Now that we’ve entered December it’s a good time to think about year-end tax strategies. But doing so is challenging because so much is different for 2020 with the passage of the CARES Act, stimulus payments, unemployment, and so forth. Also, speculation about the incoming administration trying to change tax policy complicates things further. All these moving parts make it difficult to figure out what to do, if anything, to improve your tax situation for 2020.
Going through the motions is still important, however. The process starts with getting a handle on what you expect your taxable income to be for the year. This helps you understand what tax bracket you’re likely to be in (you can Google the brackets to see how that works). If your income might be lower than normal in 2020, think about filling up your expected tax bracket with a Roth conversion or possibly pulling forward some of next year’s income into this year. You could even “harvest” gains in your portfolio to take advantage of a lower income year. Doing one (or even all) of these things helps smooth out how your income looks on paper and should save you some money in taxes over the long run.
Along these lines, here are parts of a recent article on year-end strategies from Christine Benz at Morningstar. I’ve italicized a few areas for emphasis and a link to the full article is included below. As a reminder, our tax code is full of complications, so make sure you do your homework before acting.
Take Advantage of the Hiatus on RMDs
For retirees who are subject to required minimum distributions from their IRAs and other tax-deferred accounts, 2020 may well turn out to be the lowest-tax year they experience in their retirements. That’s because the CARES Act, passed in the spring as the pandemic was just coming into view and the market was cratering, put a pause on RMDs for this year. The goal was to help retirees avoid invading their IRA assets at a time when their accounts were at a low ebb. Stocks have recovered handsomely since the first-quarter sell-off, but at the time of the CARES Act’s passage, they were deep in the red.
Even retirees who are not yet subject to RMDs may well find themselves in a lower tax year in 2020 than in the rest of their retirements. That’s because the pandemic has curtailed spending opportunities; dining out and big-ticket travel are off the table for many of us. Not only that, but tax rates are at low levels today relative to history. Retirement-portfolio withdrawals for non-RMD-subject investors are likely to be lower this year, too, as will their tax bills.
That provides an opportunity to improve the tax efficiency of your overall portfolio plan while you’re in a relatively low tax bracket relative to the rest of your retirement. A key strategy to consider is whether to convert some traditional IRA assets to Roth. There are two key advantages of doing so. The first is the ability to take tax-free withdrawals from the account in retirement, or for your heirs to do so if you don’t consume the whole IRA during your lifetime. The second is to skip RMDs on your IRA assets; traditional IRAs are subject to RMDs once you pass age 72, whereas Roth IRAs don't carry RMDs.
That said, conversions aren’t free; they’ll almost always result in a bigger tax bill in the year of the conversion than if you didn’t undertake them. It’s best if you have the funds to pay those taxes separate from the IRA--in other words, you wouldn’t want to have to pull extra from the IRA to pay the taxes due. Get some tax help and be sure to understand the nuances of conversions--specifically, the role of Medicare surcharges (or IRMAA) as well as the tax repercussions of converting an IRA balance that consists of deductible and pretax contributions.
Scout Around for Tax-Loss Sales (or Tax Gains)
Tax-loss selling can be a worthwhile strategy at year-end, too: By pruning losing holdings from your portfolio, you can use those losses to offset an equivalent amount of capital gains or, if your losses exceed your gains, up to $3,000 in ordinary income. While the broad stock market has recovered nicely thus far in 2020, it has still been a two-track market: Growth-oriented stocks and funds have enjoyed strong gains, while value stocks and strategies have languished. Energy stocks have been particularly hard-hit. Thus, investors may be able to pick off some losing positions from their taxable accounts and book the tax losses.
Tax-gain harvesting is also worthy of consideration by retirees who expect to be in the 0% tax bracket for long-term capital gains, meaning that their total income comes in under $40,000 (single filers) or $80,0000 (married couples filing jointly). Alternatively, the strategy can also make sense if a taxpayer expects to be in a lower tax bracket--albeit not the 0% bracket for long-term capital gains--in 2020 than in future years. Tax-gain harvesting can reduce the tax bills that could eventually be due if an individual is in a higher tax bracket in the future, and it can also allow an investor to rebalance and/or remove problematic positions from a portfolio with less of a tax hit than would otherwise be the case.
Develop Next Year's Cash Flow Strategy
Finally, year-end is a good time to develop your cash flow strategy for next year. How much will you withdraw from your portfolio, and which accounts will you tap for the withdrawals? Conventional withdrawal sequencing suggests that taxable assets should come first in the distribution queue, followed by tax-deferred and then Roth. But the best way to limit your taxes in a given year might be to withdraw from more than one account type (taxable, traditional tax-deferred, Roth) with an eye toward keeping yourself in the lowest possible tax bracket.
Have questions? Ask me. I can help.
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