As we come to the end of 2019, it is once again time to consider what, if any, tax planning should be considered before year end and what the next steps will be to implement these strategies.
- While tax planning is important to consider throughout the year, a little extra time spent before December 31 can help optimize your tax positioning now and in the years ahead.
- With so many demands on our time at year end, we offer the following “Top 5” planning strategies to help you work toward long-term tax saving success in 2019 and beyond.
- You should consider each of these with your tax and wealth advisors and discuss whether there might be other strategies that you can implement before year end.
Strategy 1: Take advantage of annual exclusion gifts and lifetime exemption now
The end of the year is a time when many focus on giving to family and friends. The most common method of tax-free giving is the annual exclusion gift. In 2019, you may make outright gifts of up to $15,000 in cash or property to an unlimited number of individuals without incurring any gift taxes or reducing your lifetime exemption from gift and estate tax. Married couples may double their annual exclusion gifts, giving $30,000 to each person without any gift or estate tax consequences.
In addition to annual exclusion gifts, the end of the year is also a good time to consider making larger gifts that would use some or all of your lifetime exemption from gift and estate tax. Following changes made by the passage of the 2017 Tax Cuts and Jobs Act (TCJA), each person now has a lifetime exemption of $10,000,000, adjusted annually for inflation, from federal gift and estate tax. In 2019, the exemption amount is $11,400,000 (or $22,800,000 for a married couple), which will increase to $11,580,000 (or $23,160,000 for a married couple) in 2020. This means that you may give up to that amount tax-free during your lifetime, with any unused exemption applied against federal estate tax at your death.
Unfortunately, the increased exemption amount is set to revert to $5,000,000, adjusted for inflation, on January 1, 2026, unless legislation is enacted prior to 2026 extending this increase. While 2026 may seem a long way off, it may be best to take advantage of the increase now by making larger gifts that use up some or all of your exemption. The reason for this is that the sooner the gift is made, the more time it has to potentially grow outside of your estate. For example, if a $10,000,000 gift is made in 2019 and returns 6% in 2020, it will have grown to $10,600,000 by the end of next year, all of which will be outside of your estate and accruing in the hands of the recipient. If that same gift were made in 2020, the recipient would not only lose out on that first year of growth—and all future compounding on that growth—but your estate would have potentially been increased by $600,000 instead, adding to potential future estate tax liability.
If you are considering larger gifts, then a gift to a trust, rather than outright, could provide a number of benefits, including professional management of trust assets, creditor protection, and tax mitigation. If structured as a grantor trust, all trust tax liability would be taxable to the creator of the trust, which would not only reduce the trust creator’s taxable estate by any taxes paid but also would allow the trust assets to effectively grow tax-free. As an alternative, a trust may be structured as a non-grantor trust, meaning that the trust would pay its own income taxes, but it could be established in a jurisdiction with favorable income tax rules for trusts, such as the state of Delaware. Either approach has the potential to significantly reduce or eliminate the “tax drag” on assets held by the trust.
As mentioned earlier, the increased exemption amount is set to expire on December 31, 2025, barring any legislative action prior to 2026. As we enter an election year and the prospect of a potential new occupant in the White House, it must be noted that there is a real possibility that, before 2026, the exemption could revert to pre-TCJA levels and possibly go lower even still (as recently as 2003 the exemption was $1,000,000). Additionally, there have been at least a few presidential candidates who have proposed changing the current estate and gift tax laws and potentially adding new wealth taxes altogether. This is yet another reason why it may be best to make larger gifts now while the exemption remains high and there is some certainty about the taxation of these gifts.
Strategy 2: Time your charitable gifts
Recent changes to the tax laws, including those made by the TCJA, have been largely beneficial to charitably-inclined high-net-worth taxpayers. While many ordinary deductions have been eliminated or cut back, the rules around charitable giving have remained largely untouched and, in some respects, have been enhanced. In particular, following the passage of the TCJA, taxpayers can continue to deduct contributions to public charities up to 60% of their Adjusted Gross Income, while no longer facing the phase-out of itemized deductions. These changes provide a compelling reason to continue charitable giving in 2019 and beyond.
Charitable gifts can be made with a wide range of property, from straightforward gifts of cash to more complicated gifts of appreciated property, and it is important to keep in mind the potential tax implications of the property transferred. Gifts of appreciated, publicly traded securities, for example, can be an especially beneficial type of property to gift, as the charitable deduction is based on the fair market value of the securities when transferred. Additionally, transfers of appreciated securities avoid the recognition of any capital gains that would have been recognized if the stock had been sold and the proceeds given to charity. More complex gifts can be structured through entities such as private foundations, donor advised funds, and split interest trusts, including charitable remainder and lead trusts.
High income donors looking to make charitable contributions might also consider making those gifts from their individual retirement accounts (IRAs). Generally speaking, IRAs are heavily tax burdened, as distributions from them are taxed to the recipient at ordinary income tax rates. Under current rules, individuals aged 70½ or older can transfer up to $100,000 directly from an IRA to a “qualified” charity without recognizing the income. Any amount transferred to a charity would count towards satisfying all or part of the owner’s required minimum distribution (RMD). This may reduce your income tax liability, as the RMD otherwise would be taxed to you as ordinary income.
The use of an IRA for charitable giving can also be beneficial for your heirs, as recipients of an inherited IRA are required to take annual distributions from the account, all of which is taxable to them as ordinary income. Non-IRA assets, on the other hand, receive a basis “step up” to fair market value at death, meaning that heirs will have capital gains only on future appreciation of those assets. This means that distributing IRA assets to charities now not only could help save on income taxes, but it frees up more attractive assets to go to your heirs in the future.
For the charitably inclined who cannot itemize their deductions following the increases implemented by the TCJA to the standard deduction (now $12,200 for single filers and $24,400 for married couples filing jointly), it may make sense to “bunch” charitable gifts. By making a more substantial charitable gift this year equivalent to what might be given over several years, that gift should be large enough to itemize. One consideration with this approach, however, is that it has the potential to adversely impact a receiving charity, as they may rely on a similar gift next year. This can be addressed by advising the charity that this is a one-time gift or, more strategically, through the use of a donor advised fund, from which smaller gifts may be made to the charity in subsequent years while still receiving the charitable deduction in 2019.
Strategy 3: Harvest capital losses to offset capital gains
Year end is also a good time to review your portfolio to determine if losses should be “harvested” to offset capital gains. In short, tax-loss harvesting is an end of year strategy by which underperforming assets are sold at a loss to offset realized investment gains with the aim of reducing overall tax liability.
Under current rules, losses on long-term investments (investments held for more than one year) may be applied against long-term gains, and short-term losses (investments held for one year or less) applied against short-term gains. After matching long-term losses to long-term gains, excess long-term losses may be applied against any net short-term gains (i.e., short-term gains remaining after matching short-term losses against short-term gains). Likewise, any short-term losses remaining after applying them to short-term gains may be applied against net long-term gains. To the extent that losses remain after netting long-term against short-term, up to $3,000 of unused losses can be applied against ordinary income in the year of the loss, with any losses exceeding $3,000 carried forward to the following year.
For individuals with large capital gains in 2019, tax-loss harvesting before year end may result in a meaningful reduction in tax liability. This has the potential to boost long-term investment returns in a portfolio, through effectively deferring payment of income tax on realized gains. By delaying that payment, a portfolio has the potential to grow and compound faster than it would if taxes were paid on the realized gains. Of course, while this strategy can facilitate favorable returns, it must be noted that the primary factor in deciding to purchase or sell any security should always be based on whether the timing is right from an investment perspective.
Strategy 4: Employ income and deduction timing strategies
Timing is everything when it comes to the receipt of income and deductions. For individuals, income is taxable when it is received and expenses are deductible in the year paid. Depending on your circumstances, it may be beneficial to accelerate or postpone income from year to year so that the income is taxed in a lower income tax bracket. If tax rates are expected to be lower in 2020 due to an expected drop in income, for example, it may be beneficial to defer income until after the New Year. Conversely, if 2020 is expected to be a higher income year, it may be better to receive any additional income prior to January 1, 2020.
A common approach to income timing involves the sale of publicly traded securities. If it is advisable from an investment perspective to sell a security, you might consider delaying the sale until right after the start of the New Year rather than sell at the end of this year so as to defer the tax due as a result of that sale. Another way to defer income is to wait until after the end of the year to take any discretionary distributions from your IRA. Generally, taxpayers over age 59½ may take discretionary distributions from an IRA without penalty, while those 70½ or older must meet their RMD. Unless it is required, delaying a distribution from an IRA until 2020 can reduce potential income tax liability this year. As discussed earlier, if you are required to take an RMD and are charitably inclined, you might consider directing your RMD to a qualifying charity, which would allow you to support your favorite causes while also reducing your taxable income.
Deduction timing is also an important part of year-end planning. Although the TCJA suspended or modified many of the itemized deductions previously available, there still may be opportunities to time your deductions, including certain interest and medical expense deductions. In high income tax rate years, it may be advantageous to pay deductible expenses before the end of the year. If 2019 is a lower income tax rate year either because of lower income or reduced tax rates, it might be better to defer payment of those expenses until they are due in 2020 if it is expected that income tax rates will be higher next year. Likewise, if 2019 is a high income tax rate year, it might be advisable to pay expenses prior to December 31 even if the bill is not due until January so that those expenses may be deducted for tax year 2019.
Strategy 5: Maximize contributions to tax-advantaged accounts
Regardless of your tax bracket, you may consider taking full advantage of available tax-advantaged accounts. These include employer-sponsored 401(k) plans, IRAs, health savings accounts, and 529 Education Plans. The tax advantages of these accounts vary, but they are similar in that they facilitate tax-free growth of funds while they are held in the accounts, allowing for greater returns over time. It’s important to note that these accounts are subject to certain annual contribution limits. For example, in 2019, the maximum annual contribution to a retirement account is $19,000, with taxpayers over 50 eligible to contribute an additional $6,000.
If there have been any “new additions” to the family, the end of the year is a great time to consider creating a new 529 Plan for that child, or to fund any existing plans. Like other tax-advantaged accounts, income accumulated in a 529 is not subject to federal income tax and distributions are not taxed so long as the funds are used for the qualified education expenses of the plan beneficiary. Under new rules, up to $10,000 per year per student may also be withdrawn from a 529 to pay for elementary or secondary school expenses.
A special five-year rule for 529s allows you to transfer five times the annual gift exclusion amount ($75,000 per person or $150,000 per married couple) to a 529 Plan. This means that a married couple that has not contributed to a 529 this year could add up to $150,000 to that account. For an even larger contribution, a couple could add $30,000 before December 31 and then take advantage of the five-year rule in early 2020 by adding another $150,000, bringing the total contributed in less than a year to $180,000. Importantly, however, if you elect to take advantage of this five-year rule, you cannot make any additional contributions to that 529 for five years. But, pre-funding a 529 in this way early in the beneficiary’s lifetime has the potential to enhance long-term returns, as your contribution will have more time to grow tax-free.
If you are considering a large gift to pay for a child or grandchild’s education, a 529 Plan can be a great vehicle. However, if you are interested in making an even larger gift in excess of the 529 contribution limits, a gift to a trust could be an attractive alternative. Structured properly, that trust could allow for tax-free growth while serving as an available source of funds for education and other expenses of the beneficiaries.
These are just a few of the year-end steps you can take now to help minimize your tax burden in the future and help you start 2020 optimally positioned. You may want to consider each of these with your tax and wealth advisors and discuss whether there might be other strategies that you can implement before year end. With taxes as with life, good planning is the key to long-term success.
This publication is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This publication is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
Note that financial and estate planning strategies require individual consideration, and there is no assurance that any strategy will be successful.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that, while this publication is not intended to provide tax advice, in the event that any information contained in this publication is construed to be tax advice, the information was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any matters addressed herein.
Note that a few states, including Delaware, have special trust advantages that may not be available under the laws of your state of residence.Download Article