By Philip “Rusty” Ross, Senior Wealth Advisor
The fourth quarter will bring an end to the year, but also marks the beginning of tax planning for investors. There are many factors to consider this tax season as the economy continues its recovery and President Biden looks to implement new tax policies, which the House Ways and Means Committee outlined in a recent proposal.
The House proposal noted that eventual tax proposals would affect long-term capital gains and limit the effectiveness of itemized deductions for people making $400,000 single and $450,000 married filing jointly per year.1 For those who fall in that group, it may be a good time to look at significant positions with unrealized gains when they know what the top tax rate will be.
While tax reform legislation is still up in the air, we explore a few potential strategies for investors based on the newly released proposal:
- Tax-loss harvesting: Individuals who make $1 million per year might consider this strategy, which allows investors to sell off underperforming stocks at a loss to offset profits made on other investments.2 Since investors only have to pay taxes on their net gains, selling some investments at a loss can reduce capital gains, resulting in a lower tax bill. The proposal could make these losses more powerful, noting that the 25% long-term capital gains bracket would take effect on any sales starting from the date of the proposal of tax reform.1 As such, losses from now until the end of the year could have a 25% tax benefit against gains during this period for taxpayers in the top tax bracket.
- Donor-advised funds: These are private funds held by an organization, family or individual that are managed and designated for charitable giving.3 If held for over a year, the taxpayer gets a deduction on the amount they invested in the fund at a percentage equivalent to their tax bracket. For example, if a taxpayer is in the 37% tax bracket, they will receive a deduction of 37% of their investment into the fund. Given the new proposal, investors may want to claim deduction now while tax brackets are lower and let money accumulate to make larger donations later.4
- Opportunity zone funds: For a more niche approach, investors can defer paying tax on capital gains if they reinvest those gains into an opportunity zone fund. Doing so also allows investors to earn tax-free gains on the appreciation of the capital over the length of time it remains in the fund.5 If taxpayers rushed to realize gains following the House proposal only to discover the proposed effective date of higher capital gains was to commence upon the release of the proposal, they will have 180 days to defer realized gains into an opportunity zone fund.1 This will not eliminate the tax, but would defer the tax due on the gains until 2026/2027.
- Roth IRA investment: Because tax brackets are currently low, investors will pay less now than they might in the future if Biden implements a tax structure similar to 2017. For example, in the current tax structure, a married couple filing jointly can earn up to $329,850 per year while being taxed at only a 24% rate.6 In 2017, that couple would see a 33% tax rate (not accounting for inflation).7 Thus, taking advantage of a lower tax bracket while it lasts can help increase retirement savings. This can be more lucrative for investors with large IRAs. There is a rule requiring larger required minimum distributions (RMDs) for those with income above $400,000, and retirement account (IRA, 401(k) and Roth variations) balances exceeding $10 million dollars in the recent tax proposal. Historically, there was a back-door Roth conversion strategy that is proposed to be closed for taxpayers over $400,000 single and $450,000 married filing jointly.1
- Federally declared disasters: Taxpayers living in Louisiana, Texas and Oklahoma who were affected by federally declared disasters are able to claim repairs and losses on their tax return for that year, or occasionally the year before if they want to amend a previous return, or even the year after in instances where the full extent of the damage isn’t known. If a disaster deduction is claimed and the taxpayer also receives reimbursement from insurance, then the reimbursement will count as income for tax purposes.
- State and local taxes: State, local and property tax deductions are still capped at $10,000 per year, according to the Tax Cuts and Jobs Act.8 If that threshold is exceeded, the taxpayer may be able to defer those taxes until 2022 to take advantage of a potential full deduction.
- Crypto wash sales: Previously, cryptocurrencies weren’t subject to the wash sale rules that equities face. The latest proposal will eliminate the ability to take a loss on crypto positions while simultaneously repurchasing the cryptocurrency sold.1 For those investing in cryptocurrencies, this could be attractive to help offset gains in equities over the last year.
- Estate planning: The House tax reform proposal took aim at significant estate planning tools. For instance, it removed the future effectiveness of grantor trusts, transactions with existing grantor trusts and reduced taxpayers’ lifetime exemptions.1 There remains estate planning techniques available, but those facing potential estate taxes would be best served by approaching their options expediently as the higher exemptions could expire in 2021.
It is important to consider which strategies are most advantageous for you and your goals. As such, the above considerations represent only a primer on what investors should keep in mind when starting to plan for tax season. For additional guidance, contact an Exencial advisor or visit us at https://exencialwealth.com/.
- Ways and Means Committee (data as of 9/21/21) — Responsibly funding our priorities
- Forbes (3/25/21) — Can tax loss harvesting improve your investing returns?
- Investopedia (7/13/21) — Donor-advised funds
- Forbes (6/26/21) — Maximizing the power of donor-advised funds
- IRS (8/6/21) — Opportunity zones
- NerdWallet (5/13/21) — 2020-2021 tax brackets and federal income tax rates
- Bankrate (11/28/18) — 2017 tax bracket rates
- Tax Foundation (9/9/21) — State and local tax (SALT) deduction