Year-End Tax Planning To Do's

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Christine Benz: Hi, I'm Christine Benz for Morningstar. We're coming into the home stretch of 2020, and that means that you still have a little bit of time to improve your tax position for the year. Joining me to share some ideas on this front is Tim Steffen. He is advisor education senior consultant for Pimco.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine. Great to see you again.

Benz: Good to see you, too. Let's talk about the key steps that people should take when thinking about their tax position. Let's start with the current year. What sort of information should people be gathering when thinking about their tax position for this calendar year?

Steffen: You want to understand where you fall relative to certain breakpoints and thresholds and phaseouts and all that this year. So, understand, looking at the different tax brackets, where do you fall? Which bracket are you in? How much room do you have before you can move up to a bracket, or what would it take to lower your income into a lower bracket? Where do you stand relative to realize capital gains and losses for the year? Does it make sense to maybe do some things to offset those? If this is a year where you're going to be itemizing deductions, does it make sense to try and bring some of those into the year to take advantage of that, or, if you're not going to be itemizing, what might you do? Or understanding limits like phaseouts from medical expense deductions or the limitations on charitable contributions, or all those other types of things out there. So, just take a snapshot of where you're at right now and understand: Where do I stand relative to these things? Because that's going to drive some of the decisions you make later in the year.

Benz: You also think it's important to take a look forward into 2021, think about any changes that you might see, changes that you've had perhaps in your own life or that you might see in your own tax position. Can you walk us through what people should have on their radars from that standpoint?

Steffen: A few of the big ones like, if for example, you're planning to retire in 2021 or you retired midway through 2020, you're going to be seeing this perhaps steady decline in your income from a full year's of work to a part year work to no work. So, you're going to see your taxable income maybe shrink, and does that cause you to shift the timing of recognizing certain items of income or deductions? If you're getting married next year, does that mean you're taking two--if you have two people with similar levels of income getting married, they might find themselves in a higher tax bracket. Two people with very different levels of income who get married might find themselves in a lower net bracket overall. So, there's a lot of things to take a look at. What is happening next year doesn't have any impact on what's happening now but might trigger some or force some of the decisions you make relative to, again, additional income or deductions over these next two years.

Benz: Speaking of the future, we just had a big election, and I know that many investors are thinking about how that might change their tax position going forward. Can you shed any light on that? Should people even be spending much time thinking about that at this point?

Steffen: In addition to what's going on in your own life, you got to look at what's happening outside in the rest of the world, and are there things legislatively happening that might cause you to change some of your approaches, like what we saw several years ago when the TCJA rolled in at the end of 2017. So, if you look at what might happen in a potential Biden administration next year, and we've seen a lot of the proposals that have come out from his camp on tax law changes that they might be interested in making. There's a lot of uncertainty as to whether those are actually going to happen or not. A lot depends on what's going to happen with some of these runoff races happening in Georgia as far as full control of the Senate. And then, there's some uncertainty as to the specifics of some of his proposals. There's been a lot of talk about no tax increases for anybody with income below $400,000. I'm not really sure exactly what that means. Does that mean gross income, adjusted gross income, taxable income, business income only? What about singles versus married? So, there's a lot of uncertainty as to how some of those things might impact people. But there are things out there that people should be aware of that--the other thing to consider is effective date. So, just because he maybe takes office next year, do those changes get pushed out to late in the year and maybe don't become effective until 2022. So, before you make any big decisions now, anticipating tax law changes, take a step back and really think are they really affecting me? When might be the effective date? Are they really going to happen? So, a lot of uncertainties in reacting to potential law changes right now.

Benz: Let's talk about some specific things that investors might think about as the year winds down. Let's start with some sort of portfolio considerations with respect to taxes.

Steffen: The most common one is looking at your capital gains situation, understanding the different breakpoints on capital gains rates. So, there's the zero, the 15%, the 20% rate. There's the 3.8% net investment tax that kind of filters in there somewhere. Understanding if you have net gains this year, perhaps it makes sense to accelerate some losses into the year, recognize some losses to offset those gains. Remember the netting rules on capital gains that short-term losses offset short-term gains, long-term losses offset long-term gains. And then, if you have a gain or loss in each of those, they can offset each other after they offset their own kind. So, look at your capital gains position and then understand: What are the optimal losses that I might want to recognize? Obviously, we wish you didn't have any losses in a portfolio. This has been a weird year, so, it's likely there may be some out there. If you've got them, they are an asset to you, take advantage of them, use it to offset your gains if it makes sense.

Benz: Right. Tim, you referenced this is a little bit of a weird year and that investors truly might have some really strong gainers in their portfolios, especially in the growth side of the style box, as well as some losers if they have energy names or value-oriented holdings, they may actually be able to do some of that netting.

Steffen: Exactly. And then, with mutual funds, making their distributions coming out this year with all the withdrawals that happened out of funds earlier in the year, that may have forced them to recognize some gains. People who still hold those funds are going to get those gains distributed out to them. So, you may not have done a lot in your own portfolio, but if you hold mutual funds, you might have some gains coming your way here in the next few weeks.

Benz: Let's talk about income levels. We're in a pandemic. We have still high unemployment. Many people may be experiencing lower levels of taxable income than in the past. We also have this pause on required minimum distributions. Any strategies to bear in mind if you do find yourself in what you hope will be a temporarily low tax bracket?

Steffen: Yeah, it's one of the unfortunate things of this year is we are seeing people who are going to have lower levels of income than what they're used to. But again, take a positive attitude. View that as an opportunity maybe to take advantage of some things and to time certain transactions. If your income is artificially low this year and you expect it to bounce back next year to a more normal level, whether that's through work or RMDs as you mentioned, maybe this is the year you recognize maybe some additional income from retirement accounts, consider a Roth conversion. If your income is artificially low and you're in a lower bracket than you might normally be, this might be the year to consider a conversion. Remember with conversions in particular, there's no recharacterizations anymore, so you got to really want to do the conversion. You can't undo it.

Other things to think about might be if you're a business owner, maybe trying to accelerate a little bit of billings to bring some additional income into this year, pushing off some of the expenses that you might have incurred into next year where they might be more valuable to you. Again, people with lower levels of income, your deductions aren't going to be as valuable to you. So, maybe delaying some of those year-end charitable gifts into January, they might provide a little larger tax benefit for you next year than they would this year. So, when you're at lower levels of income, the general rule of thumb is accelerate income, defer deductions, and that's going to be kind of the rule of thumb for a lot of folks this year.

Benz: You mentioned deductions. You mentioned charitable contributions. Can you shed a little more light on that for people who are thinking about making those year-end charitable gifts, any tips that you can share on that front?

Steffen: Obviously, with the changes in the tax law a few years ago, a lot fewer people are able to itemize their deductions. It's down to about 10% of taxpayers, or about a third of the people who used to itemize still itemize now. So, it's harder to get a tax benefit for those charitable gifts like we used to just kind of take for granted. If you are somebody who can take advantage of that, though, maybe you're looking at like a bunching strategy where you're accelerating future-year contributions into this year where you're going to bunch them all and get a deduction this year. Maybe you do that in combination with something like a donor-advised fund that allows you to get the tax benefit right away while still maintaining some control of the assets and distributing them out to charities later on.

Or maybe if you're not somebody who's itemizing, but you're old enough to qualify, maybe you look at something like a qualified charitable distribution--that can be a great way to get some money out of retirement plans and pass on to charity without having to worry about any tax consequences. Otherwise, if you're making charitable gifts, we always recommend considering things like appreciated property rather than cash gifts because you not only get the same deduction value but you also avoid the capital gain. So, take advantage of some of those more basic charitable giving opportunities that are out there. Make sure the gifts are completed by end of year, though. If you want to get the deduction, you got to have it done before the end of the year.

Benz: And the CARES Act also had a provision that allows even nonitemizers to get a little bit of a charitable deduction, right?

Steffen: Yeah, exactly. This is part of the CARES Act this year where they allowed for people who don't itemize their deductions, which as I said is like 90% of taxpayers now, to still be able to get a small benefit for charitable gifts. If you give up to $300 in cash to public charities, you can take what they call an above the line deduction for that. So, you get a tax benefit for it in addition to your standard deduction you might be claiming. If you itemize, you don't get that, but it is a nice benefit. It is a $300 amount regardless of your filing status. So, if you're a single person, you get $300, married couples get the same $300, so a little bit of a marriage penalty there, but we'll take that $300 deduction if we can get it.

Benz: Absolutely. Tim, thank you so much for being here. It's always so helpful.

Steffen: Great. Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.