This blog was prepared with the assistance of Peter A. Weitsen, CPA, partner at WithumSmith+Brown, PC.
Here are some tax tips for steps that can be taken early in the New Year. Tax planning is a year-round activity, and the earlier you start, the better position you’ll be in.
Withholding and estimated tax payments. Get your 2019 tax info organized, and your return done as early as possible. You should use the completed return as a roadmap for the 2020 tax year. If you will get a large refund or have a large balance due, consider adjusting your Form W-4 withholdings and/or your estimated tax payments.
Note: As of January 1, 2020, there is a revised W-4 Form to be used by new employees and employees who are seeking to adjust the amount of tax withheld. It is the first major redesign of the form since 1987, and it is simpler than the old form. The form no longer provides for “withholding allowances” and has a five-step process designed to account for all sources of income and deductions. To help fill out the form, workers are allowed to use an online tax-withholding estimator tool from the IRS, which will be updated after the first of the New Year, or a printed worksheet. The calculations using the tool or worksheet also can help in determining estimated tax payments if they are required.
If you expect any changes from 2019, including such changes as marriage or having a new baby, factor this in when adjusting your withholdings and/or estimated tax. Do it now by using a projection of your 2020 income and expenses. Most every article on tax planning suggests you prepare a projection. That is good advice, and it really should be done.
When you have a projection prepared, review the individual items to determine whether any changes can be made that would either minimize your taxes or improve your financial situation. For instance, if you are in a high tax bracket and have significant taxable interest income, perhaps you should consider tax-free bonds or other forms of investing. Use your planning “session” to consider your alternatives.
Avoiding an extension. Delaying your filing hurts current-year planning. What happened last year is done—but you have it somewhat in your power to affect 2020. If, however, you need to file an extension, then get it done early rather than waiting until a few days before April 15. When you file an extension make sure you pay the tax you expect to owe and do not forget to also file your state extension so you will avoid penalties and interest.
Self-employed retirement plans. If you have any self-employed income, consider a solo 401(k) plan. That way you might be able to put in up to $57,000, and an additional $6,000 catch-up if you are over age 50, in either tax-deducted money or into a Roth 401(k), which sets up a tax-free earnings fund for you and your family. If you do not have self-employed income, and you qualify, you should make a contribution to either a traditional or Roth IRA.
Whether you use a deductible retirement plan or a Roth plan will be determined by your financial and tax situation. Further, the earlier you contribute, the sooner the tax-deferred or tax-free compounding starts.
Mortgage interest. Mortgage interest that you pay is another cost to consider from a tax- and wealth-management standpoint. If you get no itemized deduction for the interest because you take the standard deduction, or if you itemize and get a deduction but you are in a low tax bracket, you might not be getting a significant tax benefit from the interest payments. Furthermore, interest on a mortgage usually is greater than income most people earn on their investments (unless they are comfortable taking higher investment risks). If that is your situation, consider reducing your mortgage by accelerating payments. One way is to add an extra amount to each monthly payment. Whatever you add will reduce your interest costs by the amount of your mortgage interest rate multiplied by the extra payment. For example, a $100 extra payment with a 4% interest rate will save you $4 per year. If you make the $100 extra payments monthly, you will save $48 per year after the first year and this will compound annually after that. As a result, the mortgage will be liquidated earlier than scheduled.
Charitable contributions. If you make charitable contributions and use the standard deduction, you no longer will get a deduction for this. If you are past age 70½ and are taking required minimum distributions (RMDs) from your traditional IRA, you can make the contributions from the IRA—called qualified charitable distributions (QCDs). You cannot do this with a 401(k) account. However, if you roll over the 401(k) to an IRA, you can then do this.
If you so itemize and take a charitable deduction, consider contributing appreciated securities if possible, where you will get a deduction for the full value of the shares contributed and will not have to recognize the gains for tax purposes. If you make significant contributions, consider donating appreciated securities that would cover multiple future years to a donor-advised fund and then making the transfer to your charity on your normal donation schedule. In the later years, you could use the standard deduction and get the higher charity deduction now.
Required minimum distributions. If you reached age 70½ by December 31, 2019, and need to take RMDs from IRAs, 401(k)s and/or other retirement plans in addition to the QCD, consider how you time the distributions. (Under a new federal law affecting retirement plan rules, if you did not reach age 70½ by December 31, 2019, you don’t have to start RMDs until you reach age 72.) Any RMD amounts for 2020 are determined by the retirement account balances on December 31, 2019. The distribution can be taken anytime during 2020 and, in some cases, you can elect to have no withholding tax or extra withholding tax. If you are required to make estimated tax payments during 2020 and do not have sufficient balances in your IRAs, you can have the entire year’s estimated taxes paid in December 2020 from the IRA, thereby earning tax-deferred income for as long as possible. When the withholding is paid in this manner, it is considered as being paid ratably on each payment date, thus avoiding any underpayment penalties.
You also can try timing your other distributions to take advantage of the deferrals in the IRA.
If you are contributing to your traditional IRA or 401(k) and are subject to RMDs, then consider making a contribution for 2020 at the beginning of January 2021. Contributions can be made for the 2020 tax year up to the due date of your 2020 tax return—or later for a 401(k)—and can be applied to get the 2020 deduction. If you make the 2020 contribution in 2020, it will increase the year-end 2020 balance, which will increase your RMD in 2021.
Caution: If you write checks to make your QCDs and the checks do not clear by December 31, 2020 and you use the outstanding checks as part of your RMD, you will have an underpayment and be subject to a 50% penalty. Therefore, write such checks early enough so they will certainly clear, and then check your account to verify that they did clear.
RMDs for all of your IRAs can be aggregated and taken from any of the accounts you desire, but you cannot combine the RMD from non-IRAs such as your 401(k) or employer plans.
State and local income taxes. If you pay high state and local income taxes and have the option of moving to another state, then consider the possible tax savings as one of the factors in making this decision. FYI—Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do not have any state income taxes. Again, the earlier you start the planning and implementation, the better chance you have to get it all done by the end of 2020, so you could start 2021 in a low or no tax state.
Kiddie Tax. If your children are subject to the Kiddie Tax, consider shifting their investments into lower-dividend or lower-interest alternatives. Example: Transfer some of their funds into tax-free bonds or stocks that do pay dividends.
C Corporation conversions to S. If you operate a business as a C corporation, consider making an S election starting for 2020. This must be made by March 15, 2020, to be effective for 2020. Such income could be eligible for the up-to-20% qualified business interest (QBI) deduction, but to be sure you get this deduction, you should start your planning early and consult with a knowledgeable tax adviser.
S corporation earnings. Earnings from an S corporation can be eligible for the up-to-20% QBI deduction. If the earnings are reduced by salaries to owners that work in the business, the QBI deduction will be reduced as well as those wages being subject to payroll taxes. However, the salary paid must be reasonable, meaning that it cannot be too low in relation to the operations and what others in the company are earning. One tip is that many people that put a spouse on the payroll for nominal amounts or for a salary that is actually greater than their responsibilities should reconsider this. Removing the spouse from the payroll, unless the spouse is actually earning what he is are paid, would save payroll taxes and boost the income that would be eligible for the QBI deduction. Comment: This is a complicated area, especially with the QBI deduction being limited based on salaries paid, as well as other issues affecting the QBI deduction. This is something that would best be analyzed with a tax professional. While this article is limited to individual taxes, this is included since the salaries paid to the S corporation owners would affect those individuals.
State use tax. States that have sales taxes also have a use tax that requires the tax to be paid on purchases where sales tax should have been paid but wasn’t. This applies particularly to purchases made out-of-state or out-of-the-country and the tangible property is shipped or delivered into your state of residence. This is a self-reporting tax that carries severe penalties for failure to comply. If you make such purchases, it is easier in the long run to request the vendor to charge the tax, and if not, then keep your invoices and speak to a tax expert on the proper reporting and payment method.
The above are some suggestions that can reduce your 2020 taxes or increase your cash flow or keep you in better compliance with the tax laws. As with any tax generated moves, it is advisable to consult with a knowledgeable tax adviser beforehand. Have a great 2020, and thanks for reading my tax blogs.