At the time of this writing, the members of Congress are considering several bills, contemplating various frameworks and engaging in negotiations which could lead to significant changes to the Internal Revenue Code (IRC). This article is current as of October 25, 2021.

It’s the time of year when we are thinking about back to school, the start of cooler weather, leaves turning into fall colors, the upcoming holiday season — and, dare we say, year-end tax planning? 

Now may be the best time to coordinate with your tax and legal advisor to review plans and implement strategies to optimize tax efficiencies. Here we focus on some strategies that may help you reduce this year’s tax liability and enhance your overall wealth plan.

Impacts from the COVID-19 Emergency

In 2020 and 2021, Congress created several programs and benefits to help individuals and businesses impacted by the COVID-19 emergency. Many of the benefits provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act[1] expired in 2020.

However, some benefits continued through (or through part of) 2021, and others were added by the Consolidated Appropriations Act, 2021 (the CAA)[2] and the American Rescue Plan Act of 2021 (the ARPA).[3] These statutes provided direct payments to taxpayers and expanded certain federal income tax credits and deductions. As we approach the end of 2021, we recommend that you consult with your tax advisors to discuss whether you qualify for, or have additional filing requirements based on, these relief plans. Some things to consider:

  • Direct Payments: Many taxpayers were eligible to receive a direct payment from the Department of the Treasury of up to $1,400 per individual (or up to $2,800 for eligible married couples filing a joint return) plus $1,400 per eligible dependent. These payments are really refundable tax credits paid in advance for an individual’s 2021 tax year. If the qualified individual has received an advance refund (the direct payment), the qualified individual will be treated as having made a tax payment in that same amount and the refundable credit will be reduced by that amount. If, however, the qualified individual did not receive an advance refund (the direct payment) and the credit exceeds the individual’s tax liability for 2021, the amount of the credit exceeding the tax liability will be treated as an overpayment of tax, and such amount will be refunded, without interest, to the taxpayer. As you contemplate year-end tax planning, be sure that you take these payments into consideration and how they will impact your 2021 tax return.
  • Increased Tax Credits. The ARPA expanded eligibility for certain credits against federal income tax. When doing your year-end tax planning, consider whether you qualify for any of these tax credits:
    • Child Tax Credit. The Child Tax Credit (CTC) provides a credit against tax for taxpayers who can claim a child who qualifies as a dependent. ARPA expanded the CTC by providing special rules for 2021. For 2021, ARPA increases the CTC to $3,600 for a child under age 6 at the close of the tax year and to $3,000 for a child age 6 through 17 at the close of the tax year. As with many federal tax credits, you must meet certain requirements and income limitations to qualify.
    • Earned Income Credit. The earned income credit (EIC) for individuals without qualifying children has been expanded by providing special rules for 2021. ARPA provides that for 2021, the age thresholds to qualify for the EIC have been reduced from 25 years to (i) age 24 for a specified student, (ii) age 18 for a former foster youth or a qualified homeless youth, and (iii) to age 19 in all other cases. The upper age limit of 65 years has been eliminated. The credit percentage and phaseout percentage are increased as are the earned income amounts and phase-out amounts. As with many federal tax credits, you must meet certain requirements and income limitations to qualify.
    • Child and Dependent Care Tax Credit. ARPA expanded the child and dependent care tax credit (CDCTC) for tax year 2021 only. The CDCTC provides the taxpayer with a credit against federal income tax for certain expenses paid for the care of a qualified individual which are necessary for the taxpayer to be gainfully employed. For the 2021 tax year only, ARPA makes the CDCTC a refundable credit. After a taxpayer’s income tax has been fully offset by tax credits, if a credit is refundable, any additional credit will be paid to the taxpayer as a refund. ARPA also increased the maximum credit amounts available to the taxpayer. As with many federal tax credits, you must meet certain requirements and income limitations to qualify.
    • Credits for Health Care Benefits. Certain individuals are entitled to receive a refundable income tax credit with respect to health insurance purchased pursuant to the Affordable Care Act (premium credit). For 2021, ARPA increased the amount of the refundable credit. ARPA also expanded the availability of the premium credit to any person who receives or is approved to receive unemployment benefits in 2021.
  • Other Tax Benefits. You should also be aware of other tax benefits that may be available to you in 2021. These are:
    • The amount of a student loan that is discharged (or forgiven) after December 31, 2020, and before January 1, 2026, will not be included in the gross income of the debtor, unless the discharge is made on account of services rendered to the lender.
    • With respect to a tax year beginning in 2020, if a taxpayer’s adjusted gross income (AGI) (determined after application of IRC §§ 86, 135, 137, 219, 221, 222, and 469, and without regard to new IRC § 85(c)) is less than $150,000, the first $10,200 of unemployment income received by the taxpayer (or the taxpayer’s spouse, if the taxpayer is married and files a joint return) shall be excluded from gross income.
    • Certain educational assistance up to $5,250 paid by an employer on behalf of an employee is excluded from an employee’s gross income. The CARES Act extended this provision to include payment by an employer in calendar year 2020 of principal or interest on any qualified education loan incurred by the employee for education of the employee, whether paid to the employee or to a lender, as educational assistance and, within applicable limits, may be excluded from the employee’s gross income. If the taxpayer has already excluded a student loan payment under this provision, the deduction for payment of interest on such student loan is denied. The Taxpayer Certainty and Disaster Relief Act of 2020 (TCDRA)[4] extended this exclusion from gross income of employer- paid principal or interest on any qualified education loan to payments made through December 31, 2025.
    • Primary and secondary educators are permitted an above-the-line deduction of up to $250 when determining AGI for certain expenses that would be ordinarily allowed as unreimbursed trade or business expense deductions. Often these expenses are related to instructional supplies purchased by teachers. The COVID-related Tax Relief Act of 2020 (the CTRA)[5] directs the Secretary of the Treasury to issue regulations or other guidance to clarify that expenses incurred after March 12, 2020 to purchase “personal protective equipment, disinfectant, and other supplies used for the prevention of the spread of COVID–19” are included in expenses eligible for this above-the-line deduction.
    • Employers may allow unused amounts (up to $550) remaining in a healthcare flexible spending arrangement to be carried forward to pay healthcare expenses incurred in the following year. The TCDRA expands the carry forward period for 2020 and 2021 and allows employers to extend the grace period during which carried forward amounts may be used (for 2020 or 2021) to 12 months. You should check with your employer to determine if this benefit applies to your flexible spending account.

Philanthropy

People give to charitable organizations for many reasons. As this article pertains to 2021 year-end planning, we focus on tax planning ideas using gifts to charity.

If You Itemize — Consider Giving Cash

If you itemize deductions and make charitable contributions, you may be able to deduct on your federal income tax return the amount of such contributions, limited by the application of certain percentages of your contribution base. Your contribution base is your AGI (computed without regard to any net operating loss carryback to the taxable year). The TCDRA suspended the percentage limitations for qualified contributions made in 2021. A qualified contribution is a contribution paid in cash during calendar year 2021, to a charitable organization other than a supporting organization or a donor advised fund (DAF) for which you have elected to apply these rules. In the case of qualified contributions flowing through to your return from an entity subject to tax as a partnership or corporation taxed under subchapter S of the IRC, you (and each other shareholder or partner) would make the election separately. Qualified contributions are deductible on your federal income tax return up to the full amount of your contribution base over the amount of all other charitable contributions allowed. Excess qualified contributions may be carried forward and deducted (subject to limitations) over the next five years.

If You Are Close to Being Able to Itemize — Consider Bunching

Making larger contributions less often could allow you to accumulate deductions and itemize. For example, if a married couple filing jointly contributes $15,000 per year to charity, assuming no other itemized deductions, they would not exceed the $24,800 standard deduction and would not receive a tax benefit for their contributions. However, if they contribute $30,000 every other year, they would be able to itemize in the year they make the charitable contribution and benefit from an additional $5,200 deduction that year. A DAF can be an effective tool for bunching charitable contributions. You could be eligible to take an income tax deduction in the year the contribution is made, but no minimum required distribution must be made from the DAF in any given year. If this is an option for you, be sure to factor the cost of a DAF into your decision.

If You Don’t Itemize

The Tax Cuts and Jobs Act (TCJA)[6] substantially increased the amount of the standard deduction. After enactment of the TCJA, many taxpayers who had previously itemized deductions found that the standard deduction was larger than their previously itemized amounts and that taking the standard deduction provided a greater tax benefit.[7] Yet, even if you don’t itemize deductions, you can still receive a tax benefit for making certain gifts to charitable organizations. For 2021, married taxpayers filing jointly can receive up to a $600 above-the-line deduction for qualified contributions. A qualified contribution is a charitable contribution:

(i) which is made in cash;

(ii) for which a deduction is allowable (without regard to percentage limitations for deductibility);

(iii) which is not made to a supporting organization or a DAF; and

(iv) which is not deductible due to certain increased percentage limitations or as a carry-over from a prior year. 

Individuals age 70½ and older may make qualified charitable distributions (QCD) from their IRAs directly to qualified charities up to $100,000 annually. If you make a QCD, you will not receive a charitable deduction for federal income tax purposes. On the other hand, some or all of the amount distributed will be excluded from your gross income.

The excludable amount of qualified charitable distributions for a taxable year is reduced [but not below zero] by the aggregate amount of IRA contributions deducted for the taxable year and any earlier taxable years in which the individual was age 70 ½ or older by the last day of the year (post-age 70 ½ contributions) … other than the amount of post-age 70½ contributions that caused a reduction in the excludable amount of qualified charitable distributions for earlier taxable years.[8]

Further, if you have attained age 72, a QCD will count towards some or all of your required minimum distribution. If you no longer itemize deductions, a QCD may be a tax efficient way to fulfill your charitable giving goals.

Deferred Compensation and Retirement Planning

Revisit Deferred Compensation Arrangements

Before making 2022 elections regarding non-qualified deferred compensation arrangements, we believe it’s important to determine if deferring income is right for you and to decide on the deferral timing.

Deferred compensation plans allow highly compensated employees to defer a portion of their income to a future year. The idea is to lower income levels during high-earning years. The income is paid out at a future date of your choice that is typically when overall income is less, as is your corresponding tax bracket. Additionally, during the deferral period, the income may be invested in a selection of investments set by the plan provider and may grow on a tax-deferred basis. If you leave your job, the plan typically would return your vested balance at that time.[9]

Under the TCJA, most taxpayers are now in lower tax brackets, but the lower tax rates are scheduled to expire at the end of 2025. This means any income deferred to 2026 and beyond may be subject to higher tax rates. Further, although beyond the scope of this article, at the time of this writing, Congress is considering raising income tax rates beginning in 2022 and adding an additional surtax for certain very high-income taxpayers.

The decision whether to defer income, the length of the deferral, and if election dates should be changed, if allowed, is complex. It is impossible to know what future tax rates may be (especially now, as Congress debates tax increases), but it is possible to project what your income may be at the time the compensation is taken and how deferred compensation fits in with other available planning strategies. Deferred compensation elections for 2022 must be made by December 31, 2021. However, many employers may require elections to be finalized earlier in the year.

Converting Some or All of a Traditional IRA to a Roth IRA

For many Americans, 2021 continued to be financially difficult. While perhaps not as dire as 2020, for many, 2021 income may have been reduced from normal levels. Perhaps in 2021, you had limited employment, business losses, large medical expense deductions, or other reasons for a decline in income caused by the COVID-19 emergency. In a year with reduced income, perhaps it makes sense to consider converting some or all of your traditional IRA to a Roth IRA.[10]

Although the details are beyond the scope of this article, as of this writing, Congress is considering eliminating the ability of certain high-income taxpayers from converting traditional IRAs to Roth IRAs. If passed, this strategy could be eliminated for those taxpayers in 2022. Moreover, Congress is also considering raising income tax rates on high-income taxpayers and adding a 3% surtax on very high-income taxpayers beginning in 2022.

Converting your traditional IRA to a Roth IRA could save income tax over the long-term. Although converting your IRA will cause an income tax today on the amount converted that would have been subject to income tax had you not converted to a Roth IRA,[11] future growth in the converted assets (now in a Roth IRA) will be tax-free. This could be important if tax rates rise in the future. Qualified distributions from a Roth IRA are tax free to the owner and/or beneficiary and the lifetime required minimum distribution rules do not apply to Roth IRAs.

Converting to a Roth works best when the tax incurred on the conversion can be paid from assets not held in an IRA or qualified retirement plan, as withdrawing assets therefrom to pay the income tax attributable to the Roth conversion will incur additional income tax. Roth conversions require careful analysis to determine whether incurring an income tax today will save income tax in the future. As each person’s financial circumstance is unique, before undertaking a Roth conversion you should seek the advice of your tax and financial advisors.

Repayment of Coronavirus Related Distributions

The CARES Act allowed qualified taxpayers impacted by COVID-19 to withdraw up to $100,000 from certain qualified plans and IRAs as a “coronavirus related distribution.” The CARES Act allows coronavirus related distributions to be repaid within three years. The US Treasury Department has provided detailed guidance regarding this repayment.[12] If you repaid some or all of a coronavirus distribution this year, you should take this into consideration when determining your withholding or estimated tax payments for 2021.

Explore Tax Loss Harvesting

Losses in Your Portfolio

Although, as of this writing, the U.S. domestic equity markets are generally higher than they were at the beginning of this year, you may have assets with unrealized losses in your portfolio. You may be able to use those losses to decrease your 2021 tax bill through tax-loss harvesting.

Tax-loss harvesting generates capital losses by selling assets that are currently worth less than what you paid for them. These losses are then used to offset capital gains recognized during the year. Your plan may be to repurchase the asset at some point, but if you recognize a loss you must wait at least 31 days to repurchase the same asset or the tax-loss will be disallowed.[13]

If your capital losses exceed your capital gains, you can use up to $3,000 of the excess loss to offset other income. Any remaining capital losses can be carried forward. For example, if you sell an asset and recognize a $15,000 capital loss and have $10,000 of capital gains, you can claim zero gains for the year. You can then use $3,000 of your remaining $5,000 in capital losses to offset other income in 2021. The remaining $2,000 may be used to reduce taxable income in 2022.

Gains in Your Portfolio

Market performance in 2021 may have left you with many realized capital gains and no (or very few) offsetting losses. Additionally, market performance may cause mutual fund capital gain distributions this year to be higher than usual. Accordingly, as described below, you may wish to adjust your income tax withholding or quarterly estimated income tax payment to take additional capital gains into consideration.

Deferring Losses

Although we would normally suggest offsetting current income with current losses (and perhaps accelerating losses to offset current income), the proposals being discussed in Congress could change this recommendation. Although the details of the tax proposals are beyond the scope of this article, one proposal under consideration would, with some exceptions, raise the top tax rate on capital gains from 20% to 25% for capital gains realized on or after September 13, 2021. If this proposal were enacted and your gains were subject to the top marginal rate on capital gain income, taking losses at the end of 2021 would offset gains some of which may be subject to tax at 20% and some of which may be subject to tax at 25%. As an alternative, if the proposal is enacted, postponing losses into 2022 would allow those losses to offset gains, all of which would be taxed at 25%.

Accelerating Income / Postponing Deductions / Bunching Deductions

Although the details are beyond the scope of this article, it bears mentioning that, as of this writing, Congress is considering income tax increases for 2022. No one knows for sure what, if anything, will be enacted into law by the 117th Congress, but you should watch what is happening in Washington, D.C., and plan accordingly. Even though at this moment it may be too soon to act, you may wish to prepare now, in case a tax law change happens near the end of the year and quick action is required near the end of the year.

If it looks like tax rates will go up next year, consider accelerating income that you would receive in 2022 into 2021 so that it is taxed at lower rates. Careful analysis is important, as accelerating income into 2021 could move you up in the tax brackets and cause an overall higher tax than you would have otherwise paid.

Also, if it looks like tax rates will go up next year, consider deferring deductions. A deduction is worth more when taken against income taxed at a higher rate. For example, if this year you are in the 37% tax bracket and next year you would be in the 39.6% tax bracket, a $1,000 deduction would be worth $370 this year, but $396 next year.

Also, consider bunching your deductions. Already discussed in the section of this article on Philanthropy, bunching deductions could allow you to itemize in a particular tax year and, for expenses that require a certain threshold to be deductible, qualify you to meet those thresholds. For example, to be eligible for a deduction, medical expenses must exceed 7.5% of AGI. If you will not meet the threshold in 2021, consider accelerating treatment from the 2022 tax year into 2021 to receive a deduction. The cost of medical procedures completed in 2021 but not actually paid for until 2022 may not be deducted this year. Alternatively, if it looks like income tax rates will increase next year, you could bunch your medical expenses into 2022.

Trust Planning

As of this writing, Congress is considering legislation to limit the use of so-called grantor trusts in estate planning. Although the details of the proposed legislation are beyond the scope of this article, if you are thinking about creating a grantor trust, such as an irrevocable life insurance trust (ILIT) or a spousal lifetime access trust (SLAT), you should be doing this now. Also, if you already have a grantor trust, you should consult your tax advisors to determine how the proposals moving (or not) through Congress could impact your plan.

If you plan to create a trust this year as part of your estate plan, don’t wait until the end of the year to engage your attorney. Attorneys are inundated with requests for service. Waiting until the end of the year could see your plans go unfulfilled.

Perennial Items

Review Withholding and Estimated Tax Payments

Be sure that you are withholding enough to satisfy your federal tax liability. Failure to withhold sufficient tax (or pay sufficient quarterly estimated tax) may cause you to owe tax with your return and to be subject to interest and penalties. Similarly, by withholding too much, you are making an interest free loan to the government.

The IRS has published a simplified withholding estimator (last accessed October 4, 2021) that can provide a rough estimate of overall withholding and income. By updating your W-4, your employer can adjust the amount withheld from your salary to cover any shortfall, avoiding potential underpayment penalties.

Fund Employer Sponsored Retirement Plans

Studies show that many Americans do not have resources adequate to provide for their retirement.[14] If you able to do so, you should fund your retirement plans to the extent of the amount that can be set aside before taxes. If you cannot fully-fund your employer- provided plan and if your employer matches your contributions to a defined contribution plan, at least save enough to get the employer’s match. Failing to do that is “leaving money on the table.”

Review Contributions to 529 Plans

529 plans can be an effective way to save for educational expenses. A unique feature of 529 plans allows donors to front-load accounts with up to five years of annual exclusion gifts. This means that in 2021 (if you haven’t previously front-loaded a 529 plan) you can contribute up to $75,000 ($150,000 for a married couple) to a 529 plan, all of which would qualify for annual exclusion gift treatment (being reported ratably over five years). 529 plans grow tax-free, and distributions for qualified higher education expenses are tax-free. The term “qualified higher education expenses” means: (i) tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution, (ii) expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance, and (iii) expenses for the purchase of computer or peripheral equipment (as defined in IRC §168(i)(2)(B)), computer software (as defined in IRC §197(e)(3)(B)), or Internet access and related services, if such equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution”; provided that it shall not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature. The term also includes up to $10,000 per beneficiary per year for elementary and secondary school (grades K through 12) tuition, certain expenses for registered apprenticeship programs, and the payment of up to $10,000 (in total from all plans) in student loan debt for the beneficiary and the beneficiary’s siblings (including step-siblings). The state in which you live may offer a state income tax deduction for contributions to a 529 plan. Confer with a tax advisor who understands the laws of your state to determine how contributing to a 529 plan will affect you.

Plan Now

As the daylight wanes in the Northern Hemisphere, we turn our attention to the fall and winter holidays that make the dark days brighter. It seems somehow appropriate that at the “darkest” time of the year, our annual tax liabilities become fixed. 

Each family’s tax and financial circumstances are different. Although the ideas presented herein are of a general nature, we hope you can use them to prepare for year’s end. 

We encourage you to consult with your tax, legal and financial advisors with respect to your particular circumstances.