As we start a new year, we wanted to share a few reminders of ways that individuals may lower their taxable income before filing their 2020 taxes and in the future. All else being equal, it is our view that tax rates are likely to increase in the coming years. One key factor driving this view: tax cuts passed at the end of 2017 are set to expire at the end of 2025. In addition, there may be more political will to raise taxes to fund infrastructure projects and address historically high levels of federal debt in the coming years.
Below, we highlight a few specific tools that individuals can consider using to optimize their tax exposure. Note that these are just a select few of the many tools that may be available depending on your unique situation – please contact your wealth advisor to discuss all of the ways to optimize your tax exposure this year.
Individuals who earned income in 2020 and aren’t covered by a retirement plan at work can make a tax-deductible traditional IRA contribution for themselves and for their non-covered spouse any time before April 15, 2021. These contributions reduce your 2020 taxable income. Individuals also can make non-deductible contributions to a Roth IRA any time before the April 15 filing deadline. Note that your filing status and modified adjusted gross income affect the amount of your available deduction for contributions to a traditional IRA as well as your ability to contribute to a Roth IRA. The maximum contribution across all IRAs (traditional and Roth, combined) for 2020 is $6,000, and individuals aged 50 and over can contribute an additional $1,000. For SIMPLE retirement accounts, the contribution limit for 2020 is $13,500.
Converting some or all of a traditional IRA to a Roth IRA can make sense for many investors, given that tax rates may increase in the coming years. In a Roth conversion, you withdraw money from a traditional IRA, pay the taxes due on that amount now, and invest the money in a Roth IRA that grows tax-free for the rest of your life. Distributions from a Roth IRA, which can begin at age 59 ½, are not taxed as long as a five-year holding period is met.
One of the major benefits of a Roth IRA is that, unlike with a traditional IRA, there are no required minimum distributions — if you don’t need the money, you can simply keep it in the Roth IRA indefinitely. Furthermore, your spouse can inherit your Roth IRA under the same terms (no required annual distributions). While non-spouse beneficiaries don’t have as much flexibility with the timing of withdrawals as spouse beneficiaries, non-spouse beneficiaries still pay no taxes on those distributions.
By reducing the amount remaining in the traditional IRA, Roth conversions reduce future required distributions that will be taxed at prevailing ordinary income rates. So, if you have cash available to pay the tax bill this year, a Roth conversion can be a way to lower future tax bills for yourself and your beneficiaries.
For people who like to make annual gifts, the maximum tax-free gift remains at $15,000 per recipient per donor in 2021. For example, if you and your spouse have two children, together you can gift each child $30,000 tax free in 2021. If you are funding 529 plans, contributions may be deductible from your state income taxes, depending upon where you live.
Spousal Lifetime Access Trust (SLAT)
The threshold for federal gift and estate taxes is currently quite high by historical standards — $11.58 million per individual, and $23.16 million per couple — and is scheduled to revert to approximately $5 million per person at the end of 2025. This creates an opportunity for high-net-worth investors to gift assets to beneficiaries now and reduce their taxable estate by using a Spousal Lifetime Access Trust (SLAT). At a high level, a SLAT is a gift from the donor spouse to an irrevocable trust for the benefit of the beneficiary spouse, and it allows the donor spouse to transfer up to the donor spouse’s available exemption amount without a gift tax.
Consider a wealthy couple with $40 million in assets. The current estate tax exemption would shield roughly 60% of their estate, but that percentage would drop to approximately 25% unless Congress acts between now and 2025. Creating a SLAT would allow this couple to reduce their taxable estate now, before that estate tax exemption potentially drops.
Grantor Retained Annuity Trusts (GRATs)
For wealthy individuals and families seeking to limit gift or estate tax obligations, GRATs can be used to essentially freeze the value of certain assets while transferring any potential appreciation to beneficiaries tax free. Donors also retain the right to an annuity stream from the trust for the entire term of the trust. Now is an opportune time for wealthy individuals to consider using GRATs because of a few factors, including the fact that the current estate tax exemption is set to revert to approximately $5 million per person at the end of 2025, as described above. In addition, GRATs are particularly attractive when the IRS’s Section 7520 interest rates are low, as they are today.
As long as the assets contributed to a GRAT outperform the applicable Sec. 7520 rate in effect for the month when the transfer took place, any gains in excess of the Sec. 7520 rate passes to the beneficiaries without gift tax consequences. As of December 2020, the Sec. 7520 rate was 0.6%, down from 2.0% in December 2019 and 3.6% in December 2018. So, as long as assets contributed in December 2020 gain more than 0.6% per year, any excess appreciation passes to the beneficiaries tax free. For more information on GRATs, see the Journal of Accountancy’s recent article, “Great Time for a GRAT.”
These are just a few of the many tools that may be available depending on your unique situation. For more information on these tools as well as other ways to optimize your tax exposure, please contact your wealth advisor.