Minimizing Taxes While Avoiding an IRS Audit
With the combination of general public discontent and the Coronavirus crisis, it does not matter which political party is in office next year – we can count on increased taxes. The amount of money that the U.S. government has recently printed is unprecedented. We have had previous deficits, but none have been as extensive as the national deficit created in 2020. Much of the spending will have to be recouped. So, we must all be prepared for taxes to increase.
There is an almost overwhelming probability that taxes will rise for the middle class and wealthy over the next several years. At the moment , I am advising and bracing clients for such a possibility, by looking at Roth conversions, earned income, capital gains, and charitable contributions.
Both major party presidential candidates are preparing voters for potential tax changes due to the growing budget deficits. Former Vice President Joe Biden, the Democratic nominee for the upcoming presidential election, released his tax proposal earlier this year. Mr. Biden wants to increase taxes for families with earnings above $400,000 to boost federal revenue.
Mr. Biden’s proposal includes repealing some of the tax cuts featured in the Trump administration’s 2017 tax overhaul that favored the affluent. Mr. Biden’s proposal suggested recapping itemized deductions, rolling back income tax deductions, taxing capital gains and dividends.
Even without a change of administrations, however, federal and state governments are facing overwhelming budget deficits from the pandemic. The financial fallout from stay at home orders and the rising number of layoffs are putting pressure on government finances, causing additional concern about tax increases for affluent clients.
Clients should consider taking capital gains now. The capital gains tax will likely be one of the taxes that the federal government will target to recoup its losses from the Coronavirus. The long-term capital gains tax rate is currently at 15% for incomes between $40,001 and $441,450 and 20% for income beyond that. Short-term rates match the rate on a client’s ordinary income.
For clients who have large embedded capital gains, the capital gains rates are as low as they’ve ever been. In the lowest tax bracket, there is actually a 0% capital gain tax rate. Consequently, there is some ability to harvest gains now, that might not be there in the future. If the rates increase from the 0%, 15%, 20% structure that we have currently to the 28% structure that we had previously, or the rates that candidates may propose, the result will be in a significant increase in the individual tax bill.
2020 may be the last year to make large or unlimited charitable contributions. Current tax benefits and itemized deductions are threats to wealthier taxpayers. Prior to the recent tax legislation, certain clients would not have been able to deduct large charitable contributions. But now, in the simplest case a client can take an income tax deduction in 2020 for cash contributions directly to charity of up to 100% of their income. They benefit for every dollar they give over the standard deduction.
A client might also consider qualified charitable distributions if they are 72 years old and above and have a qualifying IRA. An IRA holder can take a distribution, but instead of taking it into their personal account, they can redirect it to the charity of their choice. As long as the donation is under $100,000, the entire amount donated from an IRA is basically tax neutral. It will show up as a distribution on the tax return but then zero out.
Clients should consider making Roth conversions before the December 31,2020 deadline since the tax brackets are relatively favorable until at least that point in time. It’s an opportunity to convert all or part of an IRA to a Roth IRA, and stay within that lower tax bracket.
For example, a single person who earns $50,000 a year, and is in the 22% tax bracket could convert $35,525 of their IRA, increasing their income to $85,525, and still be in the 22% tax bracket. After this year, the tax rate for all taxpayers could increase. Consequently, converting now takes advantage of the current, lower rate. And, it makes the growth on those accounts thereafter tax-free because of that unique feature of the Roth IRA.
The pandemic pushed the government to provide financial aid in a wide variety of situations. One of those was waiving the required minimum distributions from individual retirement accounts and 401(k) plans for 2020. Clients can skip a year if they choose. This also benefits non-spousal inheritors of these retirement accounts who are required to draw down the account within 10 years instead of their life expectancy.
Clients who are in or near retirement should consider Roth conversions to capitalize on the waived Required Minimum Distributions and a recovering market. The goal would be to max out the lower tax brackets with Roth conversions this year.
Under normal circumstances, a Required Minimum Distribution cannot be converted. Instead, a conversion would be taxable distribution – in addition to and separate from – the Required Minimum Distribution. When a Required Minimum Distribution is reinvested inside a taxable investment account, future investment income and capital gains are taxed. With a Roth conversion, tax is paid once. A Roth conversion is not only good for the client, it is good for the family.
Clients’ children are often in their peak earning years. The children do not want or need additional taxable income at that point. A Roth IRA is a more attractive inheritance vehicle because the account can continue to grow tax-free for ten years, and when the required distribution is made, it doesn’t trigger any tax.
High income earners might consider deferred compensation plans to avoid the potential tax increase. The 401(k) limits are fairly low in relation to the incomes of these taxpayers. But there is a reasonable argument to not defer money in this way because of future income tax rates. What if tax rates are lower now than they will be in the future? If taxes are going up, the incentive to save in a tax deferred way is less, especially within five or so years of retiring. A better option might be to save after-tax and then grow it tax-free, such as a Roth IRA or a 401(k) Roth election.
Small business owners were hurt the most during the pandemic. Until they can get their businesses back open and running, they won’t be able to survive a tax increase. Consequently, it may be several years before the economy stabilizes, and substantial tax reform is initiated. Be prepared – taxes will go up eventually, and certainly will increase when the current tax reform expires in 2025.