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Intro:

Jeremiah Barlow: Welcome, everybody. My name is Jeremiah Barlow, and I am the head of our Family Wealth Services group here at Mercer Advisors. I am joined here with Jamie Block. She is a CPA from our Rochester branch. She’s also the branch manager and client advisor there. We’re really excited to be here with you to talk about 2020 year-end tax planning strategies. This is an interesting year, given that we’re in an election year, a lot of moving pieces on taxes, and Jamie and myself will help you navigate some of the high-level items that we should be thinking about as we approach the end of the year. As always, lots of disclosures in our industry, so this is just letting you know that anything and everything we talked about here today is not specific advice to you. Please reach out to your specific professionals to help guide you through some of the things we’re going to talk about today, and obviously reach out to your advisor, and we can help with that as well.

Tax is an interesting dynamic. It actually weaves itself through almost every piece of your financial life. Here at Mercer Advisors, we have an integrated tax team, integrated set of tax experts where we make tax planning a part of everything we talk about. Overall, I could say that weaves through your net worth, your annual budget, even estate planning. And as we talk about today, you’ll see how that comes to life beyond just the day to day that we’re used to. So, when it comes to things we’re going to talk about today, lots of items to discuss, and we’ve broken up the moving pieces into five components that we find most pressing and that you should be thinking about here. We’ll first open up with tax bracket management, then dive into some itemized deductions and timings in which you might want to realize those. Then we’ll talk about gains and harvesting, our gain harvesting, as well as loss harvesting, and then wrap up with some estate and gift tax moving pieces, when it comes to the proactive gifting to loved ones. All items that are front and center right now as we approach the end of the year just like normal, but the interesting dynamics as you added in this whole election and all the moving pieces that might be coming. So, to help talk about that, I’m going to hand it over to Jamie, and she’s going to walk us through some of the election year considerations that we should all be thinking about as we approach the end of the year and 2021.

Jamie Block: Thanks, Jeremiah. So, as you’ve stated, we have a little bit of complexity with an election year coming up or in this election year, but what we want to do is plan for the what-ifs. We don’t necessarily know what will happen and who will be elected, but we make sure that we plan accordingly. So, in this coming thought process, we have to worry about potential tax increases such as the top bracket, as well as capital gains that may increase for individuals who have over a million dollars of ordinary income. Now, in addition to income taxes, we have to worry about transfer taxes, such as the sunset of current exemptions, and elimination of the step-up of basis when someone passes, and potentially taxation of gains when someone passes or during a gift. So, let’s dive in a little bit more deeply into the Democratic Party’s tax policies that are proposed. Obviously, let me throw out that this is a caveat. This is a proposal and not necessarily going to be a law if, in fact, the Democratic party wins, so just keep that in the back of your mind that these are all just proposals.

 

Social Security

The first thing to talk about is Social Security. Right now, how Social Security works is when you have a job and you work, you pay 6.2% on the first $137,700 of earnings. And then once you hit that rate or that amount of wages, then you don’t pay any more Social Security for the rest of the year, and then next year, it starts all over again. The first proposal is once you still hit that limit of $137,700 for this year, you would still have a break of 6.2%. And then when you hit $400,000, that 6.2% would then kick in again and be on all your wages that you make. So, that’s the first proposal. Another one that would affect high-earning individuals is increase of the top tax bracket from the now 37% to 39.6% bracket. This was part of the Tax Cuts and Jobs Act that lowered that bracket. Again, if you listen to debate, I apologize but that was something that you probably heard some about. It’s just that if you repeal the Tax Cuts and Jobs Act, there’s a lot of tax legislation that was in there. It was a huge overhaul, and so we had a much increased standard deduction and got away with the personal exemptions. So, if that is repealed, we’d have a lower standard deduction, some of your itemized deductions might not be limited, and the personal exemptions would be back.

 

Capital gains rate increase

Another proposal that is in the works is this capital gains rate increase. Right now, we have really favorable capital gains rates where the maximum rate is 20%. What the proposal is doing is increasing the rate to what ordinary tax rates are, if you have over a million dollars of income. So, it’s effectively increasing it from 20% to 39.6% for capital gains. Another couple items that were talked about are basically wealth taxes, maybe an annual wealth tax, reducing the estate and gift tax exemptions and amounts that can be passed on to others, and then eliminating the step-up in basis. I’m not going to go into much detail because Jeremiah will touch on that a little bit more later. So, another thing to talk about, again, with the repealing of the Tax Cuts and Jobs Act that would then restore the Pease limits, which is the income limitation on itemized deductions. And the other component of that was to limit your itemized deductions to the 28% bracket. So, again, we’ll have to wait and see.

Corporate income taxes, they were going to talk about raising the rates from 21% to 28%, which is still lower than what it was before the Tax Cuts and Jobs Act but would be an increase from today’s rate. There’ll be a phase out of the Section 199A deduction. That’s a 20% on your net business income that you get now, and what they would do is add $400,000 of income. Anybody who makes more than that would not get the deduction. That would include your REIT dividends that have no income limitation now, so that would not necessarily be a good thing for folks that make over $400,000. And then, lastly, the retirement plan. Right now, if you contribute to a 401(k) or 403(b), any tax deferred vehicle, you get a dollar for dollar reduction of your income at whatever your tax rate is. So, if you’re in a 39.6% bracket, and you contribute to one of those plans, you’re saving at that 39.6% bracket. And so, what they want to do is instead of having that deduction, they’re going to give you a credit. So, if you contribute $10,000 into your plan, you’ll get a 28% deduction instead of that dollar for dollar. And again, that would be a real hindrance if you’re in one of those higher brackets, and may cause you to potentially do more Roth contributions instead of the tax deferred.

So, as you can see here, this is the current rate structure that we have, and you can see that the top bracket is the 37%. That would increase to 39.6%. You can also see that the capital gains there are 20%, and that would go to that 39.6% bracket as well. So, you can see that they don’t necessarily have a lot of changes for the lower brackets as of yet proposed, as you can see here in this graphic. So, on the top, you’ll see that’s married filing joint tax status, and then down on the bottom, that’s for individuals. So, the top of the bar is current, where the bottom is the proposed Biden tax plan. And you can see when you hit that $400,000, you’re essentially going from 32% way up to the 39.6% and no 35% bracket, okay? So, again, all proposed, nothing in stone. Now, one thing is not clear is if the $400,000 is going to apply to individuals as well at that rate, or if that’s going to be something different, or even if the married filing joint is going to be higher. But you can see what impact that will have on taxes for higher individuals.

 

#1 Year-End Tax Tip: Tax Bracket Management

So, with that, let’s move on to a strategy for tax bracket management. So, this is the first of the five strategies that we’re going to talk about. To go into little detail, what do I mean by tax bracket management? As you saw on the previous diagram, we have all the different tiers because we’re a progressive tax system. So, what you want to make sure you do is fill up those lower brackets in low-tax years, like this year we’ve earned a very low tax environment comparatively. So, what things do you need to consider? For individuals, you may want to consider, if Biden wins the election, you have to worry about potentially AMT coming back. What does that mean? That means that you may end up paying more tax, because the exemptions are lower, potentially. Also, the rate is going to be increased from 37 to 39.6, so you may want to increase your income this year and bring any gain in as possible to use those lower brackets up. You can do that by doing some Roth conversions. That’s something you should do, whether it’s an election year or not. Another option is looking at net unrealized appreciation recognition. You may want to do that, and maybe exercising some stock options that you have for your employer. That again, great time to do it, while capital gains are lower, and tax brackets are lower.

Now, if you’re a business owner, and you can pay yourself bonuses, you may decide, “Now’s a good year to pay myself a bonus,” to again, increase that income into this year at lower rates. Or accelerate revenue recognition, make sure you collect on your accounts receivable, or defer any of your business expenses that you can until next year to get better tax rate savings. And this is obviously not a comprehensive list, but it’s a good start of things to start looking at.

 

#2 Year-End Tax Tip: Itemized deduction timing

If we move on to the next strategy, we’ll talk about itemized deduction timing. Again, if things change, we want to make sure that we’re planning appropriately. Property taxes are one item that we have limits on this year. So, if we are able to defer some taxes into next year, where we may get a pie, you’re able to deduct the benefit, if the Pease limitations, that $10,000 goes away, and we’re not affected by the Pease limitation, it may make sense to go ahead and defer some of those real estate tax bills to next year. However, if you have high income, and you’re going to be subject to those limitations in the Pease limit, again, it may not make sense. So, again, you’d better check with your tax professional, do a projection, and just see what makes the most sense for your case. And also with that is your medical expenses. So, if at all possible, if you have some dental work and glasses and hearing aids or surgeries, best to do it all in one year, if possible, because you have to get over the income threshold first, before you can deduct those benefits. But again, if you’re able to defer those all into next year and get a deduction when those rates are higher, again, that would also be beneficial. So, again, if you have different incomes, you have to double check this and make sure you’re doing the appropriate tax planning mechanism.

Along with itemized deductions, I just want to point out that this year you can donate up to 100% of your adjusted gross income to charity with cash. If you’re very charitable and have the cash and want to help out, that’s a great thing to do. And so, again, I recommend you look at some of our other webinars that Jeremiah did on Roth conversions, because this is a great mechanism to do a large Roth conversion, donate to charity to offset the income and not pay any tax. And also, donor-advised funds are a great mechanism to use to do more bunching to actually be able to itemize, if possible. And lastly, this year only because of the CARES Act, there’s a $300 above the line deduction for charitable contributions. What does that mean? That means if you take the standard deduction, you can also take up to $300 of charitable deduction on your tax returns. Again, it’s a great benefit that you should make sure you keep track of for your tax professional.

 

#3 Year-End Tax Tip: Gain harvesting

Now, the next strategy we’re going to talk about is gain harvesting. And people must have, if you look at your stock portfolio, you might have some Apple, you might have Amazon, Netflix, Tesla, McDonald’s, Google, Netflix, you name it. If you’ve got any of these winners, you probably have some gain in your brokerage accounts that you can look at. Why is this important? Let me do an example to show you how this can be implemented. So, let’s say, last year you worked or you had required minimum distributions that you had to take off around $98,000, you had capital gains from dividends in the stock sales and such, so your total adjusted gross income is around $110,000. You take your standard deduction, that’s your freebie from the government of $24,400, and that gives you a taxable income of around $85,000. The tax, given the rates last year, on that amount was about $9,300. So, let’s say, now in 2020, the CARES Act, let’s assume we didn’t lose our job or retire, and we took the minimum distributions, even though we weren’t required to. Again, income is the same, everything remains the same. The only difference is the standard deduction went up $400, and then the tax on that is $9,031.

So, now, here’s where the planning comes into play. If you didn’t take the ordinary income, because you didn’t take that distribution that you’re required to, because the CARES Act said you didn’t have to take the RMD this year, or let’s say you were laid off from your job or you retired, so now you don’t have any income from wages or business income, so now you’re at zero ordinary income. So, in lieu of that, let’s take about $105,000 of capital gains, so we’re going to sell some of those winners, as we showed in the previous slide. We can take up to $105,000, and then again, we have our standard deduction of $24,800 that we’re going to subtract from that adjusted gross income. And then we’re left with $80,000 of taxable income, which is all capital gains. The nice thing about this is that our capital gains for married filing joint in the first two brackets is zero. So, we just recognize $105,000 of income, and we’re not paying any federal income tax. Obviously, caveat, you have to make sure you verify what your state is going to charge. But again, that’s a great tax planning mechanism to get a bunch of gain and be able to diversify out of some of these concentrated positions, especially if you have some stock of employer held security as well.

If we look at this nice little chart for the tax pyramid for 2020, you can see that the first two brackets, the 0% and the 12%, are 0% capital gains. And you can see we stayed under that 80,000, and that’s why we paid absolutely no tax. So, what’s really nice here is that shaded area, again, shows you the capital gains rate that we had there. Now, if we were taking ordinary rates or ordinary income, such as the requirement of distribution or wages, we would have paid the 12% on that up to the 80,000. So, again, this is where incurring in gain makes a lot of sense. So, I’m going to turn it over to Jeremiah, and he’s going to talk to you about some other strategies.

 

#4 Year-End Tax Tip: Loss harvesting

Jeremiah Barlow: Fantastic, the power of generating income, when most people think generating income is a bad thing. It can be so valuable. We’re going to switch gears to our fourth of our five topics regarding loss harvesting, one of the big opportunities that you have, especially in volatile markets like this year, but also, as you come into the end of the year, really strong ways of making sure that you can capture losses in order to offset those gains when you do have them, because we all expect those gains over time. So, we’re going to talk a little bit about tax loss harvesting, and then loss carry forwards on how you can use those losses to capture in future years to offset in ordinary income as well. This is one of my favorite examples, really shows how the discipline of tax loss harvesting can benefit your portfolio and, ultimately, your tax situation. Here we are looking at a time frame, a snapshot in time, from September of 2018, over here at the beginning, to June of 2020.

There’s a reason why I’m focusing on this particular scenario. And the reason is we had a couple of drops in the market here, which we’re going to highlight as we talk about it today. So, to paint a picture for your story or example, if you had invested $1 million in September of 2018 in a fund that, say, mirrors the S&P 500, be it a mutual fund or whatever the case might be, today, that same $1 million would actually be significantly higher. Overall, that same million dollars would be worth about $1,000,058 in June of 2020, which would have been on a 6% return. And that’s not fantastic. But I will say in our current environment, a lot of people would take that kind of return right now through the volatility. But the most important thing here is, like I said, these two drops, December of 2018 and March of 2020. In December of 2018, if you had timed the market perfectly, you would have been able to capture losses from when you bought them in September or, ultimately, forward to me, this is a snapshot in time of December, you will be able to capture about $193,000 of losses. And then if you did the same exact thing, didn’t just stay out of the market, because you never want to do that. You don’t want to sit on the sidelines. You want to continue to reinvest and write the market up. And then how that happened again and you timed it perfectly, you would have captured another $394,000 of losses.

The important thing here is, you’re generally never going to be able to time the market. But what you can do is be disciplined and be systematic in your loss harvesting, so like we’re doing, like Jamie does with her clients and all of our advisors. As this sort of thing starts to happen, you start to systematically capture losses as the market is correcting. We did the same thing back here in 2018. And then also, you would get back into the market. You’re not going to sit in on the sidelines over time, you’re going to buy back in as the market continues to correct. And you have as those some wash rules and so on that we need to be mindful of. But at the end of the day, you get into a similar fund that maybe tracks the Russell 1000 instead of the S&P 500, so substantially similar, but enough different where you can still keep these losses. And that’s what would happen if you try to buy back in within that 30-day period. You would actually be awry of the wash rules, which would make you lose all these losses. You wouldn’t get to keep them.

But by doing this, you really put yourself in a position to capture these losses, and be able to have them banked when you do want to generate gains in your portfolio or across your entire financial picture. Had you done this and again, timed it perfectly between these two here, you’d be sitting about a half a million dollars of losses that you can ultimately use to your advantage. Again, we don’t want losses, but when they inevitably happen, you want to take advantage of them, so that we can take care of offsetting the gains. At the end of the day, a good example of taking advantage of this, long term, is you have a scenario where you’re just ending up the extension season for taxes and if you had a need to where you needed to generate $100,000 for, say, paying your taxes, if you filed it for extension and just filed them here recently.

In this particular case, if you need to come up with $100,000 out of your portfolio, you’d like you would generate gains in doing so. In this particular case, this is an example where $100,000 of income necessary in doing so generated about $30,000 of capital gains, using the tax bracket this client is in, if you assume the 20% tax bracket for capital gains and 3.8% NEET, you’d hit about a $4,500 tax bill that they would have. However, that’s if you didn’t have any losses to offset it. At the end of the day, that’s if you do nothing, but if you do systematic loss harvesting, you’d be able to wipe out that entire gain by offsetting it with your losses. So very powerful, you’re always going to have the gains. Going to even where Jamie talked about selling your winners, sometimes you want to diversify the portfolio and having a systematic approach for taking advantage of losses, when appropriate, is very helpful and if your planning is the time to do that.

 

Let’s look at your entire portfolio.

Where do we have the losses embedded? Where can we take advantage of those as we approach the end of the year? So that we can put ourselves in a position to offset the gains that we expect to have as we end the year and move into, ultimately, the memorialization of all of our hard work for tax season, which is preparing your tax return. One more small caveat when it comes to our loss harvesting is understanding that you have loss carry-forwards, which you can decrease your annual taxes and can also offset ordinary income. So if you have long-term capital losses, normally you are limited to offsetting only long-term capital gains with those. However, the government does give you an opportunity where you can write off up to $3,000 of those long-term capital losses against your ordinary income. As long as you’re alive, as long as you’re filing a tax return, you’ll always be able to keep your losses banked, and you’ll always be able to convert 3,000 of those over. Obviously, the tax code could change. But that’s where we are right now, significant benefit to make sure you can always use these to your advantage.

So that is loss harvesting. That ends four of our five items. I do want to round out our strategic end of the year tax planning with talking about a scenario that’s happening right now and bring everything full circle to what Jamie talked about at the beginning, with what’s going on with the upcoming election and the chance of things changing. We are in a very similar world to where we were in 2012, where we expected a lot of things to change, and a lot of people are starting to think about, “How do I plan for this? What if?” Specifically, as it relates to the estate tax. For those of you who need a primer on the estate tax, the estate tax we currently have in the transfer tax world is $11,580,000, is what you get, is your exemption amount, before the 40% tax kicks in. That’s for 2020, of course. There is talks in the proposals for president nominee Joe Biden to reduce that significantly to as low as three and a half million.

Now, again, not law yet. But if that happens, you’re losing out on $7 million plus of exemption amount. And a lot of individuals want to know “how do I take advantage of that today? How do I get assets out of my estate in case that happens?” Also, this elimination of the step-up in basis, what that means is you get this big benefit right now that, although that’s a steep price to pay, when someone does pass away, all the assets inside of their estate get a step-up in basis to the date of death value. That means if you had a basis of stock that had a basis of $100, but when you passed away, it was worth 1,000, that basis would move from 100 to 1,000. And whoever the beneficiary was could actually liquidate that stock and not pay a dime of tax, if they sold it for the same value as the date of death value. So, those are two very valuable things that could potentially go away.

So, the question becomes, “How do I take advantage of this? How do I get assets out of my estate?” But like many, thinking back to 2012, and saying, “Well, if something changed, what if it doesn’t change? I want to kind of get the benefit without any of the risk.” So, there is some planning options you can use, which allows you to give assets out of your estate today, maybe anticipate the fact that some of the things might be happening but keep some strings attached to it, so that you can still access it. Some of our clients are working on putting together things like spousal access trusts, which may allow a spouse to irrevocably give assets to their spouse inside of a trust, in which their spouse is the beneficiary. And that indirectly gives them access to those assets. So that’s the strings attached. Same thing with a promissory note, you could give away a $5 million asset today in exchange for a promissory note, which will give you an income stream back. So, you’re still going to get the benefit of those assets, and if the laws change or don’t change, you can always write that promissory note off you can, you can forgive it, which will become a gift at that time. And again, it gives you the strings attached, which is irrevocably gifted out and, ultimately, you still get to keep the income up until we have more certainty.

There’s also ways to draft into plans to create flexibility, things like disclaimer planning, which means that we don’t have to make a decision today, we can make the decision in the future. And then of course, if you have irrevocable trusts that you put together, in addition to the spousal access trust to having a promissory note, utilizing what we call trust protectors is very valuable, because it allows you to appoint somebody who could actually change the trust in the future, maybe adjust to the beneficiaries are, change the income streams, adjust the trustees. Again, the string that we can keep attached to them enough to where it’s still considered a gift out of your estate, while also allowing you to leverage the benefit of getting the assets out but still continuing to maintain access to those assets over time.

The important thing to think about though, is these are things you have to do now. To Jamie’s point, at the beginning and throughout, you need to be proactive. You need to be strategic in doing this. And how are you going to ultimately do that? You need to start planning now. At this juncture, we’re right at the beginning of the fourth quarter, the perfect time to begin the year-end tax planning. When it comes to actions, gain and loss harvesting is a staple for ultimately ensuring that, at the end of the day, you take advantage of the gains that you’re going to realize, that we are going to, and how you do so, and then offsetting those with the losses. Number two, though, also is important, charitable giving. If you are charitably inclined, it is the last deduction that we have in our current tax regime in many cases, and this year can offset gains significantly, because it can literally write off up to 100% of your AGI. You get that $300 above the line deduction. You don’t even have to itemize to get that $300, as Jamie described.

 

#5 Year-End Tax Tip: Gifting

And lastly, the gifting, you do want to keep in mind that when you gift, if you’re going to do any of the things that I just talked about, it’s going to require likely setting up trust, if you don’t have them created. In this, we approach the end of the year here, all of these professionals, all of us professionals will start to get really busy with implementing these things that we need to do for clients. So, you want to get ahead of it. You need to figure out where your situation is. In order to do that, you need to reach out to your advisor, like Jamie, sit down with your advisor, do some projections for where you’re going to be, as Jamie described earlier. Doing those projections to ultimately determine what’s your tax situation going to look like, and what strategies can we implement to ultimately reduce those taxes at the end of the day, and help put yourself into position to reduce the taxes.

 

Closing

Let’s face it, when we get into February and you look at your tax situation with your CPA, it’s a little too late. For a lot of the strategies we talked about here, you can’t unwind the clock and get back into 2020. You need to be proactive about it. So, all very, very powerful strategies. I want to take a second and thank Jamie for taking the time today with us and myself, as we walked through these amazing strategies today on year-end tax planning. Thank you, everybody. I wish you all the best as we enter the end of the year.

 

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