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Taking steps to defer your federal income bill is usually a good idea, especially if you expect to be in the same or lower tax bracket in future years. If that assumption pans out, making moves that lower your current-year income will, at a minimum, put off the tax day of reckoning and leave you with more cash until the bill comes due. If your tax rate turns out to be lower in future years, deferring income into those years will cause the deferred amount(s) to be taxed lower rates. Great.
The Taxmageddon threat
The question is: can you realistically expect the same or lower tax rates in future years? Maybe not. The lower individual federal income tax rates ushered in by the Tax Cuts and Jobs Act (TCJA) (seven rates topping out at 37%) are already scheduled to expire at the end of 2025. Depending on the 2020 election outcome, they could be terminated much sooner. If that happens, the probable best-case scenario (for those who don’t enjoy paying taxes) would be a return to the pre-TCJA deal (seven rates topping out at 39.6%), starting in 2021.
The worst-case scenario (for those who don’t enjoy paying taxes) would include higher rates on ordinary income. And higher rates on dividends and long-term capital gains too, which are currently taxed at 0%, 15%, 18.8%, 20%, and 23.8%. (The 18.8% and 23.8% rates include the add-on 3.8% net investment income tax (NIIT) that can hit many higher-income folks.)
Other worst-case possibilities include eliminating more write-offs for individual taxpayers (the TCJA already eliminated some), and subjecting all wages and self-employment income to the dreaded Social Security tax (6.2% withheld from employee paychecks 12.4% owed on self-employment income). Under current law, the Social Security tax cuts out once 2020 wage or self-employment income exceeds $137,700.
The ultra-worst-case scenario is that most or all of these changes, and more, are imposed retroactively — starting with the 2020 tax year that will commence in just a few days. Yikes.
In the interest of brevity, let’s call the possibility of a bunch of near-term federal tax hikes Taxmageddon.
What to do if you believe the threat is real?
Good question. Answer: assess whether making moves that would defer taxable income into 2020 and/or 2021 still seem advisable given the current political environment. Specifically, if you believe the 2020 election will result in higher tax rates in future years (possibly as early as next year), the conclusion is that deferring taxable income would result in higher tax bills over the long haul. You would be better off just sitting tight for the rest of this year and for 2020. That would increase your tax bills for those two years but decrease your tax bills for later years by a greater amount. So, you come out ahead by playing the long game.
Remember: The notion that higher tax rates could be coming sooner rather than later is conjecture. Make your best guess(es) and act accordingly.
Tax deferral that you might want to forego
1. Selling appreciated real estate for installment payments
Installment sales postpone the recognition of taxable gains until installment payments are actually received. Postponed gains will probably be taxed at the rates for the years they are recognized. If rates go up, installment sellers will be penalized.
2. Maxing out on deductible IRA and retirement plan contributions
Tax savings from current-year deductions for these contributions are calculated using today’s rates. The taxable portion of IRA and retirement plan distributions received in future years will be taxed at the rates in effect for those years. If those rates are higher, that’s a tax detriment.
3. Prepaying deductible expenses
Tax savings from current-year deductions from prepaying expenses are calculated using today’s rates. If you don’t prepay and tax rates go up, you come out ahead by claiming deductions in a later higher-rate year.
Tax-smart moves that don’t involve tax deferral
Thankfully, you can make tax-smart moves that do not involve tax deferral with potentially negative Taxmageddon implications. Here are three ideas.
1. Contribute to Roth IRA
Because qualified withdrawals from Roth IRAs are federal-income-tax-free, Roth accounts offer the opportunity for outright tax avoidance, as opposed to tax deferral. So, making annual contributions to a Roth IRA (if your income permits) is an attractive option for those who expect to pay higher tax rates during retirement. Similarly, converting a traditional IRA into a Roth account effectively allows you to prepay the federal income tax bill on your current IRA account balance at today’s low rates instead of paying possibly higher future rates on the current balance and future account earnings. For more on Roth conversions as insurance against the Taxmageddon threat, see this earlier column.
Key point: If you qualify to make an annual Roth contribution for your 2019 tax year (potentially up to $6,000 or $7,000 if you are age 50 or older as of 12/31/19), you have until 4/15/20 to make the contribution. For 2020, the contribution maximums are the same, and you have until 4/15/21 to make them.
Contribute to Roth 401(k)
The Roth 401(k) is basically a traditional 401(k) plan with a Roth account feature added. If your employer offers a 401(k) plan with the Roth option, you can contribute after-tax dollars (an elective deferral known as a designated Roth contribution) to a designated Roth account (DRA) set up under the plan. The DRA is a separate account from which you can eventually take federal-income-tax-free qualified withdrawals. So, making DRA contributions is another attractive alternative for those who expect to pay higher tax rates during retirement. Note that unlike annual Roth IRA contributions, your right to make annual DRA contributions is not phased out at higher income levels.
Key point: If your employer offers the Roth 401(k) option, it’s too late to take advantage for the 2019 tax year, but 2020 is fair game. For 2020, the maximum allowable DRA contribution is $19,500.
Contribute to Health Savings Account (HSA)
Because withdrawals from HSAs are federal-income-tax-free when used to cover qualified medical expenses, HSAs offer the opportunity for outright tax avoidance, as opposed to tax deferral. You must have qualifying high-deductible health insurance coverage and no other general health coverage to be eligible for HSA contributions.
For the 2019 tax year, you can make a deductible HSA contribution of up to $3,500 if you have qualifying self-only coverage for the year or up to $7,000 if you have qualifying family coverage. For those who are age 55 or older as of 12/31/19, the maximum contribution is $1,000 higher ($2,000 if both you and your spouse are 55 or older).
Key point: If you have qualifying high-deductible health coverage for 2019, you have until 4/15/20 to make a deductible contribution for the 2019 tax year.
For 2020, the contribution maximums are $3,550 and $7,100, respectively. If you will be age 55 or older as of 12/31/20, the maximum contribution is $1,000 higher.
You can claim deductions for HSA contributions even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. Even billionaires can make deductible contributions if they have qualifying high-deductible health coverage.
The bottom line
Work with your tax pro to find the proper balance between tax deferral moves (if any) and the alternative of recognizing income without any contortions. Take into account the distinct possibility of higher federal income tax rates in future years. In a soon-to-follow column, I’ll cover how small business owners can counter the Taxmageddon threat. So please stay tuned.
