2021 Year-End Tax Planning Strategies for Individuals
The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 was passed by Congress to provide critical financial respite from the ravages of the COVID-19 pandemic, for both businesses and individuals. This included the Pandemic Emergency Unemployment Compensation (PEUC) program extending unemployment benefits by up to 13 weeks. The American Rescue Plan Act (ARP) of 2021 provided additional relief for individuals and employers, including recovery rebate credits (commonly known as stimulus payments), an increase in child tax credits, and the extension of several tax measures introduced during 2020.
As the IRS continues to release guidance and update tax forms to reflect changes recently enacted, it is important to stay up-to-date with the latest information for year-end tax planning. The following summarizes some of the significant planning opportunities now available to minimize individual tax obligations.
RECOVERY REBATE CREDIT
In addition to the first two rounds of stimulus payments provided by the CARES Act in 2020, the Consolidated Appropriations Act (CAA) distributed an additional $600 recovery credit to eligible individuals during 2021. Phase-out applies when adjusted gross income exceeds $150,000 (married filing joint), $112,500 (head of household) or $75,000 (others). Eligible taxpayers who did not receive the payments will be able to claim them as a credit on their 2021 tax returns filed in 2022.
CHILD TAX CREDIT
For 2021, ARP increases the child tax credit to $3,000 per qualifying child age 6 or older and $3,600 per qualifying child under 6 (up from $2,000 in 2020). The credit will be fully refundable (increased from a $1,400 credit during 2020). The maximum age for qualifying children is now 17 (raised from 16). Phase-out applies when modified adjusted gross income (MAGI) exceeds $150,000 (married filing joint), $112,500 (head of household) or $75,000 (others).
The IRS will automatically disburse advance payments for 50 percent of the credit from July 1 through December 31. Individuals do not have to take any action to receive these payments, but may check enrollment or opt out of receiving advance payments at https://www.irs.gov/childtaxcredit2021. While the Biden Administration proposes to keep the higher amounts of this child tax credit, it is currently set only for 2021.
Income from the sale of an investment held for more than one year is generally taxed at preferential capital gains rates. For 2021, the long-term capital gain and qualified dividend rates remain unchanged at 0%, 15% and 20%, based on statutory income brackets and adjusted for inflation. For example, the 20% rate applies when taxable income exceeds $501,600 (married filing joint), $473,750 (head of household) or $445,850 (others).
- Consider holding capital assets for at least 12 months, as short-term capital gains are taxed at ordinary income rates, which are higher.
- Consider gifting appreciated stock or mutual fund shares to relatives in a lower income tax bracket (such as children or grandchildren), who may pay less or no tax on the long-term capital gains when the shares are sold.
- Consider selling unrealized loss positions in your investment portfolio to offset capital gains recognized earlier in the year.
- It is worth noting that Congress is working on applying wash sale rules to digital assets including cryptocurrency. If the bill passes, the rules will go into effect in 2022.
NET INVESTMENT INCOME TAX (NIIT)
In addition to income tax, individual taxpayers with MAGI of more than $200,000 per year ($250,000 if married filing joint; $125,000 if married filing separately) may be subject to net investment income tax. NIIT equals 3.8% of the lesser of (a) net investment income or (b) the amount by which MAGI exceeds the applicable threshold. Net investment income includes interest, dividends, capital gains, rental income (unless derived from ordinary business activities) and passive activities, less deductions properly allocated to net investment income.
- Consider electing installment sale treatment so that gains are spread over a number of years. By spreading the income over multiple years, current year net investment income and MAGI may be reduced to minimize or eliminate the 3.8% tax for the current and future tax years.
- Consider selling unrealized loss positions in your investment portfolio to offset capital gains recognized earlier in the year.
- Tax exempt income is not subject to the 3.8% tax. Consider switching investments to tax exempt investments if it makes sense for your portfolio. State taxation of such investments should also be considered.
SMALL BUSINESS OWNERS
For those who own a business, consider the following strategies to minimize taxes:
- Claim the Employee Retention Credit (ERC). If your business has employees, it can claim up to $7,000 per employee per quarter to offset payroll tax liabilities. However, ERC cannot be claimed using the same wages for which PPP loan forgiveness is applied.
- Defer income. If a business uses the cash method of accounting, billing and collections for products or services can be deferred until year-end. Accrual method taxpayers can delay shipping products or delivering services.
- Accelerate expenses. Cash basis taxpayers can consider accelerating expenses by paying for business expenses by year-end. Credit card payments are deductible in the year charged rather than paid.
- Employ your child. Business owners or those who are self-employed can consider employing their children to work in the family business. The child will be taxed at his or her rate on earnings (earnings are not subject to “Kiddie Tax”). Wages paid by sole proprietors to children age 17 or younger are exempt from Social Security, Medicare and federal unemployment taxes. Make sure wages paid are reasonable given the child’s age and work skills.
- Claim a home office deduction. Eligible expenses may be deducted by taxpayers who maintain a home office used primarily for business activities. An optional standard deduction of $5 per square foot of home used for business purposes, up to 300 square feet, or a maximum $1,500 deduction, may be used.
- Acquire Assets. Acquiring business assets may be a good tax planning strategy, depending on the business situation. For assets with a useful life of more than one year, the cost must be depreciated over an IRS-determined period of years, depending on asset type. As a part of the Tax Cuts and Jobs Act (TCJA), the following favorable provisions were revised and made available for depreciating fixed assets, thus maximizing deductions:
- Section 179 Expensing Election – This election allows a deduction of 100% of the cost of qualifying assets, rather than recovery through depreciation. The maximum amount that can be expensed for 2021 is $1.05 million. This amount is reduced (but not below zero) by the amount by which the cost of total qualifying property exceeds $2.62 million.
- Bonus Depreciation – The TCJA established a 100% first-year deduction for qualified assets placed into service through December 31, 2022, with a recovery period of 20 years or less. This provision applies to both new and used property and was expanded to include qualified film, television and live theatrical productions. (For the period January 1, 2023 – December 31, 2026, bonus depreciation is scheduled to be gradually reduced.) The useful life of qualified improvement property has been corrected through the CARES Act to 15 years (previously 39 years under TCJA) to be bonus depreciation-eligible.
- States may or may not conform to these federal provisions and so should be considered separately.
For 2021, medical expenses can be deducted to the extent that expenses exceed 7.5% of adjusted gross income (unchanged from 2020). Eligible expenses include health insurance premiums (if not deducted elsewhere on your income tax return), long-term care insurance premiums (subject to limitations), medical and dental services, and prescription drugs. The CARES Act also added over-the-counter medications as qualified medical expenses.
- Since individuals generally use cash basis accounting, medical expenses must be paid in the year incurred in order to be deductible. Credit card payments are deductible in the year charged, rather than paid. Be aware, however, that prepayment of medical services in advance of the year services are actually rendered may not accelerate the deduction.
- If time permits, consider bunching elective medical procedures into 2021 (for services and purchases) if doing so will exceed the 7.5% floor and satisfy other itemized deduction limitations. The threshold will likely to be increased to 10% of AGI for 2022.
For tax years 2018-2025, the TCJA reduces the limit on interest deductions pertaining to outstanding mortgage debt incurred after December 15, 2017, from $1 million to $750,000. Interest on debt incurred prior to December 15, 2017, but refinanced later is deductible to the extent the new debt does not exceed the original debt. Furthermore, the TCJA suspended the prior provision that allowed up to $100,000 of interest on home equity debt to be treated as deductible qualified residence interest.
- Keep track of how and when loan proceeds are spent. For example, portions of mortgage debt utilized to acquire business assets are deductible as trade or business interest or as investment interest expense.
The incentives for charitable giving enacted by the CARES Act have been extended through the end of 2021. Cash donations to public charities other than a supporting organization or a donor-advised fund are fully deductible up to 100% of adjusted gross income (AGI) (unchanged from 2020), and gifts of appreciated property or gifts for use by public charities are deductible up to 30% of AGI (also unchanged). For C-corporations, up to 25% of taxable income may be deducted (up from 10% of taxable income in 2020). Taxpayers who do not itemize can claim up to $600 of cash contributions for married filing jointly ($300 for all others, increased from $300 per tax return in 2020). This deduction is not available to taxpayers who itemize deductions.
For donations made during the year, be sure to get acknowledgement letters from the qualified charities for both cash and property donations (including stock donations) over $250. If you are not certain if a particular charity is qualified, you can consult the IRS website at https://apps.irs.gov/app/eos/ and search for the organization in question.
- Consider bunching donations in 2021 to take advantage of the more generous tax deduction limits. The regular tax deduction limits are expected to return after 2021.
- Donate appreciated stock to charity to avoid paying capital gains tax and receive a fair market value deduction for stocks held for more than one year.
- Sell depreciated stock and donate the cash proceeds to charity. You will receive a charitable deduction as well as a capital loss benefit on the sale of stock. Capital losses offset capital gains, and the maximum net capital loss in any tax year is $3,000 for a married filing joint taxpayer ($1,500 for all other taxpayers). Any unused capital losses are rolled over to future years.
401K AND SEP CONTRIBUTIONS
Contributions to a traditional employer-sponsored defined contribution plan are typically pre-tax, therefore reducing taxable income. Maximize 401K plan contributions to boost retirement savings and reduce current year taxes. The maximum contribution to a 401K plan remains at $19,500 in 2021 (unchanged from 2020). Employees age 50 or older can make an additional “catch-up” contribution of up to $6,500 (also unchanged from 2020).
For those who are self-employed, consider setting up a self-employed retirement plan (SEP) or some other type of retirement plan in order to maximize the allowable contribution each year.
Coronavirus-related withdrawals from IRAs, pension plan, or 401K plan during 2020 can be re-contributed back into a qualified retirement plan at any time during the following three-year period to eliminate otherwise reportable taxable income.
FLEXIBLE SPENDING ACCOUNT (FSA)
Amounts contributed to a healthcare Flexible Spending Account (FSA) are not subject to federal income, Social Security or Medicare taxes. For 2021, the maximum contribution is limited to $2,750 (unchanged from 2020).
The dependent care contribution limit for 2021 increases to $10,500 (from $5,000 in 2020) for single taxpayers and married couples filing jointly, and to $5,250 (from $2,500 in 2020) for married individuals filing separately.
Historically, the “use it or lose it” provision applied to amounts contributed to a flexible spending account. However, for 2021, the CAA allows employers to permit participating employees to roll over all unused funds to 2022. This carryover does not count toward the annual contribution limit. Some employers may offer a grace period to incur eligible medical expenses, generally two-and-a-half months after year-end.
Check with your employer for the rules on the established FSA plan.
HEALTH SAVINGS ACCOUNT (HSA)
Individuals covered by a qualified high-deductible health plan can either contribute pre-tax income to an employer-sponsored Health Savings Account (HSA) or make deductible contributions to an HSA. For 2021, the maximum permissible contributions are $3,600 for single taxpayers (increased from $3,550 in 2020) and $7,200 for family coverage (increased from $7,100 in 2020). Taxpayers aged 55 or older as of the end of the tax year can contribute an additional $1,000. (This means HSA holders can contribute and reduce income by $9,200 if both spouses are over 55.) There is no “use it or lose it” provision with HSAs.
QUALIFIED CHARITABLE DISTRIBUTIONS (QCD)
Taxpayers who have reached age 70 ½ can donate up to $100,000 of taxable IRA distributions directly to qualified charities. The donation satisfies the minimum distribution requirement and is excluded from taxable income. A charitable deduction cannot be claimed for the contribution. It is worth noting that required minimum distributions (RMDs) from IRA accounts have resumed for 2021 and must be made by December 31.
SECTION 199A DEDUCTION FOR SOLE PROPRIETORSHIPS AND OWNERS OF PASS-THROUGH ENTITIES
The TCJA introduced Section 199A (Qualified Business Income deduction, or QBI), which provides a deduction for sole proprietorships and owners of pass-through entities (partnerships, S-corporations, trusts and estates, etc.). It is intended to provide tax relief to businesses not benefiting from the reduced top corporate rate, lowered from 35% to 21%. The 199A deduction is generally equal to 20% of QBI when taxable income is lower than the applicable threshold. The taxable income thresholds for 2021 are $329,800 for married filing joint, $164,925 for married filing separate, and $164,900 for all others.
The deduction is complex and subject to various rules and limitations based on (1) taxable income, (2) type of business(es) (i.e., specified service, trade or business), and (3) a business’ W-2 wages paid and basis at acquisition of qualified property.
- Consider making deductible retirement and HSA contributions, deferring income, or accelerating expenses to reduce taxable income.
- Review your company personnel to consider if independent contractors should be converted to employees to increase your company’s total W-2 wages.
- Consider acquiring qualified business property before year-end.
- If you have multiple qualified businesses, consider aggregating certain of them to maximize your 199A deduction. Analyze your various business revenue streams and consult with your tax advisor to determine which aggregated activities are more beneficial.
There are many potential tax savings opportunities to consider when planning for the end of the year, keeping in mind pandemic benefits and the upcoming tax law changes. Consult your Marcum tax advisor for assistance in determining which opportunities best meet your unique facts and circumstances.