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While we have all been locked up in our houses over the last year, many of us have taken the opportunity to clean a bit. Throwing things out, repurposing things, and even donating things so someone else can use them is somewhat cathartic. Similarly, we should all consider spring-cleaning in our financial lives. And what better place to start than our 2020 tax return?
A common misconception is that you are done with your tax return once your CPA finishes it. But that is when the work begins. Your tax return is a backward-looking document that needs to be converted to a forward-looking document.
In May or June of each year, you should work with your financial advisor and CPA to review the return to double-check that the financial moves you made the year before were captured correctly. This is something our fiduciary financial planning firm in Bloomington, MN, always encourages our clients to do.
Common errors to look for in 2021 (for 2020 tax returns) include:
1. RMD reversal: With COVID, retirees did not have to take their required minimum distribution (RMD) from their retirement accounts in 2020. And if someone had taken it, they could pay it back (through the end of August 2020).
The problem that arises from this is that custodians are issuing 1099s showing the distribution, but there is no corresponding document showing the payback (5498s will be issued by most big brokerages in early summer). Thus, your CPA must manually back the distribution out of the tax return so that you don’t pay taxes on something you reversed.
For those who did a partial reversal (some people still needed some of their distribution for spending) or a Roth conversion, verify those are accounted for correctly. There could be two problems here:
a. Roth conversion: If you did a Roth conversion on top of paying back the RMD, it will look like a double distribution out of the IRA on the 1099. But the reality is that only the Roth conversion should be taxable.
b. Tax payback: If your intent was to pay back 100% of the RMD, then you had to pay back the total distribution, including the tax withholding already sent to the IRS, and then file now on your 2020 return to get that withholding back. Again, make sure your CPA shows that the withholding was paid in and you paid it back to the IRA, or you might not get the refund you should expect.
2. Charitable giving: Verify that what you gave to charity was accounted for correctly. Many gave more household items in 2020 to charities like Goodwill. Account for all those receipts. And if you donated something worth more than $5,000 (like an old car), you will need an appraisal. Finally, keep in mind the CARES Act gave a special $300 above-the-line deduction for those who are otherwise taking a standard deduction. This means, even if you don’t itemize, you could still deduct $300 of charitable giving above the line (meaning it reduces your adjusted gross income and taxable income).
3. Contributions/distributions: Review all contributions (to retirement plans, HSAs, education plans, etc.) to ensure they are accounted for correctly. With that, double-check that distributions are accounted for as well. For example, if you took money out of a health savings account (HSA) to cover health care last year, verify that it was not counted as taxable income (I have seen this occasionally).
Reviewing 2020 will now make the tax return a forward-looking document as well. We will probably not see some of the breaks (such as the RMD waiver) in 2021, so now is the time to plan what the impact of income and deductions might have on this year.
With last year in mind, look toward this year with a fresh eye on the following:
1. Income: In 2021, RMDs are now back in the mix. And maybe you must start Social Security. Or maybe income is increasing due to business getting back on track. Anytime you see your income increasing or decreasing, it might present an opportunity to time that income in one year versus another.
2. Deductions: While there are fewer deduction opportunities now, charity is still one of them. If your income is going to increase in 2021, and you have charitable intent, start thinking about whether more gifting to charity this year (even through a donor-advised fund) makes sense.
3. Business or real estate sale: While nobody knows what will ultimately pass in Congress (or if anything at all), there is a lot of discussion about tax rates moving up, even the capital gains rate. I normally don’t suggest people make decisions without complete information, but it is worth considering how to sell a large asset if you want to do it anyway. You might not have enough time to react if you wait until December, so at least getting an understanding of your options over the summer could be of value.
4. Estate plan: Similar to my previous comment, if estate taxes change at all, there could be decisions you need to make in 2021. Consider spring-cleaning your estate plan and understand what changes you might make should something change in the law.
Spring and early summer are a great time to review tax returns while they are still fresh on everybody’s mind. Give your CPA a week or two after May 15 (this year’s new deadline) to relax, but feel free to check in with your financial advisor. Your financial advisor can review this with you and, if you find any concerns, then bring it back to your CPA for further review. After all, you have a team of people working for you for a reason—use them.
The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor.
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