With year end rapidly approaching, it's time to consider making some moves that will lower your 2021 federal income tax bill — and potentially position you for future tax savings. Unfortunately, tax planning is particularly challenging this year, because the tax rules for 2022 aren't yet certain. In fact, they may not even be certain for 2021.
Here are nine planning tips for you to consider making before year end. But you also may want to be ready to take last-minute corrective actions if Congress works out a deal on the Build Back Better Act and the Bipartisan Infrastructure Bill before year end.
The 2017 Tax Cuts and Jobs Act (TCJA) almost doubled the standard deduction amounts. For 2021, the standard deduction allowances are:
If your total itemizable deductions will be close to your standard deduction allowance, consider making enough additional expenditures for itemized deduction items before year end to exceed the standard deduction. Those additional expenditures will lower this year's tax bill. Next year, your standard deduction will be bigger thanks to an inflation adjustment, and you can claim it then if you're unable to itemize next year.
The easiest deductible expense to prepay is included in the mortgage payment due on January 1. Accelerating that payment into this year will give you 13 months' worth of itemized home mortgage interest deductions in 2021. Ask your tax advisor to determine whether you're affected by limits on mortgage interest deductions under current law.
Another item to consider prepaying is state and local income and property taxes that are due early next year. Prepaying those bills before year end can decrease your 2021 federal income tax bill, because your itemized deductions total will be that much higher. But, beware: The TCJA limits the amount you can deduct for state and local taxes to $10,000 ($5,000 for married individuals who file separate returns).
Important: Prepaying state and local taxes can be a bad idea if you'll owe alternative minimum tax (AMT) this year. That's because write-offs for state and local income and property taxes are completely disallowed under the AMT rules. Therefore, prepaying those expenses may do little or no good for people who are subject to the AMT. Fortunately, the TCJA eased the AMT rules, so most people are no longer at risk.
Other ways to increase your itemized deductions for 2021 include:
You can claim an itemized deduction for medical expenses to the extent they exceed 7.5% of your adjusted gross income (AGI) for 2021.
If you hold investments in taxable brokerage firm accounts, consider the tax advantage of selling appreciated securities that have been held for over 12 months. The federal income tax rate on long-term capital gains can be as high as 20%, plus the 3.8% net investment income tax (NIIT) can also apply at higher income levels. (See "Current Individual Federal Income Tax Scene" at right.)
To the extent you have capital losses from earlier this year or capital loss carryovers from prior years, selling appreciated investments this year won't result in a tax hit. In particular, sheltering net short-term capital gains with capital losses is a tax-smart move because net short-terms gains would otherwise be taxed at higher ordinary income rates of up to 37%.
Conversely, if you have some losing investments — that are currently worth less than what you paid for them — you might want to unload them. Taking the resulting capital losses this year would allow you to shelter capital gains, including high-taxed short-term gains, from other sales this year.
If selling some losing investments would cause your 2021 capital losses to exceed your 2021 capital gains, the result would be a net capital loss for the year. It can be used to shelter up to $3,000 of 2021 income from salaries, bonuses, self-employment income, interest income and royalties ($1,500 for married individuals who file separate returns). Any excess net capital loss can be carried forward indefinitely.
A capital loss carryover can be used to shelter short- and long-term gains recognized next year and beyond. This can give you extra investing flexibility in those years, because you won't have to hold appreciated securities for over a year to get a lower tax rate. You'll pay 0% to the extent you can shelter gains with your loss carryover. If your tax rates go up after this year, capital loss carryovers into 2022 and beyond could turn out to be even more valuable.
You can also make gifts to your favorite charities in conjunction with an overall revamping of your investments in taxable brokerage firm accounts. But there are two tax-smart principles to keep in mind.
First, don't give away investments that are currently worth less than what you paid for them. Instead, sell the shares and book the resulting tax-saving capital loss. Then you can give the cash sales proceeds to favored charities — plus, if you itemize, you can claim the resulting tax-saving charitable write-offs.
The second principle applies to investments in appreciated securities. These winning investments should be donated directly to a preferred charity. Why? Because, if you itemize, donations of publicly traded shares that you've owned for over a year result in charitable deductions equal to the full current market value of the shares at the time of the gift. Plus, when you donate appreciated shares, you escape any capital gains taxes on those shares. Meanwhile, the tax-exempt charitable organization can sell the donated shares without owing any federal income tax.
Note: Normally, if you take the standard deduction and don't itemize, you can't claim a deduction for charitable contributions. But a recent law allows you to claim a limited deduction on your 2021 return for cash contributions made to qualifying charitable organizations. You can claim a deduction of up to $300 for cash contributions made during this year ($600 for a married couple filing a joint return).
The principles for tax-smart gifts to charities also apply to gifts to relatives. That is, you should sell losing investments and collect the resulting tax-saving capital losses. Then give the cash sales proceeds to loved ones.
Likewise, you should give appreciated shares directly to relatives. When they sell the shares, they'll probably pay a lower tax rate than you would.
IRA owners and beneficiaries who have reached age 70½ are permitted to make cash donations totaling up to $100,000 annually to IRS-approved public charities directly out of their IRAs. You don't owe income tax on these qualified charitable distributions (QCDs), but you also don't receive an itemized charitable contribution deduction.
The upside is that the tax-free treatment of QCDs equates to an immediate 100% federal income tax deduction without having to worry about restrictions that can delay itemized charitable write-offs. Contact your tax advisor if you want to hear about the benefits of QCDs. If you're interested in taking advantage of this strategy for 2021, you'll need to arrange with your IRA trustee or custodian for money to be paid out to one or more qualifying charities before year end.
If paid for you, your spouse or a dependent to attend college, you may be eligible one of the following tax credits for higher education costs:
American Opportunity credit. This credit equals 100% of the first $2,000 of qualified postsecondary education expenses, plus 25% of the next $2,000 (assuming the phaseout rule explained later doesn't affect you). So, the maximum annual credit is $2,500.
Lifetime Learning credit. This credit equals 20% of up to $10,000 of qualified education expenses. The maximum credit is $2,000.
For 2021, both higher education credits are phased out if your modified adjusted gross income (MAGI) is between:
Numerous rules and restrictions apply to these higher education credits. If you're eligible for either credit, consider prepaying college tuition bills that aren't due until early 2022 if it would result in a bigger credit this year. Specifically, you can claim a 2021 credit based on prepaying tuition for academic periods that begin in January through March of next year.
Important: The higher education tuition and fees deduction expired at the end of 2020.
It may pay to defer some taxable income from this year into next year if you optimistically believe you'll be in the same or lower tax bracket in 2022 than in 2021. For example, if you operate a small business that uses the cash method of accounting, you can postpone taxable income by waiting until late in the year to send out some invoices. That way, you won't receive payment for them until early 2021. Small business owners can also defer taxable income by accelerating some deductible business expenditures into this year.
Both moves will postpone taxable income from this year until next year when it might be taxed at lower rates. Deferring income can also be helpful if you're affected by unfavorable phase-out rules that reduce or eliminate various tax breaks, such as the child tax credit and the higher-education tax credits.
But Congress is currently discussing tax increases for higher-income individuals to help fund various spending initiatives. So, some people could be in a higher tax bracket next year. If you're facing this situation, consider accelerating income into this year (if possible) and postponing deductible expenditures until 2022.
The best scenario for converting a traditional IRA into a Roth account is when you expect to be in the same or higher tax bracket during retirement as you are in today. If you think you might be in a higher tax bracket in the future due to proposals being discussed by Congress, now might be a good time to consider a conversion.
However, there's a current tax cost for converting. A conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth account. If you wait to convert your account until 2022 or later, the tax cost could be higher, depending on future tax rates.
After the conversion, all the income and gains that accumulate in the Roth account, and all qualified withdrawals, will be federal-income-tax-free. In general, qualified withdrawals are those taken after:
With qualified withdrawals, you (or your heirs if you die) won't be required to pay higher tax rates that might otherwise apply in future years. While the current tax hit from a Roth conversion is unwelcome, it could be a relatively small price to pay for future tax savings.
Given the uncertainties about future federal income taxes, year-end tax planning for 2021 is a tricky business. Meet with your tax pro as soon as possible to stay atop the latest developments and to discuss any last-minute moves that may be needed before December 31 to achieve the best possible results.
Assuming no retroactive changes to the contrary, the 2021 federal income tax rate picture for individuals will be the same as last year. However, the rate brackets have been adjusted slightly for inflation.
Currently, there are seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. For 2021, the top rate applies to:
Assuming no retroactive changes to the contrary, the 2021 federal income tax rate for most individuals with net long-term capital gains and qualified dividends will be 0% or 15%.
However, the maximum rate on long-term capital gains and dividends rises to 20% for:
Higher-income individuals can also see all or part of their net investment income, including capital gains and dividends, hit with the 3.8% net investment income tax (NIIT). However, the NIIT only bites you if your modified adjusted gross income (MAGI) exceeds:
The NIIT applies to the lesser of:
MAGI is your regular adjusted gross income increased by certain tax-exempt income from outside the United States.
Higher-income individuals can also get hit by the additional 0.9% Medicare tax on wages and self-employment (SE) income. The 0.9% tax is charged on salary and/or net SE income above:
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