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Investing Specialists

Retirees' Year-End Tax-Planning Guide: 2020 Edition

Strategies to consider for lowering your tax bill and improving your portfolio's positioning.

Thanks to the coronavirus pandemic, the 2020 holiday season will be a little different than in years past. We’ll still cook a turkey on Thanksgiving, and I won’t be able to resist putting up a Christmas tree and sending holiday cards. But hosting my extended family’s sometimes-raucous, always wonderful Christmas Eve gathering is off the table, as is our traditional “Yankee Swap” and dinner with my husband’s family on Christmas day. The holidays this year will feature some familiar traditions, but they won’t feel the same.

The same goes for the 2020 year-end tax season--and for the same reason. The pandemic and its related economic effects have ushered in some notable changes to the tax laws for this year. Those changes, in turn, have implications for what investors should do in the waning months of 2020. Retirees, in particular, have good reason to take notice.

As 2020 winds down, here are the key items that retirees should have on their radars.

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.

Watch Out for Mutual Fund Capital Gains Distributions
As the year winds down, mutual funds begin making capital gains distributions to their shareholders, with distribution season in full swing in December. Thanks to the combination of a generally rising equity market, especially on the growth side of the Morningstar Style Box, and redemptions from actively managed funds, many funds are on track to make distributions in 2020. Fund companies are just beginning to release their distribution estimates.

If your fund is planning to make a sizable distribution, it might seem tempting to pre-emptively sell it in advance of the distribution. That can make sense, but be sure to check your cost basis in the fund. Even if you’re able to duck the impending distribution, you may trigger a capital gain if the shares have a appreciated a lot since purchase. However, I noticed that the latest crop of capital gains distribution estimates features a lot of serial distributors--funds that made distributions in 2018 and 2019 and are also planning them this year. In that instance, longtime shareholders may have already prepaid much of the tax bill that would be due upon the sale of their shares, because their cost basis increased when they received the earlier distributions.

Revisit Charitable Giving Strategy
The pandemic has been an economic catastrophe for many households; many people are in need. The good news, for retirees who have the financial wherewithal to give, is that CARES Act ushered in a few changes for charitable giving in 2020.

One is the ability to make a deductible charitable contribution of $300, regardless of whether you itemize your taxes or not. The fact that it’s an “above-the-line” contribution helps ensure that the many taxpayers who recently may not have been able to claim a tax benefit for charitable contributions may be able to deduct at least some of their contributions. If you’ve been claiming the standard deduction recently, you may have gotten a bit lax about saving receipts for charitable contributions. But for 2020, you have an incentive to hang on to proof of your contributions--at least up to the $300 limit. Note that if you are an itemizer, you won’t be able to claim the new “above-the-line” deduction as well as additional charitable contributions on your Schedule A (itemized deductions). It’s either/or. If you’re an itemizer, your charitable gifts will remain “below the line.”

Also affecting retirees: the qualified charitable distribution, or QCD. These are still allowable in 2020; they enable investors who are age 70-1/2 and older to steer up to $100,000 from their IRAs to a qualified charity (or charities). That, in turn, reduces taxable income. Because those RMDs aren’t required this year, many investors who would normally be subject to RMDs might choose to leave their IRAs untouched for 2020.

At the same time, even if a QCD doesn’t satisfy RMDs in 2020--because there are no RMDs--it still carries a tax benefit. It allows the retiree to give pretax assets to charity, and it reduces the amount of the portfolio that will be subject to RMDs in the years ahead.

As always, retirees can also consider donating taxable assets to charity, either directly or via a donor-advised fund. Doing so removes the tax liability associated with those investments, and may also enable you to correct an overweight or otherwise problematic position in your portfolio.

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. A tax-savvy financial advisor or an investment-savvy tax advisor can help you strategize about the best accounts to tap for your income needs.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.