The year 2022 – it still sounds like a long way away, but it’s barely 30 days at this point. You’re probably thinking you still have at least three or four months before needing to deal with your 2021 tax return; however, the fourth quarter is the best time for proactive tax planning. This is the last chance to enact most tax planning strategies that can possibly lower your 2021 tax bill. Therefore, 2021 tax planning is something to think about now. In this latest version of our blog, we address a few general strategies.
Primary Tax Planning Strategy: Postponing income & accelerating deductions
This is the age-old go-to strategy. It’s not an innovative idea, but it’s almost always worth considering in any tax planning project. It usually makes sense for taxpayers, to the extent possible, to defer income into later years and accelerate deductions into the current year. It’s a simple time value of money concept. This strategy can help you lower taxes this year and also help avoid crossing over into a higher tax bracket. Thus, it can also help lower the effective tax rate you pay on the income that isn’t deferred. It can also help avoid reaching a threshold where other types of taxes – think net investment income tax – or the loss of certain deductions can kick in.
On the other hand, postponing income and accelerating deductions is not always the right tax planning strategy. For example, if you expect a substantial increase in income or anticipate a higher tax bracket in future years. In this case, accelerating income into the current year may be a more appropriate approach. There are always things related to each specific situation to consider when doing tax planning. The name of the game is to achieve the lowest possible overall tax result.
Below are a few options to keep in mind when considering postposing income and accelerating deductions.
Minimize tax on Social Security benefits
For the 2021 tax year, if you have income (other than from social security benefits) between $25,000 and $34,000, you will pay tax on up to 50% of your social security benefits. Once you have non-SSI income of over $34,000, 85% of your social security benefits is taxable. Taxpayers with income close to these thresholds should consider deferring income to avoid additional taxes on social security benefits. For example, deferring unnecessary IRA distributions that may keep social security benefits from being taxable altogether.
Defer a bonus
If your employer is flexible on paying a bonus, ask to defer a 2021 bonus until early 2022. Sure the withholding may be sufficient to offset the tax liability of the bonus itself, but also consider the impact this additional income may have on your overall tax situation.
Prepay certain expenses using a credit card
Contributions to charity and deductible medical expenses are deductible when paid. This includes charges to your credit card, even if you pay the credit card bill later.
Dispose of passive activities to take advantage of suspended passive losses
Not all taxpayers have passive investments, but if you do, considering disposing/selling those investments. Particularly with a shortage in housing inventory right now, selling a rental property might make sense. It could potentially free up lots of suspended loss carryovers. Most taxpayers are unable to deduct passive losses in excess of passive income. Instead these carry forward to future tax years. However, losses are released and can be deducted upon disposition.
Make purchases of eligible Section 179 and bonus depreciation assets
Taxpayers can elect to deduct 100% of the costs of certain tangible property used in a business rather than depreciate these costs over the life of the asset. Under Section 179, for property placed in service in 2021, each taxpayer can deduct up to a maximum $1,050,000. Also, under 168(k) bonus depreciation, taxpayers can deduct 100% of the cost of eligible property placed in service in 2021. In other words, go purchase that new business auto or large piece of equipment. Even if you finance the purchase and pay for it over a number of years, you could be eligible for an immediate tax deduction equal to 100% of the cost. This is a very solid tax planning strategy.
Realize capital losses to offset gains
Taxpayers who have capital losses in the current year, or those that might be carried over from a previous year, should consider selling appreciated investments. If you have unrealized gains from stocks or mutual funds, as an example, you can sell these and shelter the gains with your other capital losses. Similarly, if you are holding assets that have unrealized losses, you may want to consider “harvesting” these losses. You can sell them and use the losses to offset any other capital gains that are being recognized in 2021.
Maximize contributions to retirement plans
Making contributions to retirement plans is a great tax planning idea. In addition to funding your retirement, it allows you to claim a tax deduction for the amount contributed. This not only decreases your current tax liability, but it can also help avoid moving into a higher tax bracket or having deductions phased out based on income. If you don’t already have a retirement plan, it’s usually pretty easy to set one up. You can set up a traditional IRA on your own or a 401(k) with your employer. Self-employed individuals can also consider a SIMPLE or SEP IRA.
Other Tax Planning Considerations:
Withholding and Estimated Taxes
Taxpayers who expect to owe at least $1,000 in tax need to check their paystubs. It’s important to make sure there is enough federal tax withheld to avoid any tax penalties. The same concept applies to self-employed individuals making quarterly estimated tax payments. To avoid penalties for underpayment of tax, the required tax withholding is the lesser of 90% of the tax liability on the current year return or 100% of the tax liability on the prior year return. For those making over $150,000, 110% replaces the 100% of prior year tax liability requirement. There is still time left before year end to change your W-4 to revise the amount of tax withholding. Also, the 4th quarter estimated tax payment isn’t due until January 18, 2022.
If you got married or divorced in 2021, it is important to remember that this will affect your tax return filing. The IRS treats any taxpayer who marries or divorces during the year as having had that status all year. A key part of any good tax planning strategy is considering if your withholding for part of the year was based on the incorrect filing status.
The days leading up to year end are also a good time to evaluate if you want to make any year end gifts. A taxpayer can make gifts of up to $15,000 per recipient per year. This can help accomplish transfers of wealth in addition to having some tax advantages. A year end gift of appreciated property could move a taxable gain to family members in a lower tax bracket. Gifts up to the annual exemption are nontaxable and won’t count against the donor’s unified estate and gift lifetime exemption. Married taxpayers can “split” gifts in order to gift up to $30,000 per donee under these rules. Gifts must be made by December 31, 2021 to count towards the 2021 tax year.
For 2021, the lifetime estate exemption is $11,700,000. While few Americans have assets exceeding that value, newly proposed tax legislation would lower the lifetime exemption. This would make the estate tax apply to many more Americans. Now is a great time to consider using part of this higher lifetime exemption before it goes away.
Check phase-out thresholds
With year end tax planning help from the tax professionals at Culpepper CPA, you can analyze whether you might be nearing certain phase out thresholds. Taxpayers gain or lose various tax benefits at these specific dollar amounts. In many cases, we can help you determine how to keep income below those thresholds.
People often overlook year end tax planning. Some don’t see the value in it, while others simply don’t prioritize it. However, there’s no doubt that proactive tax planning can achieve a significantly beneficial impact for many taxpayers.
Here at Culpepper CPA, we work diligently to keep up with the ever changing tax laws. This allows us to help you identify areas of potential tax savings. We can run 2021 tax projections to estimate your liability for this year while also ascertaining potential strategies for lowering that burden.
We provide a full range of in-depth tax and consulting services. Let us help you proactively manage your tax situation and help you minimize your tax liability with year end tax planning. Contact us today.