E5: The ABCs of End of Year Tax Planning

Executive Summary

Listen to this week’s podcast episode to learn the ABCs of tax planning!  Advisors Abrin Berkemeyer CFP® and Tyler Hafford explain the impact of the CARES Act on taxes this year, as well as some tax planning basics.  We encourage you to reach out to your financial advisor and tax preparer to see if any of these solutions are a good fit for your particular situation.

Required Minimum Distributions (RMDs)

Advisors Abrin Berkemeyer CFP® and Tyler Hafford kick off the episode discussing Required Minimum Distributions (RMDs).  The updated rule which takes effect in 2020 states that RMDs now begin the tax year you turn 72 (previously 70½).  There is some leniency that first year, where the IRS permits you to take your RMD by the April 1st following the year you turned 72.  Every subsequent year, RMDs must be taken by December 31st.  It is critical to take RMDs, because the penalty for missing a RMD is 50% of the amount of RMD you failed to take.  So if you skipped out on taking a $20,000 RMD, you owe a $10,000 penalty.  The CARES Act waives the requirement for RMDs for 2020.  The advantage of this is your can keep that RMD amount invested, continue to have tax-deferred growth in that account, and avoid income taxes on the RMD amount.  If you do not need the income this year, that can be a great option.

Qualified Charitable Distributions (QCDs)

Abrin & Tyler explain that in years when you do need to take a RMD, you can donate it to a charitable organization in what is called a Qualified Charitable Distribution (QCD).  This strategy lets you donate all or part of your RMD to a charity and the portion donated will not count towards your taxable income.  You can search for qualifying charitable organizations on the IRS’s website HERE.

The CARES Act and Charitable Giving Changes

More filers are now fitting into the “Standard Deduction” category after the Tax Cuts And Jobs Act (TCJA) which often means those tax payers are less incentivized to make charitable contributions.  The CARES Act added an “above the line” deduction that will reduce Adjusted Gross Income (AGI) by up to $300 per taxpayer ($600 for a married couple).

The other major change for charitable giving with the CARES Act impacts those who file itemized deductions.  Previously, you could donate and deduct up to 60% of your AGI.  In 2020, you can deduct up to 100% of your AGI.  Example: your AGI this year is $100,000 and you determine that you do not need that income and you can make a charitable contribution in the amount of $100,000, and your AGI is now $0.

Contributions into a Traditional IRA & SEP IRA – Taxed LATER

Another way to minimize your AGI and current year tax burden is to make a contribution into a Traditional IRA or for Self-Employed individuals, into your SEP IRA.  The contribution deadline for a Traditional IRA is April 15th on the following year.  The contribution deadline for SEP IRA contributions is the same date as the employer’s tax-filing deadline, including extensions.

Contributions made in a Traditional IRA for individuals can result in a reduction of AGI if you (or your spouse) do not have the option to participate in any employer sponsored retirement plan like a 401(k) plan.  If you (or your spouse) can participate in an Employer-Sponsored plan, you can still contribute into your IRAs, but depending on your AGI, you might not be able to deduct that contribution from your AGI when you file your taxes.  HERE is a chart that explains your AGI and the amount of deduction you can take for your IRA contribution.  The current annual IRA contribution limits are $6,000 for individuals under the age of 50 and $7,000 for individuals 50 or older.

Self-Employed individuals have the benefit of the SEP IRA.  SEP IRAs have a much higher contribution limit.  You can contribute the lesser of 25% of your compensation OR $57,000 in 2020.  There are rules surrounding SEP IRAs, such as the need to make contributions of equal percentages of salaries for all employees.  The IRS has a helpful FAQs article HERE that you should check out if you think this might be a good option for you.

Contributions into a Roth IRA – Taxed NOW, Tax-Free Growth

Contributions into a Roth IRA will not lower your taxes today, but they can be advantageous for you over the years and in retirement.  Contributions made into a Roth IRA are post-tax dollars, meaning they will show up in your AGI on your taxes for the applicable tax year.  You can take a distribution from your Roth contributions at any time without paying any taxes or penalty, because they were post tax dollars.  If you leave all of the earnings in the account until you are of retirement age (currently 59.5), when you do distribute the earnings, they are TAX-FREE.  There is a penalty if you withdrawal the earnings prior to age 59.5 unless the distribution is for the first time purchase of a home or education expenses.  Having the ability to take funds out of a Roth IRA without increasing your AGI can be a very powerful tax planning tool.  It is also worth noting that those who inherit your Roth IRA would not be subject to taking RMDs and the assets are passed down to your heirs tax-free.

Eligibility to contribute into a Roth IRA is dependent on your AGI.  You can view the IRS’s chart for 2020 HERE.

Roth Conversions

A Roth Conversion is when you shift money from an IRA into a Roth IRA and pay taxed on the amount “converted” to post-tax dollars.  The some common instances where a conversion is used is are:

  1. Individuals who are having an unusually low income year can convert the IRA funds into Roth funds and take advantage of paying taxes in a lower bracket than they ordinarily would have.
  2. Individuals who have an IRA and recognize that the market has dipped may want to convert their pre-tax dollars now, anticipating that the market will rebound and the earnings will be tax-free.
  3. Those individuals who are high earners and are not eligible to make Roth IRA contributions directly can do a Roth conversion as a back-door into contributing into a Roth IRA.

Tax Gains/Loss Harvesting

Certain investment accounts are considered “non-qualified” or taxable accounts, meaning they are funded with post-tax dollars and do not receive benefits like tax-deferred growth (like IRAs) or tax-free growth (Roth IRAs).  For these accounts, there are 3 main actions that cause a taxable event, and each of those has a different method of taxation:

  1. A dividend is paid.  When a dividend is paid to the investor, this is typically taxed at the long-term capital gains rate.
  2. Interest is paid.  Interest paid from bond, CDs or cash in your account is generally taxed as ordinary income, unless it qualifies for exemptions such as US Treasury Bonds of Municipal Bonds.
  3. A security is sold for a profit or loss.  When a security is purchased, the price it is  purchased at is considered the cost basis.  If that security is sold for more than the cost basis, the profit is a capital gain.  If that security is sold for less than the cost basis, that is a capital loss.  If that security is held for greater than 1 year, that is a long-term capital gain/loss and is taxed at a more favorable rate than short-term capital gains.  This is where an investor and/or their asset manager should be strategically seeking out ways to optimize the tax burden.  Aligning tax gains and losses within the same tax year can offset that tax liability.  Jim Bradley has written two blogs on the topic of tax gains/loss harvesting that you can read by clicking the links below.

It’s The (tax loss) Harvest Season!

It’s also tax-GAIN harvesting season!

Staying Organized During Tax Time

The final piece of advice given was to stay organized.  When you receive tax documents, save them in a centralized location and this will save a lot of time and energy for you and your tax professional when the time comes to file your taxes!

DISCLAIMER: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security.


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Full Transcript

Abrin:  Welcome on today’s episode. We’re going to be talking about end of year tax planning. I’m Abrin Berkemeyer, CFP®

Tyler: and I’m Tyler Halford

Abrin: and this is Financial Discretion Advised

Tyler: Thanks everyone for joining us again today and like Abrin said end of year tax planning, but before we get started, we want to remind anyone who’s listening to us checks on YouTube. We’re doing videos now, if you think Abrin and I are awesome in just audio, you should see us in video. Anything that you’re finding us on any podcast streaming or YouTube, like and subscribe.  All that helps, so please write some reviews, or leave comments, we’d like to see what everyone’s thinking, but Abrin why don’t you get us started.

Abrin:  I think one of the main things that comes around this time of year for anybody of older age is generally required minimum distributions (RMDs). I think we should give everybody a little tax update on that, because that’s a big one that you need to take care of before December 31st, every year, except for this year, because we’ve got some changes.

Tyler: Yeah. A little bit of change, but like you said, big tax bite there, if you miss these and this is something, especially folks who have never taken a required minimum distribution in their life. Right? It’s just something you’re not thinking about, if you’ve never heard it, but it is a 50% tax on the money you’re supposed to take out of any retirement account if you’re not taking care of that by December 31st.

Abrin: Well, we should qualify that by saying any pretax retirement account.

Tyler: Thank you. And we’ll get into a little bit of the difference between those two, a little later on in the show, but yeah, absolutely, something to be paying attention to and up to this point, it has been, if you are 70 and a half, you have got to take out your required minimum distribution, but that’s changed recently and we’ve upped that to 72.  So if you were, if you were sweating it this year and you were 69 you got a few more years before you got started taking them out. But certainly something to pay attention to.

Abrin: And for those of you were, are required to take RMDs because you were over that age, 70 and a half threshold in the past, which used to be the old beginning date for required minimum distributions, now that is age 72. So you know that might’ve been this year would have been a year that some people probably would have thought they had to take an RMD. That got pushed out. But whether or not you thought you had to take an RMD or you’re already past that age and had started RMDs, the CARES Act is one of those things that happened this year due to the coronavirus where the United States government has said that required minimum distributions are not required this year. So, if you were sweating it, starting to think, oh, I got to call up my financial advisor, get that RMD taken care of this year. You know, there’s a reason.  That you don’t have to and it’s the CARES Act. So you know, that’s pretty good. It doesn’t just have to be anybody who is over this over the age limit for RMDs, but that also qualifies for inherited IRAs where you might’ve had to take an RMD for this year, if you’re on a life expectancy method.  That is also not required for 2020.

Tyler: I think that it’s good that you brought up the inherited IRAs as well, that you’re not required to be taken any money out.  For folks listening, wondering why Abrin and I are positioning this in fashion of not wanting to take money out of your retirement accounts, it’s because any of those qualified retirement accounts are going to come with a tax hit when you’re pulling money out of them, so in a year you don’t need to take any money out of them, it is more beneficial for you just let them sit in there and stay invested. If you don’t need to take any money out of those accounts and the government is giving you this pass, you know, coronavirus showed up, definitely take advantage of that can be a good kind of planning tool for you that you just kind of got a year of, alright, well, I didn’t have to take anything else. Pay extra tax.

Abrin: And that’s one of those big things with required minimum distributions, you know, the government says once you’re over that age, now age 72, you must start taking money out of this. We gave you a tax deduction while you were working. Yep. We’re going to get some tax money on this eventually. So

Tyler: Uncle Sam is always going to come to get his cut and you know, he’s giving you the tax break you know, back when you made those contributions, but he wants to share. And that’s what the required minimum distributions are, is kind of saying, alright, we got to get taxation out of this, but there are some ways to avoid taxation out of our your RMDs or your retirement accounts. And that’s done by qualified charitable distributions, right? So

Abrin:  If RMDs weren’t confusing enough, now you’ve got QCDs. If you, any given year say you don’t need that RMD and you have a charitable mind and are wanting to give to charities, you can give up your RMD or a portion of your RMD to a qualified charity. The IRS has a nice little search tool, you can go on and find all the other qualifying charities. So if you Google it, you can find that search tool really quick on the IRS is webpage and say, Hey, I want to give a portion of my RMD to this non-profit.

Tyler: We should have named this episode the ABCs of End of Year Tax Planning, but

Abrin:  We still have time. We haven’t named it yet. It’s not live!

Tyler: But like Abrin saying, if you’re someone who does charitable contributions anyway, it would be a good way to avoid some taxation on money you are going to have to take out.

Abrin: So that QDC, however much you give away, it doesn’t even flow through your tax return, right? You don’t have to claim that as income like you do a normal, normal required minimum distribution.

Tyler: In the realm of charitable giving the CARES Act actually made some changes to that as well. This year, just for folks who were thinking what are my tax deductions going to be on just kind of what I’ve contributed to this year. Abrin why don’t you walk us through where we were prior to the CARES Act, what this year will look like and how can we maximize that.

Abrin: Sure. So there were really two big things that came out of the CARES Act when it comes to charitable giving.  One of those was the increase in the AGI limit for anybody who’s itemizing their deductions. So typically when you’re taking a charitable contribution, you can only do so when you itemize your deductions.  A little bit of a caveat this year, which we’ll talk about,

Tyler: Which has gotten more difficult with recent tax law changes, right? So they, they, they essentially brought up the standard deduction. And what that was doing is making it more difficult than for them to itemize, in their mind a simpler tax system. Right. And when we don’t have all these itemizations what it did is actually made it more difficult for folks to get above that standard deduction with things like charitable contributions

Abrin: And the reason that’s important is if you’re not getting above that standard deduction with your itemized deductions, then you’re not going to take the lower itemized deduction because people don’t pay more in taxes than they have to. So you take the higher standard deduction and you don’t itemize in that year.  In the past for charitable contributions, which is one of the things that you can itemize it used to be that you max out as to how much you can give to charity as far as a, as far as a tax advantage at 60% of your adjusted gross income for that given year. So, say you’re just a gross income was a hundred thousand, 60% of that, mean you could give $60,000 to a public charity.  So in that case, you would only you, you would only be able to itemize $60,000 out of that a $100,000.  This year if you’re charitably inclined and you, and you don’t need the income, you can itemize up to a hundred percent of your AGI. You know, that might be obviously pretty, pretty hard to hit for a lot of people given the current economic environment, but for those who are charitably inclined and don’t necessarily need the income and want and want a good year to be able to give more than a very good option for them.

Tyler: That’s kind of what it is. It’s, you know, if you were giving up to 60% originally, arguably you had some room there to go up, and this is just giving you a little bit more of a runway there if you were if you were looking to give some more.

Abrin: The one that it’s probably say probably hits more homes and is more applicable to almost everybody in the United States is that they have another charitable deduction that you can take, even if you take the standard deduction. So now we’re not playing, picking and choosing between the itemizing and the standard deduction. But it is a much smaller deduction. So this year, if you do take the standard deduction and you give to charity, you can take an additional $300 off the top of your standard deduction. Yeah. Add that for charitable contributions and deduct that. So, you know, if you’re not deducting your whole salary, you know, you take the, take the 300 and you’re able to give to charity and, and get some tax base for that.

Tyler: And really, really nice thing too, for people to be able to itemize in this year, because arguably there is a lot to give your money to if you have the ability to do so. There’s a lot of coronavirus focused charity groups out there. You may be able to help quite a few of people. And if you have that capability, this is just another nice tax incentive to say, alright, take your standard deduction, but cut a little bit off the income there if you want to make the contribution. So kind of moving away from that and into how else can we lower our taxable income every year is using things outside of a work plan, like a traditional IRA, or maybe you’re a small business owner, you have a SEP IRA plan, those are great ways to kind of chop some money off of that adjusted gross income. A lot of times I have clients who come in and they say, you know, I just have a lump sum, now these aren’t decisions you have to make by December 31st, like the RMDs, these are the things you can do until tax time. But you know, hey, I have, you know, an extra $5,000 here that I want to, I want to put it away and get some tax defer tax deferral on that using an IRA is a great way to do that. Using a SEP, you can even have a larger runaway there.

Abrin: With Retirement plan contributions, you hit the head in the beginning, like you said, they’re incredibly flexible because you don’t have to get it done by December 31st. You don’t have to be on a routine payment plan. If you are eligible to contribute to a traditional IRA by the tax deadline, you can contribute the day before the tax deadline and get all that money in there and get it invested and get the tax deduction on your tax return.

Tyler: Anyone working with an accountant has probably had this conversation as we’ve got to the end of it, but even, you know, if you’re doing turbo tax on your own, turbo tax will even prompt yet, Hey, do you want to make a contribution to an IRA this year and lower that taxable income? So that can be, it can be a great way to shelter a little bit of money off for retirement and get a tax break today.

Abrin: Yeah. And especially for self-employed individuals, like you mentioned, the SEP IRA. So that’s an employer-based plan. And if you’re, if you’re self-employed, then you are your own employer and you can contribute into that account. Depending on how much you make, it could be more than, than you could contribute to a traditional IRA. So it’s a really good way to get some tax deferral. And once again, you don’t have to get it done by December 31st, you’ve got until April 15, so you can coordinate with your tax professional.

Tyler: And you know, this year, the SEP can be really powerful and it’s up to 25% of your compensation or $57,000, whichever ends up being the lesser of those two. So, if you had your own business and you are your only employee and, Abrin and I will have some future podcasts surrounding tools for retirement plans for individuals, because these can be very difficult. But if you are just a single business owner without any employees using that SEP, you can leverage quite a bit at the end of the year, especially right around tax time to change your entire tax picture. So that’s great.
I have a conversation with my clients quite a bit who have some money at the end of the year where we have this conversation surrounding do we want to get a tax deduction today and make a contribution to a traditional IRA or do we not really need that tax reduction today? If we don’t need to tax reduction today, do we leverage a Roth IRA?  The difference is that a Traditional IRA, you put money in today, you get a tax deduction today and then it gets taxed when you take a distribution down the road in retirement, so pretax dollars are contributed and distributions down the road are taxed, both the principal (what you contributed) and any gains.
A Roth is working in the exact opposite. You’re going to pay taxes on your contributions today, ride it out through retirement, anything earned in there, it’s going to come up tax-free which can be a powerful tool for a couple of reasons. Tax-Free growth is fantastic. It also allows you to diversify your tax picture in retirement. Those RMDs that we were talking about at the beginning of the show are required on that traditional IRA not required on the Roth. So it allows you to put some money away that the, the government is not going to force taxation on you down the road.

Abrin: And if you have legacy planning goals, Roth IRA passes down to the heirs also tax free. So that tax-free growth, that could be a really long time horizon and that compounding interest is going to add up

Tyler: Well, it’s certainly a conversation to be having with your financial advisor and your accountant.  If you have some money and you’re thinking of an IRA, do I need the tax break today? Or can I leverage something that might give me some advantages down the road?

Abrin: And I think the other big thing there is that a little outside of the scope of this podcast episode and ask your tax professional, but there are lower limits for traditional IRAs as far as how much income you can have as a household if you or your spouse have a retirement plan through work. So if you, if your household has pretty good income, and you have retirement plans through work, you might actually disqualify from taking a deduction for a Traditional IRA contribution. There are partial deductions for earnings for married couples filing jointly from $104-124k and after $124k, you can no longer deduct any of the contribution from your income.  Definitely ask your tax professional for information on your specific situation.

Tyler: There are some strategies around that, right? So even if you are kind of bumping above that income bracket, they’re still maybe ways of utilizing a Roth IRA I’m using, what’s called a backdoor Roth conversion or Roth conversions. And I’m going to let Abrin walk us through that because he’s certainly well-versed in this, but it can be a way to say, how do we have money that’s in the IRA today, but I want to convert it and get that tax-free growth down the road. How is that possible? Is it, am I locked into this kind of traditional IRA, a tax deferral bucket.

Abrin: These Roth conversion strategies, generally aren’t necessarily for folks that are in their working years, unless you’ve got a year of lower income, then it might be a good strategy for you. But if, you know, if you’re in your prime earning years, typically it’s going to be something that we might table off until closer towards retirement, when maybe you’re working part-time or half-time, or you have an early retirement and you don’t have any fixed income, coming in yet.

Tyler: You want that tax bracket coming down for this…

Abrin: Your tax bracket is hitting the floor and now you’re thinking, “okay, great. I can either pay nothing in taxes, or I can maybe decide to pay the government…”

Tyler: And to back up a little bit on that Roth conversion.  Functionally, what is happening is that we’re taking money out of the IRA, paying taxes on that distribution today as a choice.  And the idea is that we have more control over our circumstances at this point to make this decision.

Abrin: Right. Depending on how much you take out of that IRA, will determine where you are in the tax bracket

Tyler: And we’re shoving into our bank account and hitting the Cayman islands while we’re doing well. We are shifting and moving into a Roth IRA. And essentially now we’re starting tax free growth from here on out. Definitely a conversation to have with your financial advisor and your accountant. Also a Roth conversions can be advantage during market. If you see market dips, it’s kind of like what we saw in March, that might be a good time to start converting because your tax burden is going to be a little bit smaller if your account’s down 20%, right. It could be that silver lining of taking advantage of some opportunities.

Abrin: I think the next big conversation with any of your tax planning, when you’re talking about opportunities is tax loss and gain harvesting.  Us as investment managers and our firm.

Tyler: Thank you, Sam.

Abrin: Thank you, Sam. Shout out to the Batman. You know, part of our job is, is tax loss and gain harvesting throughout the year for any of our clients with taxable accounts. And just so everybody knows that a taxable account is an account that’s funded with after tax dollars, but you don’t get preferential tax treatment like you do in a Roth IRA. Instead, you have to pay income taxes on any income earned throughout the year, and you have to pay capital gains taxes on your investments when you sell them any gain that you have in those positions, but capital gain taxes are, can also be offset with capital losses, so you can lower your tax liability throughout the year. When you’ve held onto a legacy position in a long time for a portfolio and the market tanks, you can now move out of that position into something similar. So say you’ve got a large 500 US companies in it and that’s the fund that you own. And then you could sell that and purchase another fund. That’s pretty similar to that. So that way your portfolio is staying in the same risk profile, but you’re able to off offload a fund you didn’t necessarily want and not have to deal with the gains.

Tyler: It can be, like you said, real powerful. If you’re working with a financial advisor, make sure to ask them about the tax loss harvesting. Make sure that it’s happening right, that you’re taking advantage of it. If you’re one of the folks listening to us and you do it yourself, two really big things to be paying attention to that I think get lost in the do-it-yourself method is, is proper rebalancing to make sure you’re not in a risk tolerance you don’t intend to be and tax loss harvesting at the end of the year. Both of those require some attention to detail and getting into the weeds a little bit. So if you’re, if you’re at the end of the year and you’re just looking for a little help, sometimes reaching out on those two things can be real helpful for these folks doing it themselves. If you’re paying someone to invest on your behalf, both of those things should be done for you. And if they are not, please go back to the other episode that we had about finding a financial advisor and finding one that works for you, because that is important.

Abrin: It’s a good way to lower your tax liability throughout time. It can actually increase your, your rate of return over time if it’s done properly, because you’re not losing a portion of that rate of return to the taxes. So

Tyler: In an ideal world, your account is going up, but on paper it looks like we stay flat and that’s how your accountant is going to like it and how you’re going to like it.

Abrin: And I think one of the other interesting things you can do with gain harvesting, that’s kind of similar to a Roth conversion, but where the money is in a, in a taxable account where you can’t convert it what you can do is take, if you have years of low income, you can take your gains and stay below the capital gains bracket. The way capital gains tax brackets work is the first bracket starts at 0%. So if you’re under that bracket threshold, because you got minimal income or no income, and you’ve got large capital gains, you could be selling those positions at the end of this year or earlier throughout the year and paying 0% gains taxes on it. So being taxed just says 0%.

Tyler: This is powerful for folks in retirement who just have real low income, who may have some opportunities out there to, to be taking advantage of. Certainly one of those, again, I’ll always harp on this talking with a financial advisor and talking to your accountant.  Where am I on this tax bracket? And what are my opportunities to me. I tell you a 0% tax bracket is my favorite tax bracket. So using that would be helpful.

Abrin: The last thing to wrap up the whole end of year tax planning is once the end of the year comes, you’re going to start getting a lot of forms in the mail. You know, you’re going to definitely want to save those and be able to bring them to your tax professional or if you’re doing it yourself or make sure you got everything on file, so when you’re going through turbo tax or H&R block or whatever service you used, it’s not a pain.  The better organized you are, the better it is for your tax professional and the better it is for you.

Tyler: Organization ends up always being the best way to do it.

Abrin: If you don’t think that, you know, if you, if you’re wondering if you might need something that comes in the mail, just keep it.

Tyler: Easier to save things than to dive back to the trash.

Abrin: So that kind of wraps it up. I want to thank everyone for, for listening to this

Tyler: Again, check us out on YouTube. Subscribe like us, tell your friends and family, comment, and review. We love it all.

DISCLAIMER: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security.