Around April 15th, I often get the comment that “you must be busy right now with taxes.” If I am truthful, I must answer no. Because there is very little tax planning you can do after the fact. Ideally, you want to do tax planning throughout the year. For most things, the absolute latest you can—not should—wait is December. Over the past 15 years, here are the year-end tax planning moves that I keep me “busy” in December.
Retirement Plan Distributions
When it comes to year-end tax planning for retirees, one of the most common is take a retirement plan distribution. A required minimum distribution is the amount of money that you must be withdrawn each year from a traditional IRA, SEP, Simple IRA, or solo 401(k). These withdrawals begin the year you reach 70 ½. Essentially the IRS tells taxpayers that they have been deferring taxes for too long and must now begin to realize some of the liability.
The Basics of RMDs
How exactly are RMDs determined? The IRS takes the value of your account at the end of the previous year and divides it by an RMD factor. (Click here to see the Lifetime Table Used to Determine RMD).
You must take your RMDs on time. Failure to do so will result in a 50% penalty! And that is in addition to whatever income taxes you owe on the distribution. Most custodians will recommend that you have submitted distribution requests no later than December 20th to meet the December 31st deadline.
Giving Away Uncle Sam’s Money
With most individuals no longer able to itemize deductions, there is one RMD tax planning tool that has increased in popularity. Qualified Charitable Distributions (QCDs) count against the amount you must withdraw for your required minimum distribution. When you make a contribution from your IRA to a qualified charity, you will report it as a non-taxable distribution on your tax return. It won’t increase your tax rate or liability.
Quick QCD Tips
Here are a few quick tips on making Qualified Charitable Contributions. First, QCDs must go to specific qualified charities. These include 501(c)(3) and other tax-exempt organizations. Note that you cannot make QCDs to donor-advised funds or private foundations. It is always best practice to check with the charity before making a gift. Second, your RMD is not the maximum amount that you can do as a QCD. The annual limit for QCDs is $100,000 per year ($200,000 per married couples).
Warning on Checks
One final note on QCDs. QCDs are similar to RMDs in that both distributions must leave the account by December 31st of the current tax year to offset the current year’s RMD requirement. This is different than tax-deductible charitable contributions made by personal checks, which are required to be postmarked by December 31st to be deductible.
Within the last couple of years, many custodians have begun providing checkbooks linked to IRA accounts. These checks can be beneficial, especially if you find yourself making multiple small donations to qualified charities. In such cases, your custodian will not require you to fill out IRA distribution paperwork for each $25 or $50 gift. It is important to remember that your custodian must process these checks by December 31st. Make sure not to write checks in mid-December. The end of the year is a busy time. There is always the chance that there could be a delay in the charity depositing your check. And if you were relying on the check to help you meet your RMD for the year, you could find yourself in a situation where you are now subject to the dreaded 50% penalty!
If you are an individual business owner, you undoubtedly wear a lot of different hats and you have a lot of different deadlines. So what year-end tax planning moves should self-employed individuals look to make? If you don’t have any full-time employees, you may want to look into is setting up a solo 401(k).
More than One Hat to Wear?
Solo 401(k)s can be a great option because they let you wear two different hats when it comes to saving for your retirement. You can make contributions both as an employee and as an employer. In 2019, the maximum amount that you can save as an employee is $19,000. As an employer, you can add up to another $37,000. That is a total of $56,000 of retirement savings and does not include a $6,000 catch-up for those age 50 and older! (See all the 2019 Retirement Plan Limits).
What You Need to Know
The Employee Retirement Income Security Act of 1974 (ERISA) is the law that established the 401(k) and provides the framework for administration. The U.S. Department of Labor is one of the agencies responsible for the interpretation and enforcement of ERISA. For most Qualified Retirement Plans–401(k)s–employee contributions are made through payroll deductions. That means the deadline for employee contributions is December 31st. Solo 401(k)s are a little different because they are non-ERISA plans and do not fall under the Department of Labor’s rules (see footnote 4 Table 1. Key Retirement Plan Rules for 2018 in Publication 560). This can cause a bit of confusion when it comes to Solo 401(k)s. For year-end tax planning purposes, you must establish a solo 401(k) plan by the December 31st deadline. But your deadline for making employee deferrals is actually the due date of the employer’s return, including extensions.
Ever wonder What Issues You Should Consider Before the End of the Year? This checklist will give you eight different areas to take a look at.
Don’t Forget About QBI
Remember, just because you can make a tax-deferred contribution to a solo 401(k) doesn’t mean you should. The Tax Cuts and Jobs Act of 2017 (TCJA) introduced the Qualified Business Income Deduction. Depending on your tax situation, it may make sense to contribute a Roth solo 401(k) or even make an after-tax contribution. To set up these accounts, you will need plan documents. Fortunately, many custodians provide these basic plan documents for a pre-tax solo 401(k) at no charge. Even so, the paperwork can still be a little daunting.
Additionally, when your account balance reaches $250,000, you will be required to make annual filings with the IRS for your solo 401(k) plan. For all the reasons listed above, many individuals will find that it makes sense to use a third-party administrator to take care of all the paperwork and reporting requirements. Third-party administrators can also help draft plan documents that allow for Roth solo 401(k)s or solo 401(k)s that can handle after-tax contributions. These options are not typically available in a custodian’s basic plan documents.
Federal Tax Withholding
Even two years after the fact, a lot of us are still trying to figure out how much we need to withhold from each paycheck. A lot of people may not realize it, but the IRS wants to see tax liability paid equally throughout the year. This can be done through withholding or by making estimated payments. Failure to do so can result in a penalty for the underpayment of estimated taxes.
It can get a little confusing when trying to predict when and what income you have coming in during the year, so the IRS created a safe harbor(s). Most people can avoid penalties if they owe less than $1,000 after subtracting their payments and credits.
Unsure as to whether you will owe less than $1,000? Figuring out the safe harbor gets a little more complicated. If your adjusted gross income is more than $150,000 ($75,000 for those filing single), make sure that you pay in the lesser of 110% of your 2018 tax liability or 90% of your 2019 tax liability. If your adjusted gross income is less than $150,000 ($75,000 for those filing single), make sure that you pay in the lesser of 100% of your 2018 tax liability or 90% of your 2019 tax liability.
If you discover that you have not paid enough throughout the year, one year-end tax planning move would be to adjust the amount of federal withholding from a paycheck or retirement plan distribution. The IRS will treat the amount withheld as if it were made equally throughout the year.
Roth IRA Conversions
In the discussion of the most recent tax law changes, let us not fail to mention that certain parts will sunset December 31st, 2025, to meet budgetary constraints. There are two major provisions that will expire: the new income tax rates and increased standard deductions. The possibility that we will see tax rates increase at that time or even before then is probable.
A Roth IRA conversion is one way to possibly mitigate the risk of future tax increases. It allows you to realize income at the current income tax rates. In a Roth IRA conversion, you take a portion or all of an IRA account and recognize it as ordinary income. You pay tax on previously untaxed contributions and earnings. The amount realized as ordinary income is then eligible to be put into a Roth IRA where it can grow tax-free. All future distributions will also be tax-free, and the Roth will not be subject to RMDs.
Use It or Lose It
After retirement, many individuals wait to begin taking Social Security or distributions from their retirement accounts. The result is that there is very little taxable income and lower tax brackets go used and thus wasted. In such situations, it may make sense to fill up those 12%, 22%, or even 24% marginal tax brackets. Remember the goal is not to pay the lowest tax just one year. It is to pay the smallest amount of tax over your lifetime.
Before the Tax Cuts and Jobs Act of 2017 (TCJA), it was much easier to make Roth IRA conversions. Tax payers were allowed a re-do. If you did a conversion earlier in the year and later discovered you did too much or if the account went down in value, you could undo the conversion by doing a Roth recharacterization.
After the TCJA, that option is no longer available. You can no longer recharacterize a Roth IRA conversions back to an IRA. For most individuals, it now makes sense to wait until the end of the year to do a Roth conversion. It can be hard to predict how much income you will recognize at the start of the year. A Roth IRA Conversion is one year-end tax planning move that I recommend clients not do until November or December. By waiting until the end of the year, you should have more clarity as to what your total tax picture will be.
Are You SECURE?
There is one last thing to take into consideration when you do year-end tax planning. Earlier in the year, we discussed the SECURE Act. This bipartisan supported legislation is currently stuck in Congress but will have a long-ranging impact on retirement account if approved.
Stretch IRAs Put on Notice
Currently, any non-spouse beneficiary of an IRA account is required to take an RMD. The non-spouse beneficiary’s life expectancy will determine their RMD. The industry jargon used to describe this is a “stretch IRA” because distributions are stretched over the beneficiary’s life. However, there are no free lunches. To pay for the SECURE Act, Congress is proposing the elimination of the stretch IRA and replacing it with a maximum 10-year payout period.
This could prove to be a significant tax headache for your beneficiaries. Imagine a situation where you leave a substantial IRA to a beneficiary who is still working. Your beneficiary must add the inherited IRA distributions to their earned income. And don’t forget the real possibility that tax rates will increase starting in 2026. Your beneficiary could end up paying more in taxes on the distribution than you could realize today by doing a Roth conversion. Roth IRAs would still be subject to the 10-year payout period but recall that all distributions from Roth IRAs are tax-free to the beneficiary.
Keep in mind that like RMDs, most custodians recommend that you submit requests for Roth IRA conversions by December 20th. After that time, most custodian process requests on a best effort basis.
Tax planning is not something that you do in April of each year. Although this article specifically deals with a few year-end tax planning moves, it is actually a yearlong process. It should be done in coordination of your financial plan. And you should look to pay the lowest amount of tax over your lifetime, not just one year. Doing so can help you free up resources to use on the things that truly matter most.
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Hedgefield Wealth Management is a registered investment adviser. Hedgefield Wealth Management does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.