In the wake of the COVID-19 pandemic, federal and state deficits have surged to unpredicted levels. Given this scenario, tax efficiency is going to more crucial than ever. Taxes for wealthy individuals are expected to increase in the upcoming years, especially for those living in states facing significant budget deficits.
The newly elected President Joe Biden campaigned to place higher taxes on the wealthy and eliminate many of the tax cuts passed by former President Donald Trump. As he sticks to his commitments and plans, many Americans are already concerned about minimizing their tax liability under the new administration.
Even if you keep presidency and fiscal policy out of the picture, tax obligations aren’t something you should leave for the last minute. Tax returns should be viewed as an ongoing, year-round process that demands careful planning and staying informed about the available opportunities for tax efficiency. Plus, it would help if you also learned how to capitalize on them.
In this guide, you’ll study some valuable tips to increase your tax efficiency in the 2021 tax season, but before that, let’s find out, ‘what is tax efficiency?’
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What is Tax Efficiency
Tax efficiency is the concept of structuring your investment in a way that minimizes your tax liability. Based on this definition, a financial process will be tax-efficient if it is taxed at a lower rate than a comparable financial process.
Now that you know ‘what is tax efficiency?’, go through these tips to increase your tax efficiency:
Tips to Increase Your Tax Efficiency
Find out Your Marginal and Effective Tax Rate
Before anything else, it’s imperative to know your marginal and effective tax rates. It’s the first step to accelerating income reporting from year to year and crucial to examining any unexpected costs of accelerating income. These can include higher Medicare premiums due to a change in income. Remember, high-income earners typically pay higher premiums for their plans.
Avoid Over-Withholding Your Income
If you were oblivious of this change last year, the IRS issued an updated version of the Form W-4 for 2020. The most significant update included changes that resulted from the Tax Cuts and Jobs Act. The form lets you know how much income you are withholding from your paycheck.
It’s important to understand that the more income you withhold, the less you’ll receive in each paycheck. But in the end, your tax bill may be lower. In contrast, if you opt to withhold less of your income, your paychecks will certainly be higher, but the ultimate tax bill can be greater.
We recommend not over-withholding your income to receive a refund because when the government holds on to it, you can’t put your money to use and seek the benefit of compounding growth. Yet, the proportion you choose to withhold will depend on any other income you have as well as your personal situation. An experienced tax consultant can help you review your withholding and update the W-4 to ensure that it aligns with your preferences.
Convert Your Traditional IRA to a Roth
One of the most useful tips to increase your tax efficiency is to convert all or part of your traditional individual retirement account (IRA) to a Roth IRA. This will make the low tax rates of today permanent. In the Roth, funds get free from income tax and have no required minimum distributions too.
If you do take this step, be sure to study the impact of the conversion on tax. A conversion may occur in a single year or over a series of years. When considering a Roth conversion, keep in mind that when taxes are due on April 15, you’ll need to possess funds to pay the taxes due to conversion.
This measure proves most beneficial when you aggressively invest in the Roth account to foster growth and don’t use it to pay taxes at all or at least for several years. You should pay taxes from resources other than the money converted.
However, one effect of Roth conversions is that as your non-spouse beneficiaries remove funds from the inherited IRA, they’re moved into a high-tax bracket. This can put a future tax burden on your children. To avoid this, it’s best to pay the tax on the conversion right away.
Revisit Your Donation Plans
If you’re a senior aged 70.5 or more and have IRA balances, qualified charitable distributions (QCDs) are an ideal approach to charitable giving. This type of charitable donation moves directly from your IRA to the charity. Although you won’t get a deduction because of this, you won’t be required to pay income tax on QCDs.
Thus, when it comes to making charitable gifts, QCDs prove the most tax-efficient. This is because they reduce taxable IRA balances and offset required minimum distributions (RMDs). For each IRA owner, QCDs have an annual limit of $100,000.
Moreover, it’s essential to maintain a record of your QCDs. Whether you use your personal or IRA funds, you must acquire and safely store a written acknowledgment for the concerned charity for each donation you make of $250 or higher. The document must state the value of your donation as well as a description.
For instance, if you donated cash, the written acknowledgment must include the amount of money you gave. Similarly, if you give publicly traded stock, the document must specify the fair market value, number of shares, and security name. For stocks and any other noncash donations, you must submit the Noncash Charitable Contributions Form 8283 with your return.
Plus, for all noncash property contributions other than publicly traded securities, you must submit a qualified appraisal when claiming a deduction of $5,000 or more.
The organization you donate to should also state whether they gave any products or services in return for the gift. If they did, you’d be required to provide an estimate and description of the value of those items or services in good faith. This receipt of what you received in return will be nondeductible.
If you make contributions via payroll deductions, you may want to leverage a pledge card issued by the charitable organization. This may also come with employer-furnished documents, such as a pay stub, that verify the amount you withheld and paid to the organization.
Understand the Requirements of State Taxes
To stay safe from the COVID-19 virus, many people have sought shelter in states other than their home state. If that sounds like you and you’re currently sheltering in a state that’s different from where you live and work and trying to manage a remote workplace’s fundamentals. You may be required to file your returns as a non-resident.
Also, keep in mind that residency rules vary from one state to another. In some states, you’re regarded as a resident if you spend more than a specified number of days, even if you don’t plan to stay in the state for a very long time. Therefore, you must understand the residency requirements of the state where you’re sheltering.
Besides, the virus, combined with the imminent tax increases, has forced high-income earners to consider moving from high-tax states. Some states in crisis may even boost taxes for wealthy people to fill the holes in the COVID-19 budget. Relocating from one state to another is particularly easy for those working from home.
Tax Loss Harvesting
Tax-loss harvesting is an incredible investing strategy to achieve tax efficiency or save substantially on your tax bill. While everyone wants their investments to rise in value, this doesn’t always happen. In many cases, they’ll suddenly decline. This can actually work to your benefit as per the concept of tax-loss harvesting.
Let’s take an example to clarify the concept. Suppose you purchased a mutual fund in a brokerage account. If this investment outside of your retirement account drops in value, sell it. The discrepancy between how much you paid for the mutual fund and your sale proceeds for it is reported as a capital loss on your tax return. This figure will proportionately offset against your other capital gains.
This capital loss that you’ve created against other capital gains would be carried over to the next year if you could not offset them this year. It can always be used for future capital gains.
However, it’s important to note here that as per the ‘wash-sale’ rules, you won’t be able to purchase the same investment for a month once you sell a mutual fund. To make sure that you’re still invested, you’ll need to purchase something similar. This way, you should be able to join any future market recovery.
Bunching Charitable Donations
Although bunching charitable donations isn’t a new strategy, given the high standard deduction amounts under the current tax law, the tactic is more valuable than ever. The standard deduction amount in 2020 for single taxpayers is $12,400, while that for married couples amounts to $24,800.
As a result of this, most taxpayers won’t be able to itemize, and many others won’t simply possess enough deductions to surpass those limits. This should become clear if you view it under the current tax law, which allows you to deduct no more than $10,000 for property taxes and state income.
As per the current tax law, you may never be able to achieve a tax benefit through charitable donations if you’re married, already paid off your mortgage, and donate $10,000 in charity every year. That’s because the standard deduction might be higher than your itemized deductions. In a situation like this, it’s a much better strategy to donate $30,000 in one year and then donate nothing for the next two years. This should allow you to fetch a tax deduction for some proportion of your charitable donations.
The only problem with this approach is that you may find charities knocking on your door forever when you donate a sizable amount. To avoid this, you can use a donor-advised fund to make your donations.
Maximize Contributions to Tax-Deferred Accounts
Tax-deferred accounts include your IRAs, health savings accounts (HSA), and 401(k). Maximizing your contributions to these accounts is a great strategy to increase your tax efficiency.
The 2021 combined annual contribution limit for traditional and Roth IRAs is unchanged from 2020 at $6,000. If your age is 50 or more, the limit is $7,000 for you. Your traditional IRA contributions might be tax-deductible, depending on your tax-filing status and income level.
Besides, you can also contribute up to $19,500 to 401 (k). If you’re 50 or older, you may wish to contribute up to $ 6,500 of additional funds.
Considering that you’re enrolled in a high-deductible health plan, you can contribute up to $3,600 (self-only) or $7,200 (family) to your health savings account in 2021. Not only are these contributions tax-deductible, but distributions from HSAs are also exempt from taxes, given that they’re used for qualifying medical expenses. Keeping in mind the ever-increasing health care costs, this can be a valuable solution for medical expenses after retirement.
Final Word
Tax returns are a mandatory obligation, but this doesn’t mean you can’t do anything to your benefit. By following the above-explained tips to increase your tax efficiency, you can greatly reduce your tax liability for the upcoming tax season.
If you’re filing your tax returns for the first time and believe the strategies discussed in this article are too complex for you, it’s best to rely on an experienced tax consultant such as Fully Accountable.
Fully Accountable has been offering consultancy and financial services to eCommerce, digital, and other companies for many years. It will help you fulfill your tax obligations and help you gain full control of your financials. Schedule a 30-minute strategy call, or request a quote today!
Chris Giorgio is the President of Fully Accountable. Fully Accountable is an outsourced accounting firm specializing in eCommerce and digital businesses. Chris has served as a CPA, CFO and has over 14 years of experience in the accounting and finance industry. Chris has dedicated his career towards helping entrepreneurs and high-level business owners achieve greater profitability through specialized outsource accounting functions.
