Preparing for Potential Tax Changes in 2021
Preparing for Potential Tax Changes in 2021
By: Stacey Nickens
With 2021 on the horizon, many of us are wondering how tax law may change under a new administration. First off, I think it’s important to remember that we will likely have a divided government. A divided government is unlikely to pass sweeping changes to current legislation. However, some more moderate changes could occur, such as an increase to capital gains taxes. Additionally, taxes tend to increase over time as it is. Knowing this, how can you prepare for a potential tax increase or tax law change in 2021?
You could first consider taking advantage of current capital gains tax rates. Review your investment portfolio. Have any of your positions appreciated significantly since you purchased those securities? If so, selling those securities would trigger a short-term or long-term capital gain, on which you would owe taxes. If you believe capital gains taxes are going to increase, you could sell those securities in 2020 and pay the current capital gains tax rate for those securities. Moving forward, you would then not have to pay a potentially higher capital gains tax rate on those securities.
Before considering this strategy, you need to make sure you’re capable of paying your capital gains tax bill for 2020. Your short-term capital gains are for investments you held for less than one year, while your long-term capital gains are for investments you’ve held for longer than one year. Net your short-term and long-term capital gains or losses to see where you stand for this year. Short-term gains are taxed at your income rate. Long-term capital gains are taxed at a 0%, 15%, or 20% rate, depending on your income bracket. You can click here to learn more about managing capital gains taxes.
If you choose not to trigger capital gains for the 2020 tax year, you could still use other strategies in the future. Pretend the government raises capital gains taxes in 2021. Additionally, you have appreciated securities that would trigger the higher capital gains tax. You could consider tax-loss harvesting, whereby you sell securities for a loss in order to offset gains. You could also consider donating appreciated securities to a charity.
Another strategy would involve taking a faux RMD (required minimum distribution) in 2020. RMDs are not required in 2020, but you can still withdraw the amount of your RMD from your IRA. Doing so would mean you pay the current tax rate on the RMD. This could be a preventative measure if taxes were to increase in the future. Additionally, you would reduce the size of your IRA, and thus reduce the size of your future RMDs. Were tax rates to increase in the future, you would be paying that higher tax rate on a smaller RMD.
Along those lines, you could consider a Qualified Charitable Distribution (QCD) from one of your tax-deferred accounts. Investors above the age of 70.5 can direct up to $100,000 of their IRA distributions to a qualified charity. In other years, these charitable distributions would satisfy your RMD requirements. While you may not have to take an RMD this year, giving a QCD still allows you to donate pre-tax assets. Additionally, you’re reducing the size of your IRA and thus reducing the size of your future RMDs. Moreover, unlike the above strategy, you wouldn’t have to pay taxes on your QCD.
Finally, you could also look into a Roth IRA conversion. You would convert all or part of your IRA balance into a Roth IRA. You would then pay taxes on that amount under 2020’s tax laws. If you can face the higher tax bill for 2020, this strategy may be appropriate for you. After a conversion, your money could then grow tax-free, and changing tax laws wouldn’t impact this retirement account.
