Individual tax planning highlights
Taxpayers should consider whether they can minimize their tax bills by shifting income or deductions between 2021 and 2022. Ideally, income should be received in the year with the lower marginal tax rate, and deductible expenses should be paid in the year with the higher marginal tax rate. If the marginal tax rate is the same in both years, deferring income from 2021 to 2022 will produce a one-year tax deferral and accelerating deductions from 2022 to 2021 will lower the 2021 income tax liability.
Actions to consider that may result in a reduction or deferral of taxes include:
- Delaying closing capital gain transactions until after year end or structuring 2021 transactions as installment sales so that gain is deferred past 2021 (also see Long Term Capital Gains, below).
- Considering whether to trigger capital losses before the end of 2021 to offset 2021 capital gains.
- Delaying interest or dividend payments from closely held corporations to individual business-owner taxpayers.
- Deferring commission income by closing sales in early 2022 instead of late 2021.
- Accelerating deductions for expenses such as mortgage interest and charitable donations (including donations of appreciated property) into 2021 (subject to AGI limitations).
- Evaluating whether non-business bad debts are worthless by the end of 2021 and should be recognized as a short-term capital loss.
- Year end bonuses should be taken in 2021 or delayed until 2022 based on anticipated marginal tax rate.
- Paying 2022 tuition in 2021 to take full advantage of the American Opportunity Tax Credit, an above-the-line tax credit worth up to $2,500 per student that helps cover the cost of tuition, fees, and course materials paid during the taxable year. Forty percent of the credit (up to $1,000) is refundable, which means you can get it even if you owe no tax. To claim the credit, your modified adjusted gross income must be $80,000 or less ($160,000 or less for married filing jointly).
- Accelerating income into 2021 is also a good idea if you anticipate being in a higher tax bracket next year. This is especially true for taxpayers whose earnings are close to threshold amounts that make them liable for the Additional Medicare Tax or Net Investment Income Tax ($200,000 for single filers and $250,000 for married filing jointly). See more about these two topics below.
- Taxpayers close to threshold amounts for the Net Investment Income Tax (3.8 percent of net investment income) should pay close attention to “one-time” income spikes such as those associated with Roth conversions, sale of investments or any other large asset that may be subject to tax.
- Shifting investments to municipal bonds or investments that do not pay dividends to reduce taxable income in future years.
On the other hand, taxpayers that will be in a higher tax bracket in 2022 or that would be subject to the proposed 2022 surcharges may want to consider potential ways to move taxable income from 2022 into 2021, such that the taxable income is taxed at a lower tax rate. Current year actions to consider that could reduce 2022 taxes include:
- Accelerating capital gains into 2021 or deferring capital losses until 2022.
- Electing out of the installment sale method for 2021 installment sales.
- Deferring deductions such as large charitable contributions to 2022.
Long-term capital gains
Investment decisions are often more about managing capital gains than about minimizing taxes. For example, taxpayers below threshold amounts in 2021 might want to take gains, whereas taxpayers above threshold amounts might want to take losses. Tax-loss harvesting – offsetting capital gains with losses – may be a good strategy to use if you have an unusually high income this year or significant losses.
In 2021, tax rates on capital gains and dividends remain the same as 2020 rates (0%, 15%, and a top rate of 20%); however, threshold amounts have been adjusted for inflation as follows:
- 0% – Maximum capital gains tax rate for taxpayers with income up to $40,400 for single filers, $80,800 for married filing jointly;
- 15% – Capital gains tax rate for taxpayers with income of $40,400 to $445,850 for single filers and $80,800 to $501,600 for married filing jointly;
- 20% – Capital gains tax rate for taxpayers with income above $445,850 for single filers, $501,600 for married filing jointly.
Where feasible, reduce all capital gains and generate short-term capital losses up to $3,000. As a general rule, if you have a significant capital gain this year, consider selling an investment on which you have an accumulated loss. You can claim capital losses up to the amount of your capital gains plus $3,000 per year ($1,500 if married filing separately) as a deduction against income.
After selling a securities investment to generate a capital loss, you can repurchase it after 30 days. This is known as the “Wash Rule Sale.” If you buy it back within 30 days, the loss will be disallowed. Or you can immediately repurchase a similar (but not the same) investment, e.g., an ETF or another mutual fund with the same objectives as the one you sold. The wash sale rule only applies to stocks and securities. It does not currently apply to cryptocurrencies such as Bitcoin, which means you can sell Bitcoin and immediately buy it back. If you have losses, you might consider selling securities at a gain and then immediately repurchasing them since the 30-day rule does not apply to gains. That way, your gain will be tax-free, your original investment is restored, and you have a higher cost basis for your new investment (i.e., any future gain will be lower).
Long-term capital gains (and qualified dividends) are subject to a lower tax rate than other types of income. Investors should consider the following when planning for capital gains:
- Holding capital assets for more than a year (more than three years for assets attributable to carried interests) so that the gain upon disposition qualifies for the lower long-term capital gains rate. Short-term capital gains are taxed as ordinary income.
- Considering long-term deferral strategies for capital gains such as reinvesting capital gains into designated qualified opportunity zones.
- Investing in, and holding, “qualified small business stock” for at least five years.
- Donating appreciated property to a qualified charity to avoid long term capital gains tax.
Mutual fund investments
Before investing in a mutual fund, ask whether a dividend is paid at the end of the year or whether it will be paid early in the following year but be deemed paid this year. The year-end dividend could make a substantial difference in the tax you pay.
Action: You invest $20,000 in a mutual fund in 2021. You opt for automatic reinvestment of dividends, and in late December of 2021, the fund pays a $1,000 dividend on the shares you bought. The $1,000 is automatically reinvested.
Result: You must pay tax on the $1,000 dividend. You will have to take funds from another source to pay that tax because of the automatic reinvestment feature. The mutual fund’s long-term capital gains pass through to you as capital gains dividends taxed at long-term rates, however long or short your holding period.
The mutual fund’s distributions to you of dividends it receives generally qualify for the same tax relief as long-term capital gains. If the mutual fund passes through its short-term capital gains, these are reported to you as “ordinary dividends” that don’t qualify for relief.
Depending on your financial circumstances, it may or may not be a good idea to buy shares right before the fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax consequences. Or the market could be moving up, with share prices expected to be higher after the ex-dividend date. To find out a fund’s ex-dividend date, call the fund directly.
Net investment income tax (NIIT)
The Net Investment Income Tax, which went into effect in 2013, is a 3.8 percent tax applied to investment income such as long-term capital gains for earners above a certain threshold amount ($200,000 for single filers and $250,000 for married taxpayers filing jointly). Short-term capital gains are subject to ordinary income tax rates as well as the 3.8 percent NIIT. This information is something to think about as you plan your long-term investments. Under current tax law, business income is not subject to the NIIT, provided the individual business owner materially participates in the business.
Social security tax
The Old-Age, Survivors, and Disability Insurance (OASDI) program is funded by contributions from employees and employers through FICA tax. The FICA tax rate for both employees and employers is 6.2% of the employee’s gross pay, but only on wages up to $142,800 for 2021 and $147,000 for 2022. Self-employed persons pay a similar tax, called SECA (or self-employment tax), based on 12.4% of the net income of their businesses.
Employers, employees, and self-employed persons also pay a tax for Medicare/Medicaid hospitalization insurance (HI), which is part of the FICA tax, but is not capped by the OASDI wage base. The HI payroll tax is 2.9%, which applies to earned income only. Self-employed persons pay the full amount, while employers and employees each pay 1.45%. An extra 0.9% Medicare (HI) payroll tax must be paid by individual taxpayers on earned income that is above certain adjusted gross income (AGI) thresholds, i.e., $200,000 for individuals, $250,000 for married couples filing jointly and $125,000 for married couples filing separately. However, employers do not pay this extra tax.
Retirement plan contributions
Individuals may want to maximize their annual contributions to qualified retirement plans and Individual Retirement Accounts (IRAs).
- The maximum amount of elective contributions that an employee can make in 2021 to a 401(k) or 403(b) plan is $19,500 ($26,000 if age 50 or over and the plan allows “catch up” contributions). For 2022, these limits are $20,500 and $27,000, respectively.
- The SECURE Act permits a penalty-free withdrawal of up to $5,000 from traditional IRAs and qualified retirement plans for qualifying expenses related to the birth or adoption of a child after December 31, 2019. The $5,000 distribution limit is per individual, so a married couple could each receive $5,000.
- If you are employed or self-employed with no retirement plan, you can make a deductible contribution of up to $6,000 a year to a traditional IRA (deduction is sometimes allowed even if you have a plan). Further, there is also an additional catch-up contribution of $1,000 if age 50 or over.
- Under the SECURE Act, individuals are now able to contribute to their traditional IRAs in or after the year in which they turn 70½.
- The SECURE Act changes the age for required minimum distributions (RMDs) from tax-qualified retirement plans and IRAs from age 70½ to age 72 for individuals born on or after July 1, 1949. Generally, the first RMD for such individuals is due by April 1 of the year after the year in which they turn 72.
- Individuals age 70½ or older can donate up to $100,000 to a qualified charity directly from a taxable IRA.
- The SECURE Act generally requires that designated beneficiaries of persons who die after December 31, 2019, take inherited plan benefits over a 10-year period. Eligible designated beneficiaries (i.e., surviving spouses, minor children of the plan participant, disabled and chronically ill beneficiaries and beneficiaries who are less than 10 years younger than the plan participant) are not limited to the 10-year payout rule. Special rules apply to certain trusts.
- Small businesses can contribute the lesser of (i) 25% of employees’ salaries or (ii) an annual maximum set by the IRS each year to a Simplified Employee Pension (SEP) plan by the extended due date of the employer’s federal income tax return for the year that the contribution is made. The maximum SEP contribution for 2021 for the self-employed individual is $58,000. The maximum SEP contribution for 2022 is $61,000. The calculation of the 25% limit for self-employed individuals is based on net self-employment income, which is calculated after the reduction in income from the SEP contribution (as well as for other things, such as self-employment taxes).
Qualified charitable distributions (QCDs)
Taxpayers who are age 70 1/2 and older can reduce income tax owed on required minimum distributions (RMDs) – a maximum of $100,000 or $200,000 for married couples – from IRA accounts by donating them to a charitable organization(s) instead.
Starting in 2020, taxpayers required to take required minimum distributions from IRAs, SIMPLE IRAs, SEP IRAs, or other retirement plan accounts can wait until age 72. In prior years, the age was 70 1/2.
Foreign earned income exclusion
The foreign earned income exclusion is $108,700 in 2021, to be increased to $112,000 in 2022.
Alternative minimum tax
The alternative minimum tax (AMT) applies to high-income taxpayers that take advantage of deductions and credits to reduce their taxable income. The AMT ensures that those taxpayers pay at least a minimum amount of tax and was made permanent under the American Taxpayer Relief Act (ATRA) of 2012. Furthermore, the exemption amounts increased significantly under the Tax Cuts and Jobs Act of 2017 (TCJA). As such, not as many taxpayers are affected as were in previous years. In 2021, the phaseout threshold increased to $523,600 ($1,047,200 for married filing jointly). Both the exemption and threshold amounts are indexed for inflation.
AMT exemption amounts for 2021 are as follows:
- $73,600 for single and head of household filers,
- $114,600 for married people filing jointly and for qualifying widows or widowers,
- $57,300 for married people filing separately.
The unearned income of a child is taxed at the parents’ tax rates if those rates are higher than the child’s tax rate. Children with unearned income are allowed a standard deduction of the greater of $1,100 or the child’s earned income plus $350, but not more than the regular standard deduction ($12,750 in 2021). The next $1,100 of unearned income is taxed at the child’s tax rate. Any amounts over $2,200 are taxed at the rates for single individual filers. If the child is under age 19 (or under age 24 and a full-time student) and both the parent and child meet certain qualifications, then the parent can include the child’s income on the parent’s tax return.
If your company grants stock options, then you may want to exercise the option or sell stock acquired by exercising an option this year. Use this strategy if you think your tax bracket will be higher in 2022. Generally, exercising this option is a taxable event; the sale of the stock is almost always a taxable event.
Limitation on deductions of state and local taxes (SALT Limitation)
For individual taxpayers who itemize their deductions, the Tax Cuts and Jobs Act (TCJA) introduced a $10,000 limit on deductions of state and local taxes paid during the year ($5,000 for married individuals filing separately). The limitation applies to taxable years beginning on or after December 31, 2017 and before January 1, 2026. Various states have enacted new rules that allow owners of pass-through entities to avoid the SALT deduction limitation in certain cases.
Medical expenses are deductible only to the extent they exceed a certain percentage of adjusted gross income (AGI); therefore, you might pay medical bills in whichever year they would do you the most tax good. In 2021, deductible medical and dental expenses must exceed 7.5 percent of AGI. By bunching medical expenses into one year, rather than spreading them out over two years, you have a better chance of exceeding the thresholds, thereby maximizing the deduction.
Deductible expenses such as medical expenses and charitable contributions can be prepaid this year using a credit card or check. You can only deduct medical and dental expenses you paid this year – not payments for medical or dental care you will receive in a future year. For example, suppose you charge a medical expense in December but pay the bill in January. Assuming it’s an eligible medical expense, you can take the deduction on your 2021 tax return.
The Taxpayer Certainty and Disaster Relief Act of 2020 extended the temporary suspension of the AGI limitation on certain qualifying cash contributions to publicly supported charities under the CARES Act. As a result, individual taxpayers are permitted to take a charitable contribution deduction for qualifying cash contributions made in 2021 to the extent such contributions do not exceed the taxpayer’s AGI. Any excess carries forward as a charitable contribution that is usable in the succeeding five years. Contributions to non-operating private foundations or donor-advised funds are not eligible for the 100% AGI limitation. The limitations for cash contributions continue to be 30% of AGI for non-operating private foundations and 60% of AGI for donor advised funds. The temporary suspension of the AGI limitation on qualifying cash contributions will no longer apply to contributions made in 2022. Contributions made in 2022 will be subject to a 60% AGI limitation. Tax planning around charitable contributions may include:
- Maximizing 2021 cash charitable contributions to qualified charities to take advantage of the 100% AGI limitation.
- Creating and funding a private foundation, donor advised fund or charitable remainder trust.
- Donating appreciated property to a qualified charity to avoid long term capital gains tax.
- Bunching charitable deductions every other year if it enables a taxpayer to get over the standard deduction threshold.
Sound estate planning often begins with lifetime gifts to family members. In other words, gifts that reduce the donor’s assets are subject to future estate tax. Such gifts are often made at year-end, during the holiday season, in ways that qualify for exemption from federal gift tax. Gifts to a spouse who is a U.S. citizen are free of federal gift tax. Gifts to non-spouse donees are exempt from the gift tax for amounts up to $15,000 and $16,000 for 2022. An unused annual exemption doesn’t carry over to later years. To make use of the exemption for 2021, you must make your gift by December 31.
- Husband-wife joint gifts to any third person are exempt from gift tax for amounts up to $30,000 ($15,000 each). Though what’s given may come from either you or your spouse or both of you, both of you must consent to such “split gifts.”
- Gifts of “future interests” are assets that the donee can only enjoy at some future period such as certain gifts in trust and generally don’t qualify for exemption. Gifts for the benefit of a minor child, however, can be made to qualify.
- Cash or publicly traded securities raise the fewest problems. However, you may choose to give property you expect to increase substantially in value later. Shifting future appreciation to your heirs keeps that value out of your estate. But this can trigger IRS questions about the gift’s true value when given.
- You may choose to give property that has already appreciated. The idea here is that the donee, not you, will realize and pay income tax on future earnings and built-in gain on the sale.
Gift tax returns for 2021 are due on the same date as your income tax return (April 18, 2022). Gifts over $15,000 (including husband-wife split gifts totaling more than $15,000) and gifts of future interests must file a gift tax return. Though you are not required to file if your gifts do not exceed $15,000, you might consider filing anyway as a tactical move to block a future IRS challenge about gifts not “adequately disclosed.” Please call the office if you’re considering making a gift of property whose value isn’t unquestionably less than $15,000.
For 2021, the unified estate and gift tax exemption and generation-skipping transfer tax exemption is $11,700,000 per person. For 2022, the exemption is $12,060,000 under current tax law.
Net operating losses
The CARES Act permitted individuals with net operating losses generated in taxable years beginning after December 31, 2017, and before January 1, 2021, to carry those losses back five taxable years. The unused portion of such losses was eligible to be carried forward indefinitely and without limitation. Net operating losses generated beginning in 2021 are subject to the TCJA rules that limit carryforwards to 80% of taxable income and do not permit losses to be carried back.
Excess business loss limitation
A non-corporate taxpayer may deduct net business losses of up to $262,000 ($524,000 for joint filers) in 2021. The limitation is $270,000 ($540,000 for joint filers) for 2022.
Roth conversions allow a taxpayer to convert funds in a pre-tax individual retirement account or 401(k) to a post-tax Roth IRA. The amount withdrawn from the IRA is considered income and subject to tax; however, future Roth IRA distributions are tax-free.
You do not have to convert your entire IRA to a Roth IRA at once; you can convert all or part of it during different tax years. For example, if you have $90,000 in a 401(k), you can convert it over three years – $30,000 in the first year and $30,000 per year for the next two years. This strategy works well for taxpayers who want to eliminate to minimize RMDs (Required Minimum Distributions) at age 72 from their IRAs and leave more of your retirement account funds to heirs.
Converting to a Roth IRA from a traditional IRA makes sense if you’ve experienced a loss of income (lowering your tax bracket) or your retirement accounts have decreased in value. Please call if you would like more information about Roth conversions.
Health savings accounts
Consider setting up a health savings account (HSA) if you are covered by a high deductible plan. You can deduct contributions to the account, investment earnings are tax-deferred until withdrawn, and any amounts you withdraw are tax-free when used to pay medical bills. In effect, medical expenses paid from the account are deductible from the first dollar (unlike the usual rule limiting such deductions to the amount of excess over 7.5 percent of AGI). For amounts withdrawn at age 65 or later not used for medical bills, the HSA functions much like an IRA.
529 education plans
Maximize contributions to 529 plans, which can now be used for elementary and secondary school tuition as well as college or vocational school.