Basics of Tax Planning in Times of Uncertainty

Basics of Tax Planning in Times of Uncertainty

When it comes to taxes, nobody wants to pay more than what they owe; however, without careful tax planning, this is exactly what can happen. Effective tax planning helps ensure that you are paying your fair share of taxes, and not a penny more.

Possible Changes to Tax Laws

Since we recently had a change in political leadership, both in the White House and Congress (where Democrats regained a narrow majority), there is even more uncertainty than usual around tax law, and what changes could be in the works. Though laws may change that could impact your taxes, it is still important to do as much tax planning as possible. Our approach at ML&R Wealth Management is to plan within the current tax laws about which we know. We would rather revise the planning for our clients later if things change, rather than react or speculate, and make changes that could prove costly later. Before we explore the basics of tax planning, let’s look at potential tax law changes under consideration.

Given the scale of the ongoing economic damage caused by COVID-19, sweeping tax law changes that would affect the majority of Americans appear unlikely, at least in the near future. The majority of the proposed changes would most likely affect people whose income exceeds the threshold for the highest tax bracket (or those earning over $400,000 per year).

Tax law changes enacted at the end of 2017 reduced the highest income tax rate from 39.6% to 37%. This rate could potentially go back up to 39.6%, for income over $400,000. Currently, Social Security taxes are levied equally on employers and employees (totaling 12.4%, or 6.2% each). This tax only applies to income up to $142,800. Income over $142,800 is currently not subject to Social Security taxes. There is a proposal to make income over $400,000 subject to the 12.4% Social Security tax.

Capital gains and qualified dividend tax rates could increase for those earning over $1 million a year. The top tax rate for long-term capital gains and qualified dividends is currently 20% (15% for most taxpayers, and 20% for individuals earning more than $445,850 or married couples earning more than $501,600). Under President Biden’s proposal, the income tax rate on long-term capital gains and qualified dividends for individuals who earn more than $1 million could increase from 20% to the proposed top ordinary income tax rate of 39.6%.

Another proposed change that would affect those earning over $400,000 a year is the amount of itemized deductions they could use to reduce their taxable income. Currently, an individual who pays tax at the top rate of 37% and who incurs a deductible expense of $1,000 reduces his or her tax bill by $370. The proposal by President Biden would cap itemized deductions at 28% for those earning over $400,000, and not the potentially new top bracket of 39.6%.

Significant estate and gift tax law changes could also be on the horizon soon. One proposal that could have repercussions for more people is the possible elimination of the step-up in basis of inherited assets. Basis is what is used to calculate how much a capital gain is. For example, if your mother bought 1,000 shares of IBM stock in the mid-90s when it was trading at $10 per share, her basis would be $10,000. If she sold those shares at today’s price of $120, her capital gain (profit) would be $110,000. Currently, if she were to pass away and leave those shares to you, you would not inherit her basis, but would get a “step-up” and your new basis would be the fair market value of the stock on the date of her passing. You could then immediately sell the shares and not pay any capital gains taxes, because your basis would be the same as the value of the stock and there effectively would be no profit, from a tax standpoint. President Biden’s proposal would mean that your mother’s lower basis of $10,000 would be passed on to you, resulting in capital gains taxes if you sold the shares.

The other major estate tax proposal is a reduction of the lifetime estate and gift exclusion amount. Currently, individuals can exclude up to $11.7 million of lifetime gifts and assets left at death from being subject to estate taxes. Estates that exceed the exclusion amount would have to pay taxes (40% in 2021) on the amount over $11.7 million. Historically speaking, $11.7 million is a relatively high exclusion amount, and Democrats have said that they want to return it to a level more consistent with historical norms (possibly in the range of $3.5 – $5.8 million). If no legislation is passed, the exclusion amount would automatically revert back to about $5 million in 2026 (adjusted for inflation), when elements of the 2017 tax law expire (or “sunset”).

Estate tax laws can get complicated depending on your personal situation, so it is best to consult a professional before making any changes to your estate planning. We are happy to assist with this!

Also remember, these proposed tax law changes may or may not happen, and there will likely be some level of compromise on the specific proposed numbers. We at ML&R Wealth Management will be monitoring these potential tax changes closely, so please check our website and future newsletters for the latest developments.

Basics of Tax Planning

Now, let’s explore the basics of tax planning that should hopefully remain relevant regardless of the proposed tax law changes discussed above.

Retirement Savings
For 2021, the maximum contribution to an IRA is $6,000 (plus $1,000 catch up for age 50 and older). The maximum contribution to a 401(k) account is $19,500 (plus $6,500 catch up for age 50 and older). Traditional IRA contributions and 401(k) salary deferrals are pre-tax, so in addition to saving more for retirement, you get the added benefit of reducing your taxable income.

Roth IRA Conversions
Roth IRAs are treated differently than Traditional IRAs from a tax perspective. Contributions to Roth IRAs are not tax-deductible, but distributions from them in retirement are not taxed. The opposite is true with Traditional IRAs–contributions are tax-deductible, but distributions are taxed at your ordinary-income rate in retirement. One option Traditional IRA owners have is to convert a portion or all of their IRA holdings to a Roth IRA. The conversion amount counts as ordinary income on your tax return, but depending on your current tax bracket, this might be a good strategy. For example, let’s say you are 60 years old, you have just retired so you do not have W-2 income, and you have $500,000 in a Traditional IRA. You will not have to start taking taxable required minimum distributions from your IRA until age 72. Also, let’s assume you have decided to defer taking Social Security benefits until age 70 to get an increased monthly benefit. This scenario creates a 10-year window in which you could be in a lower tax bracket than when you reach age 70 and start receiving Social Security benefits. This is the perfect opportunity to convert some of your Traditional IRA assets to Roth at a lower tax rate. While you do have to pick up the conversion amount as income, once the assets are in your Roth IRA you will never be taxed on them again. Just be sure you do not convert too much and bump yourself up into a higher tax bracket. You can no longer “unwind” or correct the amount you converted.

Qualified Charitable Distributions (QCD)
At age 70½ IRA owners can donate up to $100,000 a year to a qualified charity, directly from their IRA. QCDs satisfy the Required Minimum Distribution, and the distribution is not included as taxable income. For example, let’s say a married couple usually donates $10,000 a year to a qualified charity, and that their annual RMD amount is also about $10,000. Since the standard deduction is now $27,400 for people age 65 and older, the couple would likely not itemize deductions if their total itemized deductions are less than the standard deduction. If the couple writes a check directly out of their IRAs to the qualified charity, they will get the benefit of reduced adjusted gross income by donating their IRA distribution rather than having to capture it as income on their return. They will also still get the benefit of the $27,400 standard deduction.  

Tax Loss Harvesting
While we certainly do not like stock market declines, we do look for opportunities to harvest capital losses that can be used to offset future capital gains taxes when the market does decline. If you own a mutual fund that has declined in value, you can sell it and buy a similar fund to replace it. You can use the capital loss you just “harvested” to offset capital gains and up to $3,000 a year in ordinary income once you have offset all of your capital gains. Capital losses can be carried forward indefinitely. One thing to be careful of: the IRS will disallow the loss you just harvested if you buy the same asset that you just sold within 30 days of selling it.

Asset Location
If you have a combination of taxable brokerage accounts and tax-deferred retirement accounts (IRAs, 401(k)s), pay attention to where the different types of assets that you own are located. To the extent that you own bonds and REITs, which generate taxable income at your ordinary rate, those assets should be held in tax-deferred accounts. You do not pay taxes on income generated in tax-deferred accounts until it is withdrawn. Assets that are expected to appreciate faster, like stock mutual funds, should be placed in taxable brokerage accounts. Although interest and dividends that are generated from stocks are taxed at your ordinary tax rate, these assets typically generate less taxable income than bonds and REITs. Also, when you sell the stock mutual funds you receive the more favorable capital gains rate of 15% (or 20% for people whose income reaches the top tax brackets), as long as the assets were held for over a year before you sell them. 


While nobody likes paying taxes, with careful planning you can ensure that you are not paying any more to the IRS than you have to. If you have any questions about the basics of tax planning or any other topics or know of someone who could benefit from our expertise, please do not hesitate to reach out to us. We would be happy to give your finances a second look.

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About Author

Scott Adair, CFP®

Your wealth management goals are in good hands. Scott Adair hones in on your investment strategies and comes up with a plan that works for you. Scott is an Investment Advisor Representative and Certified Financial Planner (CFP®). His advice is tailored to each individual client.

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