to 39.6% from 37% (already scheduled to revert to 39.6% in 2026 under current tax laws), and 2. He proposes adding Social Security taxes on these wages (currently, you don’t pay social security taxes on income greater $137,700). As of this writing, it appears the $400k income Biden is targeting is for single filers and is likely to be higher for those married filing jointly but we cannot be certain. If you are likely to be affected by these tax increases, your first step is to maximize all appropriate tax deductions and credits, including maximizing contributions to your 401k and Healthcare Savings Account (HSA). If you are still likely to be affected, investigate changing the nature of your compensation. Discuss with your employer whether they could divert some of your income into a retirement plan by either increasing their profit-sharing contribution or even starting a defined benefits plan. Additionally, consider taking compensation in the form of stock options. Stock options can be held long enough to qualify for capital gains tax treatment(5) and can be strategically liquidated depending on your tax situation each year. Of course, be mindful that stock options come with both company specific and general stock market risks.
8. Meet with your Estate Planning Attorney. When you die, the IRS uses the value of your assets on the day of your death and calculates your taxable estate. This estate may be subject to the Estate Tax if it is higher than the estate tax exemption in-place the year of your death. Biden proposes reducing the estate tax exemption for singles to $3.5 million from $11.18 million and increasing the top rate for estate tax to 45 percent from 40 percent(2,6). Those exemption figures are doubled for married couples - only if they have the proper estate planning strategies in-place to maximize both spouse’s estate tax exemptions. Therefore, even for carefully planned-for estates, married couples would be subject to a 45% estate tax on every dollar over $7 million of taxable estate value. Several strategies like irrevocable trusts, charitable giving, and gifting can be implemented to reduce the overall size of your estate. You should discuss all these strategies with a qualified estate planning attorney immediately. Gifting is one of the simplest aspects of an estate plan, so we will discuss it here. Gifting money to your beneficiaries now can reduce the size of your estate at your death. You not only get today’s monetary value out of your estate, but also any future growth on those funds. Normally, each grantor can gift $15k per recipient, per year, without triggering a gift tax and without eating into their lifetime gift exemption(6). Any gift over $15k/grantor/recipient will trigger the gift tax. Instead of paying the gift tax, the grantor can dig into their lifetime gift tax exemption and avoid paying taxes on the gift. There is a catch, though, as any use of the lifetime gift exemption lowers the grantor's estate tax exemption on a dollar-for-dollar basis. And, since the lifetime gift tax exemption is equal to the estate tax exemption, it is likely to decrease if the estate tax exemption decreases! Here's a crafty way to get around the $15k gifting limit without eating into your gifting/estate tax exemption AND getting assets out of your taxable estate value - consider gifting to grandchildren via a 529 College Savings Plan. Talk about 3 birds with one stone! Using a 529 college savings plan, each grantor can “front load” 5-years’ worth of gifts in a single year ($15k/year x 5-years =$75k) without triggering gift taxes or using any of their lifetime gift exemption(7). For a married couple, they can transfer $150k per recipient into a 529 Plan in a single year. As a bonus, these funds are not included in your taxable estate when calculating estate taxes. Proper elections on relevant tax forms are required to take advantage of these rules. There are many in’s and out’s to estate planning. Be sure to contact your tax advisor and a qualified estate planning attorney prior to making any decisions.
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Financial Planning and Investment Advisory Services provided by Cogent Independent Advisors (Cogent), a Registered Investment Advisor. Cogent can only do business with clients domiciled in states where authorized or exempt from authorization. Cogent is not a tax or legal advisor. Consult your tax and legal advisors prior to acting.