With the new season comes the opportunity to review your current method of tax planning and consider an update. Ever since the Tax Cuts and Jobs Act was put into effect in 2017 (TCJA), tax rates have remained relatively low. However, most TCJA provisions are set to expire in 2025. In addition, recent federal budget deficits have risen to unprecedented levels, and there is uncertainty around tax policy as a new administration takes office, and these factors set the stage for a need for increased revenue, which could translate into higher taxes. Experts recommend that investors should consider certain strategies in order to attempt to hinder the risk of higher taxes, as the current tax environment and potential for higher tax rates in the future create an opportunity for tax-smart planning.

1. Consider Roth IRA conversions

A strategy utilizing Roth conversions can be an effective way to hedge against the threat of higher taxes in the future. Lower tax rates now translate to a lower cost for converting traditional IRA assets to a Roth IRA. It is impossible to predict tax rates in the future, given uncertainty in Congress, or to have a good idea of what your personal tax circumstances will look like years from now. Like all income from retirement accounts, Roth income is not subject to the 3.8% surtax and is also not included in the calculation for the $200,000 income threshold ($250,000 for couples) to determine if the surtax applies. IRA owners considering a conversion to a Roth IRA should carefully evaluate that transaction since the option to recharacterize, or undo, a Roth IRA conversion is no longer available.

2. Explore alternative ways to fund Roth accounts

Taxpayers at higher income levels are prohibited from contributing directly to Roth IRAs. For 2021, income phaseouts begin at $125,000 ($198,000 for married couples filing a joint return). Taxpayers may want to consider funding a non-deductible (after-tax) IRA and then subsequently converting the account to a Roth IRA. There are no income restrictions on Roth IRA conversions. However, adverse tax consequences, referred to as the “pro rata” rule, may apply if the individual owns other pretax IRAs (including SEP-IRA or SIMPLE-IRA). Before considering this strategy, taxpayers should consult with their tax professional. Also, participants in 401(k) plans may be able to make voluntary after-tax contributions into their plan in excess of their salary deferral limit ($19,500 or $26,000 if age 50 or older). When allowed by the plan, after-tax contributions may be directly transferred to a Roth IRA without any income tax consequences upon a plan triggering event.* This may be a strategy for higher-income taxpayers to diversify their tax liability in retirement.

3. Maximize deductions in years when itemizing

With the increase in the standard deduction under recent tax law changes, and the scaling back of many popular deductions, fewer taxpayers are choosing to itemize deductions. Some taxpayers may benefit by alternating between claiming the standard deduction in some years and itemizing deductions in other years. Investors may want to “lump” as many deductions into those years when itemizing. For example, taxpayers may want to consider making a substantial charitable contribution during a tax year when itemizing instead of making regular annual gifts. In addition, with the repeal of the “Pease rule,” there are no phaseouts on itemized deductions at higher income levels.

4. Be mindful of irrevocable trusts and taxes

There is a low income threshold ($13,050 for 2021), that will subject income retained within an irrevocable trust to the highest marginal tax rates and the 3.8% Medicare surtax. For this reason, trustees may want to reconsider investment choices inside of the trust (municipal bonds, life insurance, etc.). Trustees might also consider (if possible) distributing more income out of the trust to beneficiaries who may be in lower income tax brackets.

5. Expand use of 529 accounts for education savings

The use of 529 college savings plans provide several tax advantages. Account earnings are free of federal income tax, and a special gift-tax exclusion allows account owners to treat up to $75,000 of contributions as though they had been made over a five-year period. Qualified education expenses were expanded in recent years to include laptops, computers, and related technology. Recent changes allow families to use up to $10,000 annually for K–12 tuition. Make sure to consult with a tax professional if considering a distribution for K–12 expenses since there may be adverse state income tax consequences.

6. Consider the charitable rollover option for retirees

Retired IRA owners (age 70½ and older) may benefit from directing charitable gifts tax free from their IRA. Since even more retirees will claim the higher standard deduction, they will not benefit tax-wise from making those charitable gifts unless they itemize deductions. Account owners are limited to donating $100,000 annually, which can include the required minimum distribution (RMD), and the proceeds must be sent directly to a qualified charity.

7. Seek advice

With any tax strategy, it is important to consult with a financial professional or tax expert with knowledge of your personal financial situation. Making changes to tax strategies may have an impact on your overall tax plan. Read Putnam’s “10 income and estate planning strategies” for more information about tax-smart strategies for 2021.

*IRS Notice 2014-54


Important Disclosures: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. All investing involves risks including possible loss of principal.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion.

Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing. Securities offered through LPL Financial, Member of FINRA/SIPC. InVestment advice offered through Independent Advisor Alliance, a registered investment advisor. Independent Advisor Alliance and InVestra Financial Services are separate entities from LPL Financial.

This material was prepared for the use of InVestra Financial Services

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