All Nerd's Eye View Articles On Income Tax Planning

Why The New 100%-Of-AGI Charitable Deduction Limit Isn’t Actually Good Tax Planning

January 20, 2021 07:06 am 6 Comments CATEGORY: Taxes

For many financial advisors, helping affluent clients with charitable planning strategies is a common objective, particularly those who have more than enough to satisfy their own retirement and family goals and also wish to make substantial charitable contributions that will help others in need. Which in recent years has become even more flexible, as the Tax Cuts and Jobs Act increased the percentage-of-AGI limit on cash contributions from 50% to 60%, and the CARES Act (as extended by the Coronavirus Stimulus Act) further increased the limit from 60% to 100%(!) of AGI, making it possible for the most charitable inclined clients to fully offset their income and reduce their tax bill to zero! Yet as it turns out, reducing one’s tax bill all the way to nothing actually produces tax savings at the lowest tax brackets… such that in the end, the new 100%-of-AGI charitable giving limit actually is not such a great deal after all!

Taxpayers who itemize deductions on their Federal income tax return can generally deduct contributions made to qualifying charitable organizations up to some percentage of their Adjusted Gross Income (AGI), traditionally ranging from 20% to 50% of AGI, and is dictated by such factors as the nature of the asset donated (e.g., cash gifts vs Capital Gain property) and the type of charitable organization receiving the gift (e.g., “50% Limit Organizations”, which include churches, educational institutions, hospitals, government entities, and public charities; and “Other Charitable Organizations” which include any charity not considered a 50% Limit Organization).

As a result, charitable contributions can be categorized into four primary groups: 1) cash contributions to 50% Limit Organizations, 2) cash contributions to Other Charitable Organizations, 3) Capital Gain property contributions to 50% Limit Organizations, and 4) Capital Gain property contributions to Other Charitable Organizations. And when contributions in a given year overlap between multiple categories, there is a specific order of operations to be employed, which first prioritizes cash over Capital Gain property contributions, and then 50% Limit Organizations over Other Charitable Organizations.

With the CARES Act of 2020, though, a new 100%-of-AGI limit on deductions for category 1 – certain “qualified” cash contributions to charities – was implemented (and extended through 2021 with the passage of the Consolidated Appropriations Act) to provide some additional incentives for charitable giving in the face of the financial impact that COVID-19 has had on Americans. Which means that taxpayers can technically offset all of their taxable income with charitable contribution deductions, resulting in a tax bill of $0!

Still, though, the fact that one can take charitable contribution deductions up to 100% of their income doesn’t necessarily mean it’s a good deal to actually do so. Because it is often simply be better for a taxpayer who normally finds themselves in a higher ordinary income tax bracket to go ahead and actually pay taxes on a portion of their gross income at lower tax rates (and not offset it with a charitable deduction), thereby preserving their charitable giving (or at least their charitable deduction) for future years when their rates may be higher again. And by spreading charitable contributions out over multiple tax years (and leveraging the five-year carryforward allowances for unused charitable contribution deductions), they can effectively offset income in years when they would be subject to higher tax rates, thereby producing a greater total tax benefit.

Ultimately, the key point is that while the new CARES Act (now extended by the Coronavirus Stimulus legislation) makes it possible to claim Qualified Contribution deductions (with 100%-of-AGI limits) and zero out one’s tax bill, in practice it is rarely a good idea to do so. As while there is a small group of ultra-high-income individuals who can occasionally still benefit from using the increased deduction limits they provide, in most cases, high income donors are better served to stretch out or carry over a portion of their charitable giving (and charitable deductions) across multiple high income years instead. Though for financial advisors who have clients who won’t necessarily benefit from the provision, simply being able to explain why the better option would be not to take potential deductions as soon as possible can be a valuable service, in and of itself!

Coronavirus Stimulus 2.0: Analysis & Planning Opportunities In The Consolidated Appropriations Act of 2021

December 23, 2020 01:52 pm 23 Comments CATEGORY: Taxes

After months of debate about providing additional economic relief in response to the coronavirus pandemic, the latest “Coronavirus Stimulus 2.0” bill passed out of Congress on December 21, 2020, as an attachment to the larger 5,000+ page Consolidated Appropriations Act of 2021, which provides Federal funding through September 2021, extends and amends various expiring tax provisions, and addresses several other financial planning-related issues.

The relief legislation includes a fresh round of $600 stimulus checks and extensions to unemployment benefits (including another $300/week of unemployment insurance relief for 11 weeks). In addition, small businesses will also gain access to a greatly expanded Employee Retention Tax Credit (potentially up to $7,000/employee/quarter) if they experienced at least a 20% decline in quarterly revenue and a new forgivable Paycheck Protection Program (PPP2) loan opportunity if revenue was down by at least 25% in any quarter of 2020.

In addition, the Coronavirus Stimulus 2.0 legislation includes a wide range of Personal Income Tax planning relief provisions, from an extension of the 100%-of-AGI limit on cash contributions to a charity into 2021, the opportunity to carry forward unused Flexible Spending Account balances in 2021, a reduction in the hurdle for Medical Expense Deductions to ‘permanently’ return to 7.5%-of-AGI, the ability to deduct meals and entertainment expenses at restaurants for 100% of the expense, the elimination of the Tuition and Related Expenses deduction for education to be replaced with an expanded (and even more generous) Lifetime Learning Credit, and more.

On the other hand, it’s notable that some widely discussed potential changes were not included, from additional relief on Required Minimum Distributions, to further relief on student loan deferrals (though the legislation does authorize a substantive change to FAFSA forms for Financial Aid in the future!).

Fortunately, the Coronavirus Stimulus 2.0 legislation does not introduce a number of ultra-short-term end-of-year planning needs – as some prior end-of-year tax legislation has in the past – but does set the table for significant planning opportunities with clients (especially small business owner clients still suffering from the pandemic) as 2020 comes to a close and into 2021!

Year-End Tax Planning Under The Forthcoming Biden Presidency

November 25, 2020 07:04 am 2 Comments CATEGORY: Taxes

The November 3, 2020 elections produced a wholly unsatisfying result for financial advisors and their clients from a financial planning perspective, regardless of their political affiliation. The political clarity – leading to planning clarity – that many had hoped for, did not emerge. Instead, control of the US Senate, which will determine whether Democrats can drive their legislative agenda or if Republicans will have a ‘check’ over a Democratic-controlled White House and House of Representatives that could lead to gridlock instead, continues to hang in the balance.

The problem? The control-determining Senate races won’t be decided until a Georgia run-off on January 5^th of 2021… which is too late to take most actions that influence a client’s 2020 tax bill! Thus, planners are left with a substantial dilemma: act now and make potential changes that could be costly and/or unwanted if substantial changes to the tax code are not implemented for 2021, or wait and risk the chance that such changes may be implemented, potentially dramatically increasing costs.

Given President-elect Biden’s proposal to increase the ordinary income tax rate for those making more than $400,000 per year, and to make the long-term capital gains rate equal to the ordinary income tax rate for income in excess of $1 million, many taxpayers and planners have considered the possibility of accelerating income for high earners into 2020. Problematically, clients who are just slightly above the threshold may actually have the most to lose with potential tax bracket changes, but also the most adverse impact if they accelerate significant amounts of income but no changes occur… while those significantly above the threshold have less potential benefit for accelerating income, but if they’re already in the top tax bracket, there’s limited downside to accelerating income even if tax brackets aren’t changed (and still some benefit if the Biden tax plan is implemented).

With respect to a change in the top long-term capital gains rate, if one is to believe that the Biden-platform income figure of $1 million is ‘real’, the decision of whether to sell or hold positions with existing gains is more nuanced. On one hand, the cost of selling such investments in 2020 (i.e., harvesting capital gains in the current tax year before the increase) would trigger a 20% long-term capital gains tax that might be a tough pill to swallow. But should the Biden proposal become law, it would nearly double the current top long-term capital gains rate from 20% to 39.6%! Which means those with very high income or especially sizable capital gains may still want to take some chips off the table with year-end capital gains harvesting, if only as a form of “tax insurance” to hedge against the risk of potentially dramatic increases in long-term capital gains rates next year.

But, as if that decision wasn’t complicated enough on its own, further complexity is added to the mix when considering the additional Biden tax proposal calling for the elimination of the step-up in basis of capital assets upon death. Ironically, holding appreciated assets until death would rapidly switch from a very desirable tax strategy to an especially undesirable one (because taxing all appreciated investments at death, all at once, would be even more likely to push capital gains into the new higher capital gains rate!).

As the end of the year approaches, clients must also make decisions with respect to expenses that may qualify for itemized deductions. As while in general, a potential tax increase next year means there is a benefit to accelerate income (into 2020’s lower tax rates) and defer deductions (when they’d be more valuable at 2021’s higher tax rates), in practice most high-income taxpayers who already itemize deductions will benefit more by claiming their deductions in 2020 at current rates, due to the potential of the Biden-proposed cap of 28% on the value of itemized deductions! Meanwhile, clients of all income levels should still defer any expenses that won’t be counted as an itemized deduction in 2020 (such as SALT expenses in excess of $10,000, or any potential itemized deductions if the taxpayer’s standard deduction will still exceed their itemized deductions), but at least have the chance of helping boost deductions in 2021 if the rules are changed.

Finally, while the overwhelming majority of taxpayers won’t have to worry about estate and gift taxes whether the exemption remains at its current level, or is dropped back down to its pre-TCJA level as called for by the Biden proposal, advisors must address the ‘lucky’ few clients who do still face Federal estate tax exposure. Though obstacles loom large, for clients who have a net worth that will almost certainly subject their estate to an estate tax liability upon their passing (or may grow to that point in the future), there is a strong impetus to act now and engage in potentially substantial year-end gifting – up to their entire $11.58 million Federal estate tax exemption amount, to ensure they do not lose out on maximizing the current exemption while it lasts.

Ultimately, the key point is that now that the election has passed, clients are looking for guidance as to what they should be doing – or not doing – before the end of 2020 and beyond. And while in many cases, the ‘right’ answer may not be able to be definitively known today, not having a conversation about it at all is decidedly the wrong ‘move’ for proactive advisors seeking to reassure and inform clients.

Using Retirement Accounts To Reduce Estimated Tax Penalties Via Tax Withholding From (Required Minimum) Distributions

November 4, 2020 07:23 am 17 Comments CATEGORY: Taxes

The United States tax system is set up on a “pay-as-you-go” basis, which means that taxpayers are required to pay taxes throughout the year as income is earned, whether it be through withholding income or making estimated tax payments. Individuals who don’t pay timely taxes throughout the year may be assessed Estimated Tax Penalties by the IRS, which are based on the amount of unpaid tax and the Federal short-term rate (in the first month of the quarter in which taxes were not paid) plus three percent. While understanding and helping clients comply with the requirements of tax payments can preclude Estimated Tax Penalties, advisors can also use simple arbitrage strategies to help clients maximize their savings when making estimated tax payments with tax-advantaged retirement account distributions.

While taxpayers who have income withheld to pay their tax liability generally aren’t required to make quarterly payments (as the IRS considers withholdings as if they were paid throughout the year, regardless of when they were actually paid), those who opt to make estimated tax payments must pay their estimated tax liability on a quarterly basis following a schedule of “General Due Dates for Estimated Tax Installment Payments” provided by the IRS. For taxpayers who choose to pay their taxes with estimated tax payments (versus through withholding taxes from paychecks or other qualifying accounts such as pensions or retirement plans), there are basically three options to calculate tax payments. Tax payments can be estimated based on the taxpayer’s prior year’s tax liability, where the estimated annual amount is equal to 100% of the prior year’s tax for income under $150,000, or 110% for income over $150,000, with the total estimated amount paid in equal quarterly installments. While this is generally the simpler way to calculate estimated payments (and more fool-proof in avoiding penalties, since the prior year’s tax will generally be known), individuals can also make estimated tax payments based on the current year’s tax liability instead. In this case, the amount due would be 90% of the current year’s liability paid in equal quarterly installments. The caveat to using the current year’s tax liability to calculate estimated tax payments is that, if the tax liability is underestimated, tax payments may be too low, and an Estimated Tax Penalty may result. The third way to make estimated tax payments is to use the Annualized Income Installment method, in which payments are based on the individual’s actual quarterly tax liability. While this method is cumbersome and time-consuming, it can be beneficial for taxpayers who earn income unevenly throughout the year.

Clients who pay their taxes by withholding income can benefit from the fact that quarterly payments are not necessarily required by the IRS. While paychecks are generally received on a regular basis throughout the year, resulting in withholding taxes in a true “pay-as-you-go” manner as intended by the IRS, retirement account distributions are often made only once per year, which effectively creates a “pay-as-you-go” loophole for taxpayers whose income consists of retirement account distributions! Because of this, advisors whose clients rely on retirement account distributions for income can help maximize savings by withholding taxes later in the year, thereby letting clients keep their money longer (and letting those funds grow in the meantime) without risk of incurring Estimated Tax Penalties.

For clients who may have inadvertently underpaid (or missed) estimated tax payments during the year, using an ‘erase-and-replace’ strategy can help them avoid an Estimated Tax Penalty by using a retirement account to withdraw the amount of underpaid estimated tax and withholding the entire amount from that distribution. The client can then ‘roll over’ non-retirement funds (that otherwise would have been used to make the estimated tax payment) within 60 days of the distribution to avoid any taxes due on the distribution itself, provided that no other rollovers have been made in the last year (so as not to violate the once-per-year-IRA-rollover ule).

Ultimately, the key point is that by leveraging the flexibility of tax withholding from retirement account distributions, advisors can develop strategies to help clients avoid tax penalties while keeping their money invested for longer and postponing tax withholdings until later in the year.

The Biden Tax Plan: Proposed Changes And Year-End Planning Opportunities

September 30, 2020 07:02 am 34 Comments CATEGORY: Taxes

When President Donald Trump oversaw the passing of the Tax Cuts and Jobs Act (TCJA) in 2017, substantive tax reforms were made with the intention of promoting economic growth that affected corporations, small businesses, and individuals. With the upcoming election in November, though, former Vice President and Democratic presidential nominee Joe Biden has proposed a tax plan that challenges several aspects of the current system in an effort to increase Federal tax revenues and address income/wealth inequality.

One of the key features of Joe Biden’s proposed plan is for ordinary income brackets to be adjusted for individuals with annual incomes over $400,000 (although whether this threshold applies to individuals or joint filers remains unclear), increasing the top tax bracket to the pre-TCJA rate of 39.6%. The income brackets for those with annual income levels under $400,000 will remain unaffected.

Biden’s plan also includes the elimination of the Qualified Business Income (QBI) tax deduction for pass-through business owners (e.g., partnerships, LLCs, S corporations, and sole proprietors) whose individual annual income is $400,000 or more, in effect, potentially increasing the tax bracket for high earners by 10% (from 29.6% for those eligible for the QBI deduction to the proposed highest rate of 39.6%). The plan would also cap the value of the rate at which itemized deductions can be taken to 28%, which affects those in the tax brackets above 28%, as their rate to determine itemized deductions would be reduced from their income tax bracket.

Another feature of Biden’s tax plan is a flat retirement contribution credit, as determined by a specific percentage (currently anticipated to be 26%) of the contribution amount to replace deductions of those retirement account contributions. This would, in effect, lower the tax burden for taxpayers in tax brackets under the proposed set rate (incentivizing taxpayers in lower tax brackets to contribute to tax-deferred retirement accounts), while increasing it for taxpayers in brackets over the proposed rate. Financial advisors who want to prepare for an expected Biden victory might consider accelerating income and deductions into 2020 for high-income earners because, for this group, income tax rates may be higher and deductions not as favorable if the passage of Biden’s tax plan does come to fruition. Accordingly, year-end Roth conversions may be a good strategy for some high-income earners to forgo the 26% credit in the present for the benefit of tax-free distributions in the future.

Enhancements to personal income tax credits made by the proposal include a higher Child Tax Credit (increased from $2,000 for children under 17 to $3,600 for children under 6 and $3,000 for all other children under 17), Child and Dependent Care Credit (from $3,000 to $8,000 for one child, and from $6,000 to $16,000 for two or more). The First-time Homebuyer Credit would be reintroduced as a refundable and advanceable credit of up to $15,000, and a brand-new proposed Caregiver Credit would provide $5,000 for informal long-term caregivers.

Long-term capital gains and qualified dividend tax rates would increase to ordinary income tax rates for income over $1 million under the proposed Biden plan (with the 3.8% surtax on net investment income to remain in place), and 1031 Exchanges would be eliminated for taxpayers with annual income over $400,000. Some strategies to mitigate the impact of these proposed changes would be to target lower annual capital gains realized, use municipal bonds for their (largely) tax-free character, reduce investments in the portfolio that produce dividends, take advantage of the tax deferral of investment-only variable annuities (for accredited investors, Private Placement annuities can also be a useful option), and use installment sales to regulate annual income levels, keeping them under $1 million as much as possible.

Additionally, Biden’s tax plan proposes to eliminate the step-up in basis rules that currently apply to inherited assets (that are not considered Income In Respect of a Decedent), which would impact both higher- and lower-earners potentially facing a significant and problematic tax bill on inherited assets. Thus, life insurance could see renewed potential as a tool to provide liquidity and/or mitigate the burden of a high tax liability resulting from the inheritance. Alternately, a more structured sale or gifting strategy throughout the owner’s lifetime can be a good way to mitigate taxes for the beneficiary should Biden’s plan pass.

A final key feature of the proposed tax plan would be a 50% reduction of the exclusion amount for estate and gift taxes, from $11.58 million to the pre-TCJA amount of $5.79 million. To be cautious, advisors may want to encourage their clients to use as much of their exemption in 2020 in case Biden is elected to office and his tax plan is approved. Other strategies that can be considered to deal with a smaller exemption in the long-term can potentially include the use of Grantor Retained Annuity Trusts (GRATs), Charitable Lead Annuity Trusts (CLATs), and sales to Intentionally Defective Grantor Trusts (IDGTs).

Ultimately, the key point is that even though there is much that can be planned for at this stage prior to the election – regardless of who wins the race – the most important thing for advisors to do in the present moment is to educate themselves (and their clients) about the impact that each candidate’s position will have on them, and to help them plan accordingly as election results come in!

Isolating IRA Basis For More Tax Efficient Roth IRA Conversions

September 2, 2020 07:02 am 23 Comments CATEGORY: Taxes

The Roth IRA was first introduced in 1997 and has since been a popular tax planning tool for financial advisors and their clients. As while Roth IRA accounts generate tax-free growth and income from retirement savings, making Roth IRA contributions is most beneficial when a client is in a relatively low marginal tax bracket. This is in contrast to deferring pre-tax dollars to a Traditional IRA, which is often most beneficial when a client’s current marginal tax bracket is high (and anticipated future tax brackets are lower). While Roth conversions are often used to transfer Traditional IRA funds into a Roth IRA account, reporting these transactions for income tax purposes can be complicated when the Traditional IRA from which the funds are being transferred include both pre- and post-tax funds.

Although contributions made to a Traditional IRA usually consist of pre-tax dollars (for which taxpayers can take an above-the-line income tax deduction on their tax returns), there are occasions when post-tax dollars are included as well. For instance, nondeductible contributions are made when a taxpayer (or their spouse) is an active participant in an employer-sponsored retirement plan, and their MAGI exceeds the applicable limit for their filing status. Rollovers originating from an employer-sponsored retirement plan can also include after-tax funds if the plan allowed for after-tax contributions.

When Traditional IRA accounts hold both pre-tax and post-tax dollars, the balance will be subject to the “Pro Rata Rule”, which stipulates that, in general, distributions from a taxpayer’s IRA maintain the same ratable proportion of pre-tax and post-tax funds as the taxpayer’s total IRA balance. Which means that distributions from accounts with a mix of pre-tax and post-tax funds cannot be made as solely pre-tax or post-tax and that transferring these distributions into a Roth IRA will need to be accounted for accordingly.

Despite the intricacies of reporting Roth conversions from Traditional IRAs with pre- and post-tax funding, converting Traditional IRA accounts can make sense, especially when a substantial percentage of after-tax dollars are in the Traditional IRA. As while the after-tax contributions themselves will be tax-free, the growth on those funds will be taxable! Therefore, paying tax on the pre-tax portion of the Traditional IRA balance can be worthwhile when considering the tax-free growth of all contributions made to a Roth IRA.

Accordingly, there are few strategies that advisors can use to make Roth conversions more compelling, which can be particularly useful when the Traditional IRA may not (initially) have a large proportion of after-tax funding. For instance, some clients may have access to an employer-sponsored plan that allows for rollovers of IRA funds into the plan. Since IRA-to-plan rollovers are restricted to pre-tax dollars, such rollovers can essentially serve to reduce the pre-tax balance of a Traditional IRA, maximizing the after-tax balance available for the Roth conversion. Importantly, rolling funds back into an IRA from an employer plan, after completing a Roth conversion, should not be done until after the calendar year in which the Roth conversion was carried out, as doing so would result in the basis of the rollover to be included in the converted amount.

Another strategy available to increase the proportion of IRA after-tax dollars is to make a Qualified Charitable Distribution (QCD), as these distributions are restricted to pre-tax dollars from the IRA. Thus, as in the case of rollovers into an employer-sponsored plan, QCDs effectively reduce the pre-tax portion of the IRA account balance, leaving a larger post-tax balance available for Roth conversions.

Ultimately, Roth conversions continue to be a powerful and versatile tool for financial advisors to help their clients mitigate the tax bite from distributions taken from their retirement accounts. By planning around current and expected marginal tax brackets, and by strategizing to isolate the basis of pre-tax dollars in Traditional IRA accounts, advisors can facilitate substantial tax savings for their clients by way of efficient Roth conversions.

Maximizing Premium Assistance Tax Credits For Self-Employed Health Insurance Costs

August 19, 2020 07:02 am 7 Comments CATEGORY: Taxes

In 2014, the Affordable Care Act (also known as “Obamacare”) established state health insurance programs with the intent to make health insurance accessible to all individuals and families – including the self-employed – without needing to obtain coverage through a (larger) group employer. For those with lower income who may not be able to afford coverage from the state marketplaces, the Affordable Care Act also established the Premium Tax Credit (PTC; also known as the Premium Assistance Tax Credit, or PATC), a fully refundable Federal income tax credit meant to subsidize the cost of insurance premiums for individuals who purchase insurance through the Health Insurance Marketplaces. The PTC provides support by effectively capping health insurance premiums (for the second-lowest-cost Silver health plan available in their state) to a certain percentage of the individual’s household income, calculated on a sliding scale for those earning up to 400% of the Federal Poverty Level (which amounts to $104,800 for a family of 4). Though because of the unique control that self-employed individuals have over the income and expenses of their businesses, they have a unique opportunity to make business decisions that can also help maximize their ability to receive Premium Tax Credits.

In this guest post, Vinicius Hiratuka, founder of Elevated Retirement Financial Services, examines planning strategies that self-employed individuals can use to manage their reportable income levels in order to qualify for the Premium Tax Credit, and maximize the amount of the PTC they receive.

Maintaining income levels within the allowed threshold to qualify for the PTC in the first place - between 100% and 400% of the Federal Poverty Limit (FPL) - is crucial because as little as a single dollar of income over the 400% FPL will result in the complete loss of the PTC.

Maximizing the PTC (once meeting the FPL-qualifying threshold) is largely influenced by managing above-the-line tax deductions (that affect the calculation of an individual’s AGI used to determine the PTC in the first place). As such, self-employed individuals often have greater flexibility to employ tax-savings strategies through business expense and retirement contribution planning, such as accelerating business expenses (e.g., at the end of the year) to reduce income and contributing to Health Savings Accounts (HSAs) and/or tax-deferred retirement accounts, which can be used to increase above-the-line deductions, and thus reduce their income for purposes of calculating the PTC itself, thereby increasing the amount of the PTC benefit being received.

However, financial advisors should assess if and how their planning strategy will affect both their self-employed clients’ PTC benefit and also their Qualified Business Income (QBI) deduction. For example, while a Solo 401(k) contribution may decrease income (which both improves the PTC and reduces the Federal tax liability), the reduced income may also make the QBI deduction lower. As a result, making contributions to a Traditional IRA account instead of a Solo 401(k) could be even more beneficial, as the result would still reduce MAGI to increase the PTC, but would not reduce the QBI deduction for the self-employed individual (as IRA contributions are considered personal and, technically, not business-related contributions).

Ultimately, financial advisors can help clients by simply clarifying what health insurance options and potential Premium Tax Credit assistance is available to them. This can help the client understand how the PTC benefits their tax situation, and at the same time alleviate the fears that many clients who are considering self-employment have about the high cost of health insurance for self-employed business owners. Advisors can also add value for their clients by walking them through detailed tax projections that illustrate how the PTC (and other deductions and credits) play into their overall tax liability. Not only does this provide potential opportunities to strengthen the relationship with clients’ tax professionals, but at the end of the day, the collaborative efforts will ensure that the client has a more holistically prepared financial plan, and health insurance they can afford to keep!

Preserving Capital Losses At Death By Gifting Embedded Loss Assets To Avoid A Step-Down In Basis

August 12, 2020 07:04 am 6 Comments CATEGORY: Taxes

Over the past couple of decades, Congress has passed several laws impacting the Federal estate tax exemption, resulting in a significant increase from $675,000 in 2001 to $11.58 million today. As a result, under the current rules, most taxpayers will not be subject to a Federal estate tax liability, and thus, the current focus of tax planning for one’s estate should generally focus on reducing Federal income tax liability. Basis management is a critical part of this process and includes strategies to both maximize the step-up in basis, as well as to minimize the loss of any unrealized and/or carryforward capital losses.

For spouses, two questions are important in determining adjustments to the basis of inherited (non-IRD) assets: 1) who owns the asset, and 2) whether the state of residence is a community property or separate property state. In separate property states, property ownership is generally determined by common law, which generally dictates that property is owned as it is actually titled. Thus, if an asset is in an account that belongs solely to the deceased spouse, then 100% of the asset is subject to a step-up (or step-down) basis adjustment; however, for assets held jointly (typically either as joint tenants with rights of survivorship or tenants by the entirety), the surviving spouse will typically receive a step-up/step-down basis adjustment on only one-half of the assets (the half of assets considered to have been owned by the deceased spouse).

By contrast, in states that follow the “community property” rules (AZ, CA, ID, LA, NV, NM, TX, WA, and WI; with AK also allowing couples to opt-in to community property treatment), most assets acquired during marriage, as well as those assets which are mutually agreed upon to be jointly owned or that can’t clearly be identified as either spouse’s separate property, are essentially treated as being simultaneously owned 100% by each spouse. Accordingly, these assets will automatically receive a full step-up/step-down adjustment on the entire value of the property upon the death of either spouse.

This basis adjustment of inherited assets at death can potentially result in losing out on the opportunity to benefit from realized capital losses, which can be used to offset capital gains and up to $3,000 ordinary income each year. However, by gifting assets prior to death, the original owner’s basis can be retained, and unrealized capital losses preserved!

For non-spouse beneficiaries, the benefits of gifting assets with potential capital losses are not quite as favorable as those for spouse beneficiaries but remain valuable, nonetheless. More specifically, when a non-spouse receives an asset with unrealized capital losses, the so-called ‘double basis’ rules apply. These rules use the value of a gifted asset on the date of the gift to calculate the amount of any capital loss. On the other hand, the donor’s basis at the time of the gift is used to calculate the amount of any capital gain.

Application of the ‘double basis’ rules results in three potential consequences for non-spouses who are gifted with assets that have unrealized capital losses: 1) If the sale price of the asset is less than the fair market value on the date of the gift, then the recipient of the gift can claim a loss equal to the difference between those two values; 2) If the sale price of the asset is more than the original owner’s basis on the gift date, then the recipient of the gift has a capital gain equal to the difference between those two values; and 3) If the sale price of the gifted asset is in between the fair market value on the gift date and the original owner’s basis, the recipient has neither a capital gain nor a capital loss.

Ultimately, the key point is that gifting assets is a simple yet effective strategy to preserve the economic value of unrealized capital losses that can be used to reduce future capital gains (and up to $3,000 of ordinary income, annually). As while the basis of inherited assets will generally receive a step-up (or step-down, depending on the FMV) adjustment at death, unrealized capital losses from inherited assets are essentially useless after the original owner’s death since they will no longer be available for use to offset any gains in tax years after death.

Using Coronavirus-Related Distributions To Reduce The Tax Impact Of Distributions From Retirement Accounts

May 6, 2020 07:06 am 7 Comments CATEGORY: Taxes

In response to the COVID-19 global pandemic, the US Senate passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act last month. A more than $2 trillion emergency fiscal stimulus package, the CARES Act was enacted to help ease the effects of the resulting economic damage caused by the pandemic by providing a wide range of provisions, including loans and tax credits, with the aim of helping individuals, businesses, healthcare entities, and state and local governments meet short-term cashflow demands. Among the many provisions provided by the CARES Act is the Coronavirus-Related Distribution for individuals affected by COVID-19.

Coronavirus-Related Distributions of up to $100,000 can be made from IRAs, employer-sponsored defined contribution plans, and/or employer-sponsored defined benefit plans in 2020 (and 2020 only) by a qualifying individual. Qualifying individuals are persons whose health or finances have been impacted by the coronavirus as described by the CARES Act. More specifically, individuals (or their spouses or dependents) who have been diagnosed with COVID-19 by a test approved by the Centers for Disease Control and Prevention are eligible, as well as individuals who have been financially impacted by COVID-19 because they have been quarantined, furloughed, laid off, or have had to reduce their work hours; unable to work due to lack of childcare; or are business owners who have had to close their business or reduce the number of business hours they can remain open. The Secretary of the Treasury may determine additional factors for eligibility, though no further factors have been established to date.

The $100,000 Coronavirus-Related Distribution limit is an aggregate amount for all 2020 Coronavirus-Related Distributions beginning January 1, 2020. While distributions from IRAs can be taken as long as the individual meets the requirements to take a distribution in the first place, current employees who are participants in employer-sponsored defined contribution and defined benefit plans won’t be able to take distributions if the plan does not allow participants to access their funds prior to separation from the company.

Current employees of a company participating in the employer’s defined contribution plan may be able to access plan money to take a Coronavirus-Related Distribution via a plan’s hardship or in-service distribution provision. Additionally, the CARES Act allows employers to amend their documents to make Coronavirus-Related Distributions their own distributable event, allowing any qualifying individuals to take such distributions at any time during 2020!

Distributions from defined benefit plans to current employees are more restricted, however, since hardship distributions are not allowed. Furthermore, while employers have the option to allow in-service withdrawals for participants age 59 ½ or older, employers do not have the option to amend their defined benefit plan to allow for Coronavirus-Related Distributions to be their own distributable event (as can be done with defined contribution plans). Accordingly, current employees who meet the requirements for Coronavirus-Related Distributions may only take a distribution from a defined benefit plan if their plan allows for in-service withdrawals, assuming they meet the age requirement for those plan withdrawals (no younger than 59 ½).

There are several potential benefits of Coronavirus-Related Distributions, including that they are exempt from the 10% early distribution penalty, income from the distribution (which must all be taken in 2020) can be reported as taxable income over three years, and repayments of the distribution can be made up to three years after the Coronavirus-Related Distribution was received. In addition, mandatory tax withholdings are not required for distributions from employer-sponsored retirement plans, and employers can amend defined contribution plans to permit participant withdrawals that would otherwise be prohibited.

Coronavirus-Related Distributions provide opportunities for advisors to help eligible clients with some alternative planning strategies. One such strategy can be used by clients who already took 2020 RMDs but who didn’t need to use the funds; they can designate the RMD as a Coronavirus-Related Distribution instead, as a means to return the unwanted RMD (as the CARES Act eliminated 2020 RMDs from IRAs and employer-sponsored defined contribution plans). Another strategy can be used by clients who may benefit from moving less-accessible funds in an employer-sponsored retirement plan into a more-accessible IRA (e.g., if a client believes they may be subject to limited cashflow in 2021 or later, having funds in their IRA may be much easier to access in subsequent years than funds in their 401(k) plan that only allowed for Coronavirus-Related Distributions to be taken in 2020).

Ultimately, the key point is that the CARES Act offers individuals whose health or financial situation is affected by COVID-19 some relief through Coronavirus-Related Distributions by potentially allowing them to more easily access retirement funds that may not have otherwise been accessible.

Analyzing The CARES Act: From Rebate Checks To Small Business Relief For The Coronavirus Pandemic

March 27, 2020 12:56 pm 101 Comments CATEGORY: Taxes

In response to the unfolding COVID-19 global pandemic (as the US this week surpassed China as the country with the most confirmed cases in the world), the US Senate has passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a $2 trillion emergency fiscal stimulus package, in order to help ease the effects of the resulting economic damage. While the House has yet to vote on the bill, it is anticipated to be approved and signed into law by President Trump shortly thereafter and includes a wide range of provisions for both loans and outright rebate payments or tax credits aimed at helping individuals, businesses, healthcare entities, and state and local governments meet short-term cashflow demands.

In the context of financial advisors and the clients they serve, the most notable provision in the bill is the direct payments to taxpayers. Specifically, individuals who had up to $75,000 in adjusted gross income in 2019 will receive a one-time payment of $1,200, while married couples with AGI up to $150,000 will get $2,400. Additionally, taxpayers will receive an additional $500 for each qualified child, while individuals and families with income above their respective thresholds will see their relief payments reduced by $50 for every $1,000 in AGI. Notably, while individuals must have a work-eligible Social Security number (and not be claimed as a dependent), they do not have to have had reportable income in 2019 and can also be eligible for other income-benefit programs as well.

From the retirement planning perspective, notable provisions of the CARES Act include the elimination of the 10% early withdrawal penalty on distributions from retirement accounts for so-called “Coronavirus-Related Distributions” (with the option to spread income taxation over three years, and the ability to recontribute back to those same accounts to make up in the future), the suspension of required minimum distributions (RMDs) in 2020 for a wide variety of retirement account (for both account owners as well as beneficiaries) as well as the ability to return current-year distributions, an increase of $600 per week for unemployment benefits for up to four months as well as an expansion of benefits for those who would otherwise not normally qualify (like self-employed individuals and independent contractors), and the deferral of Federal student loan payments through September 30, 2020.

With respect to small businesses that have been impacted by COVID-19, certain small businesses with up to 500 employees will be able to take out loans (up to $10M depending on payroll costs and other factors), which will be eligible for forgiveness if used to cover payroll and other expenses (like rent and utilities), along with other ‘employee retention’ tax credit opportunities. Other benefits for businesses include a delay in the employer’s portion of Social Security payroll tax until January 1, 2021 (with half of the deferred amounts due at the end of 2021, and the other half due at the end of 2022), and more flexible Net Operating Loss rules to obtain immediate refunds, among others.

Beyond benefits for individuals and businesses, the CARES Act provides for $454 billion in emergency lending, not only to states and municipalities, but to airlines and other businesses critical to US national security, and another $150 billion allocated proportionally to state and local governments to offset amounts used to respond to the pandemic.

Ultimately, the key point is that the CARES Act is a historic emergency relief program for Americans and provides much-needed assistance for those affected by the pandemic and the resulting economic damage. And with changes in tax laws come planning opportunities for clients. However, the CARES Act is not without its caveats. As while relief payments to individuals and families are based on 2019 AGI levels, there will be countless Americans currently experiencing sudden financial hardship and unemployment who are seeing significant declines in income, but sadly, will not qualify for relief checks. Similarly, small business relief provisions – for both clients of financial advisors, and potentially financial advisors in their own businesses – do have very specific requirements to qualify (in an effort to ensure the dollars go where needed most, but inevitably meaning that some that are close to ‘the line’ must engage in planning to actually qualify). At the very least, though, the CARES Act will be a dominant conversation for financial advisors and their clients in the months to come as Americans (and the world) continue to cope with the current COVID-19 crisis.