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Financial and Tax Planning To-Do's Before Year-End

Tips for both pre-retirees and retirees.

Christine Benz: Hi, I'm Christine Benz for Morningstar. We're in the fourth quarter and that means the clock is ticking on the 2021 tax year. Joining me to discuss some year-end tax and financial planning to-do's is Tim Steffen. He is director of tax planning for Baird.

Tim, thank you so much for being here.

Tim Steffen: Thanks for having me, Christine.

Benz: Tim, let's talk about strategies that investors should have on their radar as 2021 winds down. You like to say that even though it is wise to think about some year-end planning strategies, you should still think of this as sort of a multi-year tax-planning process. Can you talk about that?

Steffen: Yeah, tax planning in general should always be done with a view toward multiple years. It's not just about what you do this year because really anything you do this year is something you may not be able to do next year. Or if you miss the window to do it this year, you can do it next year. So, rather than just thinking about what are the things I have to rush through at the end of this year, think about how your situation may be changing from one year to the next. For example, if you're retiring, your income next year might be a lot lower than what it is this year. So, that might drive some of the decisions you make. If you sold a business or you're selling a business next year, that can drive some of the decisions you might make. Maybe you are out of work this year, like a lot of people were, and you're just getting back into the workforce, next year might be a higher-income year for you. So, keep the big picture in mind about how your situation might change from one year to the next, and that can drive a lot of the decisions. There are outside factors to consider as well--tax-law changes, which we'll talk about, but understand your own situation, too.

Benz: I want to talk a little bit about market environment because Morningstar.com is an investing site and I think investors sometimes hear that they should be scouting around for tax-loss candidates in their taxable portfolios. We've had a great market environment. My guess is that most investors don't have tax losses in their portfolios, and if they do, they're not big. But do you have any overarching guidance you can share for investors who are looking to trim their investment-related tax bills?

Steffen: Yeah. So, first of all, get a snapshot of where you're at right now. If you're doing your own trading, you probably have a good handle. If you've got a managed account, maybe you don't know exactly where you're at. If you've got a mutual fund portfolio, you might be getting capital gain distributions yet this year that can kind of throw a wrench into your plans. But try to understand as best you can where you're at right now in terms of gains and losses. Now, a lot of people like to try and net the losses against the gains. Obviously, you'd rather not have losses, and as you said, there may not be as many out there this year as there were in prior years. That's a good thing. You'd rather have gains and losses. But if you have some losses, maybe use this as an opportunity to help offset some of the gains you've got. Look at your allocation. Has your allocation gotten out of whack during the course of the year? Maybe year-end is a good time to think about rebalancing and using some of those losses to offset some of the gains and again zeroing out your tax position.

Look at where you are in the capital gains brackets. Now, most people think of capital gains as 15%, but that's really not true necessarily in all cases. Really low-income people might have a 0% capital gains situation. If you're in that case, take advantage of it. Realize some gains at a 0% tax rate if you can. Be aware of the breakpoints then as you move into the 15% to the 20% and maybe under some of these new proposals that are out there, perhaps a 25% rate now. And then, also, be aware of the 3.8% net investment income tax that's out there. So, understand the marginal cost of your gains and take advantage of the lower brackets to the extent you can.

Benz: You alluded to this House Ways and Means Committee tax proposal. It's very wide-ranging. But one of the provisions does relate to what's called the backdoor Roth IRA, and I know that's very popular among many of our readers and viewers on Morningstar com. So, can you talk about how that might change going forward and how the backdoor Roth IRA and the mega-backdoor Roth IRA maybe over starting with next year?

Steffen: Yeah. So, just to quickly explain what we're talking about here: the backdoor Roth, the mega-backdoor Roth, they've always been a way for people to get money into a Roth IRA that otherwise might not be eligible because your income is too high, for example. So, what these techniques allow you to do is maybe with the backdoor Roth put money into a traditional IRA that you don't get a deduction for and then immediately convert that into the Roth. It's been a technique people have used for the last decade or so. It was never intended to work this way, but it's one of those loopholes that all the great planners discovered, and people have been taking advantage of it, and it feels like the gravy train is coming to an end on that.

The latest congressional proposal would effectively eliminate that technique through a couple of different ways. One would be saying, when you do a conversion, you can only convert dollars that would have been taxable, which means if you've got aftertax money in that traditional IRA, you won't be able to convert it to a Roth anymore. Now, that wouldn't be effective until next year, until 2022, if it even passes. But if it does, that would be the end of the backdoor Roth. So, if you're somebody who's done that on an annual basis, make sure you get it done this calendar year. And that doesn't mean make your contribution early next year for 2021. It means you got to have the whole thing done, the contribution and the conversion done, before the end of this calendar year. The other one is the mega-backdoor that involves more with employer plans, putting extra money into your 401(k) or your 403(b) on an aftertax basis if you can and then immediately converting that to a Roth 401(k) or even a Roth IRA. The latest proposal would say you can't do that anymore either. No more aftertax money in employer plans. So, this would be your last year--2021 might be the last year to take advantage of those techniques. So, if it's something you've done in the past, get going on it and make sure you can do it this year because this might be your last opportunity.

Benz: I want to talk about people who are retired and are subject to required minimum distributions. RMDs were paused for 2020. They're back on for 2021. So, can you walk through some considerations for people who are over age 72 and subject to those RMDs?

Steffen: Well, the first thing I would tell you is to make sure you take your RMD. You said they were off last year. They are back on. There is no expectation that they're going to be waived again for this year. So, if you've been holding out, time to face reality, you're going to have to take the distribution this year. And don't miss it because there's a 50% penalty if you don't take it out on what you should have taken out. So, it's a big penalty. Make sure you take it out. In terms of when, it doesn't matter when during the year you do it, you can do it now or on December 31st. It doesn't really matter. Just make sure it's out before the end of the calendar year. If you're looking for ways to minimize the tax cost on that, there's not a lot of great techniques out there for RMDs. It's just basically income. So, you would offset that just like any other ordinary or high-income year that you might have.

The one that is unique to RMDs is this qualified charitable distribution, the ability to have your RMD go directly to a charity, in which case, then you don't have to report the RMD as income. You don't get a charitable deduction either, but you don't have to report the RMD as income. For somebody who is charitably inclined but doesn't itemize because the standard deduction is so high, you don't give that much to charity, this can be a great way to get a tax benefit for your charitable contributions against your RMDs. Other than that, it's all the normal tax-reduction techniques. You could still take your RMD out and keep it and do a qualified charitable distribution with other dollars in your IRA. The QCD doesn't have to be your RMD, but it can be. Minimize other sources of income, if you can, to keep the RMD from falling into a higher tax bracket, et c. Maybe the other one is if you're somebody who turns 72 this year--in 2021 we're in--you have the ability to delay your RMD until April of next year. But then you have to take two next year. You might not want to do that. You might want to take one this year and take next year's next year. Rather than doubling up probably just take them in every year when you have to start taking them.

Benz: Now, there's a little bit of a disconnect between the QCD age and the RMD age. Can you walk through that?

Steffen: Yeah. This is something that came about as part of the Secure Act, I think it was, a couple of years ago where this one changed. RMDs had always been for, as long as we know, age 70.5. The year you turn 70.5 is when you have to start taking distributions. They also tied that to the qualified charitable distribution and said that qualified charitable distributions are also done at age 70.5. When they moved the RMD age up to 72, they left qualified charitable distributions at 70.5. So, now that means you can take money out of your IRA and have it sent directly to charity, not have to report it as income even before you get to RMDs. You're still capped to the $100,000 maximum you can do the QCD on, and all the other rules on that still apply. But you have the ability to do a QCD before you even get to RMDs. The advantage of doing that is your IRA balance gets a little lower because of the QCDs you've done, which makes that first year's RMD just that much smaller. So, you can kind of hedge your RMDs a little bit earlier on if you wanted to do those early QCDs.

Benz: How about for people who are charitably inclined who aren't yet eligible to do the QCDs? Year-end is often a time where people think about charitable giving. Can you discuss some strategies for people who aren't yet 70.5?

Steffen: Sure. Once you're 59.5, you can always take money out of the IRA and turn around and give it to charity if you want. You have to report it as income and then you get the deduction to offset it. And for the most part, it's a direct offset, maybe not exactly. But if you're looking for other ways to meet some charitable obligations without touching your IRA, probably the best one out there is giving appreciated property. We talked about the gains in the portfolios this year. You've got some appreciated assets, giving those to charity is a great way to meet a charitable obligation while avoiding the tax on that gain. Big thing there: Make sure you held the position for at least a year. If it's considered short-term property, your deduction is only equal to your basis, and that's not what you want to do at all. So, appreciated assets are a great way to meet some charitable obligations. Be aware of the limitations on deducting charitable gifts. Generally, appreciated stocks can offset up to 30% of your income. Cash is normally 60%. There is a provision this year that allows you to offset up to 100% of your income with cash gifts. I don't know that makes a lot of sense for most people. But it does give you the ability if you want to be very charitable in this year to offset all of your income with charitable giving. Maybe not the most tax-efficient way to do it, but it can be done.

Benz: Tim, you've given us all a good list of to-do's to get working on between now and year-end. Thank you so much for being here.

Steffen: Thanks for having me again, Christine.

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