As the year comes to a close, we’re delighted to share the first post from our newest team member, Tom Hines. Joining TCM in February this year, Tom brings a wealth of experience in tax, accounting and advisory roles that substantially broadens the scope of TCM’s services.

As we approach the end of another tumultuous year, it is time to assess your income tax situation before 12/31/2021 so that you might minimize your total tax bill. Below is meant to be a succinct summary of several thoughts on tax planning but it is not meant to be a compendium on all the tax issues facing a household. In addition, the article below is not meant to provide specific tax or legal advice as the concepts are based on generally accepted tax principles based on current law. Please seek the advice of your tax accountant to see how you can maximize the utility of your tax dollars.

*2021 Important Numbers. Click image to download file. Source: fpPATHFINDER*

Estimate your income and deductions

A time-tested maxim of tax planning is to defer as much income into the next year while accelerating as many deductions as possible into the current year to reduce your overall taxable income. However, it is also important to smooth out your income from year to year so that you take advantage of lower tax brackets each year as opposed to jumping around into a much higher brackets in one year while in a subsequent year being in a much lower bracket. It is important to know your marginal tax rate every year so that you are aware of how the next $1 will be taxed or how much a deduction will save you. It is a best practice for a tax preparer to prepare two-year tax projections that include the current year and the following year. Please refer to “2021 Important Numbers” as a guide. If you are a financial oriented person, there are many websites that allow you to prepare these projections your self such as www.aaii.com and www.turbotax.com.

Tax balance due and underpayment penalties

For employed persons, the Form W-4 that is used to determine your withholdings can be a very confusing document to complete. If your employment compensation and/or outside income changes materially, you want to make sure you update your Form W-4. For self employed persons, it is critical to prepare a year end forecast of your net income to assess the extent of your balance due that might be best paid at the last estimated tax payment date in January 2022 to avoid estimated tax penalties. Federal law requires the payment of income taxes throughout the year as you earn your income. A person can meet this obligation through withholding or quarterly estimated tax payments.

There are many rules that govern how a person can avoid estimated tax penalties so seek out the guidance of your tax preparer or consult Publication 505 from the IRS website www.irs.gov.

Capital Gains timing

The last couple of years have generally been fruitful for clients invested in equity markets possibly resulting in long term capital gains. One of the most common mistakes clients make is to not manage the realization of capital gains with the different marginal tax brackets that apply to them (i.e., see long term capital gains tax on 2021 Important Numbers). There are many tax proposals being considered that have one thing in common, and that is to materially raise the capital gains tax rate from its current levels. To qualify for long term capital gains treatment, one must hold the asset for at least one year and a day. Assets held less than that time and sold, will be considered short term capital gains, and taxed at ordinary income tax rates. Currently, the LTCG rate for MFJ taxpayers is 15% for income from $80,800-$501,600 while the rate is 0% for income less than $80,800. If a person has experienced a runup in their stock, mutual fund or ETF holdings and they know that they may have to sell the asset in the next few years, it is important to understand that he current LTCG rates are at historic lows, and it may be prudent to realize the gain in 2021 and 2022 not knowing how high the proposed rate might be in the future. It is also prudent to take losses in assets at year end to offset gains as opposed to hopelessly waiting for a holding to come back when there are many viable growth alternatives in the marketplace today.

Section 529 plans

Section 529 plans have become one of the most popular vehicles for families to save for the ever-increasing college expenses. Most states offer very attractive incentives to contribute to these plans in the form of a tax credit. For example, Illinois provides a 5% credit for MFJ couples to the extent of their contributions of $10,000 per person. While many families might not have saved for years for college, it may be prudent to contribute what they can prior to year end for the inevitable tuition, room and board and book expenses in the Spring. Getting a 5% tax credit is like achieving a guaranteed 5% rate of return on those funds. Please see the website for your states Section 529 plans and refer to www.brightstart.com for Illinois residents.

Maximize contributions to retirement & self-employment plans

Most employers provide some sort of retirement plan and if not, you can set up your own IRA or Roth IRA depending on your income level (see p.2 of “2021 Important Numbers for limits”). Life continues to get more expensive every year and so does your eventual retirement so you must plan for it. The old days of working for the same company for 30 years and getting a pension are generally over. Most companies have eliminated their pension plans putting the burden on the employee to fund their retirement.

At a minimum, it is important for employees to try to budget so they can take advantage of their company match which is akin to getting a 100% return on your savings up to the match. It is also extremely beneficial to contribute beyond the match to the extent of your ability.

Roth 401k plans have become available lately and withdrawals from those plans are not subject to income tax but there is no income tax deduction for the contribution. For employees in the 12% tax bracket, it is generally more beneficial to contribute to a Roth 401k while those in the 22%-37% may find more advantages in a tax-deductible 401k but that analysis is dependent on the age of the participant, projected income tax rates in retirement and other factors.

A frequently overlooked item is when high school or college students earn income at summer jobs and they are in very low tax brackets or not subject to tax at all. This is a great opportunity for them to open a Roth IRA and let the contributions grow tax deferred for several decades.

Self employed persons generally opt to open SEP IRAs where they can contribute a maximum of $58,000 in 2021. The contribution is limited to 25% of adjust net earnings of self-employment. For self employed persons 45 or older, they may be able to contribute much more to a defined benefit pension plan. A defined benefit pension plan is like the old pension plans companies used to have. They are designed to pay the participant a monthly benefit at retirement and the necessary contributions are based on the salary of the employee, age, rate of return assumptions and other factors. The current annual contribution limit for these plans is $230,000. The contributions must be actuarially calculated and there are many firms that specialize in doing so at very reasonable costs. The defined benefit plans can be set up as a cash balance plan so that the person can control the investments to suit their risk profile.

For self employed persons in their 50’s and 60’s, a cash balance defined benefit pension plan can be very fruitful in allowing participants to contribute significantly more than SEP IRAs. Many tax preparers are unfamiliar with defined benefit pension plans, so it is unfortunate that many self-employed persons do not take advantage of this tax planning opportunity.

Mutual Fund versus ETF investing

As you may have gains in your taxable mutual fund or ETF investments, you need to understand the potential tax differences between the two structures. Mutual funds are required by law to make regular capital gains distributions to their shareholders, and they are generally distributed from October through December 31st every year.

ETFs on the other hand, are not required to distribute capital gains every year due to the difference in their structure and formation. So, most ETFs throw off very little income or capital gain every year except those that distribute a yield. Therefore, when an investor has a 20% gain in a mutual fund, it generally is not as beneficial as a 20% gain in and ETF since the mutual fund investor will receive capital gain distributions where the ETF investor generally will receive far less. Unforeseen capital gain distributions at year end can push individuals into underpayment of estimated tax penalties as they have not accounted for such income. Generally, if you are comparing two investments that both have similar return expectations, it is more advantageous to utilize the ETF vehicle versus the mutual fund, all other things being equal. For more detailed information on these differences, this article is a good resource.

While there are many more topics than can be covered regarding tax planning, I tried to focus on the most common subjects that pertain to taxpayers. Contact your tax preparer or go online and start gathering your tax data and prepare a tax projection to uncover any possible savings opportunities.