With the 2020 tax filing deadline over, it may be time to think about the year ahead.
In response to the pandemic, the 2020 tax season was extended. Taxpayers could file returns as late as May 17, assuming no extension was requested.
Since tax season can be a burden on taxpayers and their advisors (gathering documents, preparing forms and schedules, responding to requests from their tax professionals, etc.), many taxpayers choose to put their thoughts on taxes aside once their return has been filed.
Unfortunately, this can lead to missed opportunities throughout the year to manage taxes more efficiently. Once year-end approaches, certain options may be lost at that point.
A better course of action is to keep taxes in mind and look for potential opportunities throughout the calendar year. For example, taxpayers may be well-served by reviewing their 2020 return now to look for opportunities for 2021.
The 1040 form can provide a blueprint for tax-planning strategies
1. Maximize the child tax credit (CTC)
- For 2020 and 2021, the CTC has been expanded, and there are proposals to extend this expanded benefit through 2025
- For 2021, taxpayers receive a tax credit of $3,000 per child age 17 and under and will receive an extra $600 credit for children under age 6
- This tax credit, which was recently expanded through the American Rescue Plan, is available to single taxpayers with less than $75,000 in modified adjusted gross income (MAGI), and married couples filing a joint return under $150,000
- The “regular” CTC of $2,000 per qualifying child is still available to single taxpayers with MAGI of less than $200,000, and married couples filing a joint return less than $400,000 (note that the CTC is reduced to $500 per qualifying dependent age 18 and full-time students through age 24)
- Taxpayers may want to manage their income throughout the year (deferring income through retirement plan contributions, for example) to make maximum use of the CTC
- In addition, beginning in July, the IRS will make advance payments of the CTC to taxpayers per a provision of the American Rescue Plan
2. Taxes on investment income (lines 2 and 3)
- Depending on the marginal tax bracket and other investment-related factors, does it make sense to consider tax-free municipal bonds that may provide a higher tax-equivalent yield?
- Investors may also want to explore opportunities to benefit from lower tax rates on investment income generated through qualified dividends
3. Taxes on retirement income (lines 4, 5, and 6)
- While required minimum distributions (RMDs) were suspended for 2020, they return for 2021
- For those age 70½, IRA distributions to qualified charities through qualified charitable distributions (QCDs) are tax free. This could be a good option to satisfy philanthropic goals while avoiding taxes on IRA withdrawals. For details, read, “Donating IRA assets to charity”
- Is there an opportunity to convert pretax retirement assets to a Roth IRA? A Roth can provide tax-free income in retirement, is not subject to RMDs, and the income generated will not negatively impact the taxation of Social Security benefits
4. Managing capital gains (line 7)
- Throughout the calendar year, investors may want to consider harvesting capital losses that may be used to offset capital gains For more information read, “Using investment losses to your advantage”
- An additional 3.8% surtax applies on investment income – including capital gains – at modified adjusted gross income (MAGI) of $200,000 for an individual, and $250,000 for a married couple filing a joint return)
- Don’t forget that some taxpayers will not pay taxes on long-term capital gains (single filers with less than $40,000, married couples filing a joint return with less than $80,000)
5. Tax-smart options for deductions (line 12)
- With the scale-back for many popular deductions after 2017 and a near-doubling of the standard deduction, the majority of taxpayers currently claim the standard deduction when filing their tax return
- Does it make sense to lump deductions, if possible, into one tax year in order to itemize deductions for that year?
- For example, instead of making consistent charitable gifts each year, consider making a large gift in one year, or funding a donor-advised fund, if that allows you to itemize deductions on your tax return. Claim the standard deduction in other years
6. Deduction for business owners (line 13)
- Since 2018, certain business owners of pass-through entities have benefited from a 20% deduction on qualified business income (QBI)
- There are limits to the deduction based on income and the nature of the business. Owners may want to consult with their tax professional on options to manage income throughout the year. This strategy may help them maximize the deduction.
7. Determine your marginal tax bracket (line 15)
- A review of your 2020 return may give you a sense of your projected marginal income tax bracket for 2021
- Knowing your marginal income tax bracket can provide a basis for determining whether it may make sense to defer income throughout the year (increasing retirement plan contributions for example) or maybe generating income through a Roth IRA conversion in exchange for the benefit of tax-free income in retirement
8. Should tax withholding be adjusted? (line 25)
- Withholding too much during the tax year is basically akin to providing the federal government with an interest-free loan. Review your 2020 return to see if changes should be made for 2021
- Also, there may be IRS penalties for under-withholding as well. Generally, this applies if you pay less than 90% of your tax liability during the tax year
Tax planning
With all the changes to the tax code during the pandemic, including many temporary programs and updates, it’s important to discuss tax planning with a financial professional with knowledge of your financial situation.
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