2020 Individual Year-End Tax Planning Tips Continued
Year-end planning for 2020 takes place against the backdrop of a global pandemic that has impacted so many individuals. The following is a brief overview and continuation of our previous blog post for some of the many individual year-end tax saving strategies.
Consider Contributing to 401(k) Plans that Accept Roth 401(k) Contributions
Earnings on funds in a Roth IRA grow tax-free (as opposed to merely tax deferred as in a traditional IRA or 401(k) plan). However, higher-income taxpayers are ineligible to make Roth IRA contributions. Currently, taxpayers covered by a 401(k) plan will be able to designate some or all of their 401(k) contributions as Roth 401(k) contributions. Thus, they will be able to take advantage of tax-free growth in their retirement account just like those who are able to contribute to Roth IRAs. The 2019 contribution limit for Roth 401(k) plans is $19,500 ($26,000 if age 50 or older), which is much higher than the $6,000 ($7,000 if age 50 or older) limit on Roth IRA contributions.
One Caution: Unlike “regular” 401(k) contributions, contributions that you designate as Roth 401(k) contributions are taxed to you the year they’re made. But the benefit of tax-free earnings and distributions on those contributions (provided they’re held in the plan for a certain amount of time) will often outweigh the tax-deferral on a regular 401(k) plan contribution. This is especially true if your tax rate is higher when you withdraw the money from your 401(k) plan than it was when the funds were contributed (which could be the case given the current federal deficit picture).
Convert Traditional IRA to Roth IRA
If your traditional IRA has dropped in value or you expect to pay higher federal income tax rates in future years, you might want to consider converting all or part of your traditional IRA balance into a Roth IRA. Here’s why: If you convert, it will trigger a current tax hit on the amount you convert. But with your traditional IRA balance at a depressed level (and possible your overall income too) the tax hit will be less. After the conversion, all the income and gains that accumulate in your Roth IRA, and all withdrawals after you reach age 59 ½ will be totally free of federal taxes, assuming you meet the tax-free withdrawal rules. In contrast, future withdrawals from a traditional IRA could be hit with tax rates that are higher than today’s rates.
Of course, conversion is not a no-brainer. You have to be satisfied that paying the upfront tax bill makes sense in your circumstances. In particular, converting a big account all at once could push you into higher tax brackets, which would not be good. You must also make assumptions about future tax rates, how long you will leave the account untouched, the rate of return earned on your Roth IRA investments, and so forth. If the Roth IRA conversion idea intrigues you, please contact us for a full analysis of the tax consequences.
Consider Year-End Donations
You can accelerate contributions planned for 2021 into 2020, but you must charge them or mail the checks by December 31st to ensure a write-off. Try to make your donations with appreciated stock that you’ve owned for over a year. This way, you can deduct the full face value and never pay capital gains tax on the appreciation.
Check Your Health Flexible Spending Account (FSA)
You must clean it out by December 31st if your employer hasn’t implemented the 2 ½ - month grace period or the $500 carryover rule. Otherwise, you will forfeit any money left in your account. Also, consider electing to contribute to health FSA for 2021. You can contribute up to $2,750 to your employer’s health FSA to cover out-of-pocket medical expenses. Amounts contributed to an FSA escape the federal income tax as well as payroll taxes.
Tax planning in 2020 is complex and made even more so with the pandemic. Avoid any surprises next April 15th and be proactive in your tax strategizing. Davis & Hodgdon Associates CPAs has been assisting individuals and businesses throughout Vermont and New England for more than 30 years so please reach out to us in Williston 802-308-4310) or Rutland (802.775.7132) to schedule a strategy session today! You can also email us at firstname.lastname@example.org.