Issue 1: Deductions
How can taxpayers still make the most of the few deductions available to them?
The Congressional Budget Office estimates that 90% of taxpayers will take the standard deduction moving forward, so tax planning should focus on whether taxpayers should incur expenses that potentially are itemized deductions, and how best to benefit from that expense. As a result, they may want to “bunch” available itemized deductions (for example shifting the timing of state estimated tax payments and property taxes to one year) to receive the standard deduction.
For example, Bob is a single filer with a $200,000 mortgage and his total itemized deductions are $13,250. If he underpays his state estimated taxes in 2020 and then defers payment of state taxes or other deductible items until next year, he’ll receive the full benefit of the $12,400 standard deduction this year and can potentially itemize in 2021.
By underpaying his state taxes, he will incur additional deductions for the subsequent year and will realize significant tax savings. Obviously, careful planning with a tax advisor is required to avoid an underpayment penalty for any state taxes, but you get the idea.
Another example of when it might make sense to “bunch” deductions is for medical expenses. Under the previous law, taxpayers were allowed to deduct out-of-pocket medical expenses that exceeded 10% of their adjusted gross income (AGI). As a result of the TCJA, filers can deduct expenses that exceeded 7.5% of AGI until 2020. Taxpayers can take advantage of the larger standard deduction by perhaps claiming the standard deduction in one year, and then bunching medical expenses into the next year which will enable them to take advantage of the higher itemized deduction in an alternate year. For example, you could prepay in one year for a child’s braces in order to itemize or opt for elective surgery in conjunction with dental work.
Also, if you are close to the standard deduction threshold, you can “front load” charitable contributions into a Donor-Advised Fund (DAF) so as to exceed the standard deduction and take the fullest advantage of the deductions. In a DAF, donors can make a large up-front donation, gain an immediate tax benefit and then allocate the funds to charities over a period of years. In short, the taxpayer makes multiple years of charitable donations in one year to get the highest tax benefit (and itemize that year) but spreads the actual contribution across subsequent years, in which the taxpayer claims the standard deduction.
Also, if you are over the age of 72 and do itemize, you can contribute up to $100,000 out of your IRAs directly to a charity and have your donations count toward your required minimum distributions (RMDs). This is not only a convenient way to contribute to a charity, but the amount satisfies the RMD and it doesn’t increase your adjusted gross income (AGI), which would help reduce taxes on Social Security benefit and avoid Medicare premiums charges.