Tax Alert: End-of-Year Planning Strategies You Don't Want to Miss

One of Jerry Seinfeld's funniest stand-up moments was his "Night Guy" bit. In the bit, he introduces the audience to the inner voice inside our head who temps us to stay-up late, otherwise known as Night Guy. Night Guy isn't concerned with how tired and groggy you'll feel in the morning after only 5 hours of sleep because that's a problem for "Morning Guy," the other voice you hear at 6 a.m. cursing Night Guy for keeping you up until midnight on a Tuesday.

Seinfeld's Morning Guy bit is a profoundly accurate and hysterically honest example of why people procrastinate. If it's not urgent, important, relevant or immediately satisfying in the moment, then it's likely to be delayed or neglected until tomorrow or next week. It's "Tomorrow Guy's" problem and "Today Guy" already has an agenda that favors instant gratification over delayed fulfillment. Sound familiar?

One of the most common areas of procrastination shouldn't come as a surprise: financial planning. Even the term itself sounds lame and boring and something better suited for Tomorrow Guy. Sure, you know it's important to have your finances in order and enjoy saving money, but there's always a reason why you haven't scheduled that meeting with your estate attorney or sat down with your CPA. "Yeah, I need to do that," or "I've been meaning to make an appointment," are common excuses I hear from Today Guy. Don't feel bad, I've been Today Guy more often than I care to admit.

The problem with procrastination, as least as it pertains to financial planning, is that the benefits of being financially proactive aren't clearly communicated, making the task less urgent in the moment. If I told you it's important to consider tax-loss harvesting before year-end to help reduce your income tax liability, would you take action and schedule a meeting with your advisor? What if instead I offered to give you a $1,500 coupon redeemable in four months if you make an appointment today to discuss with your advisor opportunities of turning investment losses into tax savings? Which offer resonates with you more?

Today Guy will tell you that taxes aren't due until April 15th so you have nothing financially to worry about until April 14th. Tomorrow Guy is here to provide you with a summary of financial planning strategies with clearly defined benefits in terms of dollars-saved that you should consider implementing before it's too late.

What to Do Before December 31, 2020

Let me start by stating the dollar figures used below will be based off of simple, arbitrary examples contrived by me to illustrate value. These amounts are by no means definitive for everyone and I recommend consulting with your tax or financial professional before carrying out any of these strategies.

1. Tax-loss Harvesting - $1,500 Redeemable Coupon Savings

In an earlier post I wrote more in detail about tax-loss harvesting, but the short of it is selling an investment at a loss to offset other gains and/or income on your tax return.

Example: Your taxable investment account shows year-to-date capital gains of $20,000. Assuming your income exceeds $80,000 per year, you'll owe $3,000 in taxes on those gains if you do nothing. If however you have another investment with an unrealized loss of, say $10,000, you could sell this investment and reinvest the proceeds into something different, thereby cutting your capital gain of $20,000 in half and saving you $1,500 in taxes when you file.

When executed correctly, tax-loss harvesting can be a highly effective strategy for investors looking to minimize taxes before year-end. Just remember the wash sale rule which prevents you from deducting the loss if you repurchase the same, or similar security, within 30 days of the sale. So if the investment you sold was, for example a large-cap value fund, you wouldn't want to purchase another large-cap value fund but instead purchase something unrelated such as a broad index like the S&P 500.

2. No RMDs - $0 in Taxes on Your Capital Gains

One of the many changes enacted in 2020 as a result of the pandemic was the suppression of Required Minimum Distributions, or RMDs, from IRAs. From a tax perspective, this means your income, and taxes for 2020 could be less than in prior years (assuming you didn't need to take your RMD) as RMDs are taxed as ordinary income. This creates an opportunity to take some investment risk off the table while potentially avoiding paying taxes.

Example: Your RMD for 2020 was $40,000. You currently receive Social Security benefits of $40,000 which, when combined with your RMD, total $80,000 in taxable income.

But let's assume you didn't take your RMD in 2020, meaning your only taxable income would be Social Security of $40,000. If you have other highly-appreciated investments such as a single stock holding held in a taxable account or a piece of real estate, you could consider selling the investment and end up paying little-to-nothing in capital gains tax.

The current long-term capital gains rate for a married couple making under $80,000 per year is 0%. For example, if you own TSLA stock in a taxable account that has appreciated by $40,000, you could sell your position and theoretically owe $0 in capital gains tax on the sale. And even if you wanted to hold TSLA, you could still sell the stock and then repurchase, thereby eliminating the gain and increasing your cost basis tax-free.

3. Side-Stepping Capital Gain Distributions to Save $2,696

If you own mutual funds in a taxable account you'll want to check the Mutual Fund Observer to see what, if any capital gain distributions are coming your way. Remember, these aren't distributions in the traditional sense as you never physically receive money. Instead, you're handed a tax bill from the mutual fund company.

Example: You own $100,000 of the Invesco Select Risk High Growth Investor Fund which per the chart below taken from the Mutual Fund Observer has an expected capital gain distribution of 17.97% of net asset value, or NAV.

In this example, Invesco would issue you a 1099 with reportable items to include on your tax return, including a long-term capital gain (LTCG) of approximately $17,970 ($100,000 x 17.97%). And assuming you're in the 15% LTCG bracket, you'd have to pay $2,696 in taxes just for holding this investment.

To avoid this, you might consider selling the fund before the capital gain distribution is incurred to avoid paying tax, assuming of course the gain from selling doesn't exceed the pending distribution. Meaning, if you show an increase in value of $18,000 or more on your Invesco fund, it would make more sense to hold rather than sell as the capital gain distribution in this example ($17,970) would be less than the gain incurred had you sold. However, if the fund hasn't moved much since it was purchased, or even better has declined in value, you may want to sell and dodge a hefty tax bill.

Taxes aren't everything, though. The fund may have performed extremely well or be an essential component of an expertly crafted investment strategy, in which case it may be advantageous to eat the gain and pay the tax.

4. Charitable Giving - Above the Line $300 Tax Deduction

Prior to 2020, taxpayers were only allowed to write off charitable deductions on their tax returns if they itemized. That is, if their deductible expenses such as state, local and real estate taxes exceeded the standard deduction which, for 2019 was $24,400 for a married couple filing jointly.

Now, thanks to the CARES Act, the IRS allows up to $300 of charitable donations to be deducted against your income, regardless if you itemize. While this isn't likely to make a substantial difference in tax savings (this equates to about $66 in savings if you're in the 22% tax bracket), it does provide an added incentive to be extra generous in a year when the less fortunate need it the most.

5. Pre-pay for College - Save $900 in State Taxes

The maximum amount of allowable annual contributions to most 529 plans is fairly substantial. However, most states limit the amount you can deduct on your tax return which, in 2020 for the state of Pennsylvania, is equal to annual gifting limits of $15,000 and $30,000 for individuals and couples, respectively.

Despite the limitations, contributing the maximum deductible amount to a 529 plan ($30,000 for a couple) in 2020 would save you around $900 in Pennsylvania state taxes ($30,000 x 3.07%). Further, your contributions will grow tax-free with the potential of avoiding any taxes in the future as distributions taken for qualified education expenses like tuition are tax-free.

6. Foreign Taxes - $2,000 in Your Pocket

While there are a variety of tax credits available to taxpayers, I want to focus on the foreign tax credit as it's often overlooked, yet can provide significant savings for investors over the long run.

American taxpayers are eligible to claim a tax credit, or dollar-for-dollar reduction in tax liability, for income taxes paid to foreign governments. This is commonly seen in the investment world as many international funds and ETFs invest in a wide range of foreign companies that payout taxable interest and dividends to shareholders.

However, investors can't claim the credit if the foreign taxes were paid from a qualified account like an IRA. So if you paid $2,000 of foreign income taxes on XYZ Emerging Markets Fund held in your IRA, you won't be able to take advantage of the credit.

One way around this is to re-position your retirement assets so that the bulk of your international investments are held in a taxable account. Most retirees with multiple investment accounts (IRAs, brokerage, etc.) who employ some level of diversification generally have both international and domestic stocks in each of their investment accounts. Favoring international investments in a taxable account and domestic in the others ensures your overall investments remain globally diversified while giving you the opportunity to claim tax credits on foreign taxes paid from your taxable account. So if the XYZ Emerging Markets Fund been held in your brokerage account instead of your IRA, you'd have been able to claim that $2,000 tax credit.

Remember, a tax credit is far more valuable than a tax deduction:

Deduction: A $2,000 tax deduction for someone in the 22% tax bracket = $440 in tax savings

Credit: A $2,000 tax credit for someone in the 22% tax bracket = $2,000 in tax savings

Obviously, there may be tax consequences from repositioning (buying and selling) foreign and domestic investments between taxable and tax-deferred accounts. And you may already have a planned distribution strategy in place preventing a reallocation of international and domestic investments. Accordingly, it may take time and careful planning before your investments are realigned for optimized tax savings.

7. 401(k) Contributions - Get Paid $5,720 to Save Your Own Money