Amid the challenges of the COVID-19 era, when many taxpayers have experienced or expect to experience significant reductions in income, tax-advantaged planning opportunities may arise to at least mitigate some of the financial hardship. This article identifies some practical steps taxpayers may take to maximize after-tax income, especially where earnings and other customary sources may have shrunk. Further, recognizing that diminishment of financial resources often detrimentally affects an individual's ability to assume investment risk, this article suggests several risk-averse investment strategies.
EMPLOYEE STOCK PURCHASE PLANS
Where available, qualified employee stock purchase plans (ESPPs) under Sec. 423 may often offer an employee with some discretionary extra cash a path to greater retirement savings. Such plans may offer discounts of up to 15% and often even allow for a six-month lookback, providing opportunities for employees to avail themselves of built-in gains.
Sec. 423(b)(6) provides that an ESPP option may not be priced lower than the lesser of (1) 85% of the fair market value of the stock at the time the option is granted, or (2) any equal or higher amount specified under the option's terms on the date the option is exercised. Some companies provide eligible employees a period, often six months, at the end of which they can purchase an option for 85% of the lesser of the stock price on either the first or the last business day of the period, and to be deemed to exercise on the last day of the period an option granted on its first day. See IRS Letter Ruling 200418020 for an example.
Further, since qualifying stock can normally be sold immediately after purchase, the benefit can be achieved as a lower-risk transaction. Although all the income attributable to the discount is ordinary, the overall tax effect may be reduced for those taxpayers who, due to the COVID-19 pandemic or other economic adversity, find themselves in a lower tax bracket than usual for the year (e.g., 12% vs. 22%). Advisers should check with clients to determine whether they might be missing out on this excellent employee perk. According to an employer survey, it is estimated that, for nearly 70% of companies with an ESPP, fewer than half of eligible employees participate in it ("2018 Global Employee Stock Purchase Plan Trends Survey," Deloitte).
Planning for the start of the new year
Since an employee may be subject to limitations on how much and when company stock can be purchased, it may be best for him or her to sign up for the purchase plan as early in the year as possible. Advisers may also need to explain to their clients that ESPPs are an employee benefit that is distinct from an employer-sponsored annuity plan.
Following the passage of the safe-harbor annuity provisions of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, P.L. 116-94, more employers were also expected to offer employer-sponsored annuity plans this year for the first time. In general, under the SECURE Act, an employer is protected against liability in the event of a failure by the underwriting insurer if the fiduciary meets the safe-harbor requirements, which include obtaining written representation from the insurer that for the preceding seven years, the insurer met designated state licensing requirements; filed the applicable audited financial statements; fulfilled appropriate reserve requirements; and is not operating under an order of supervision, rehabilitation, or liquidation. See Section 204 of the SECURE Act (29 U.S.C. §1104(e)) for the other safe-harbor requirements.
CAPITAL GAINS TAXED AT 0%
Taxpayers who have experienced economic hardship during the COVID-19 era and, thus, a decline in their marginal tax bracket may have opportunities to recognize capital gains at a 0% tax rate.
A married couple filing jointly have for many years been subject to a high marginal income tax bracket. However, in 2020, they have experienced a substantial decline in business and anticipate that their taxable income for the year will be lower than usual, $50,000. As a result, the couple could recognize up to $30,000 in net capital gain and dividends taxed as net capital gain ($80,000 (the maximum capital gains zero rate amount for joint filers in 2020) − $50,000) at a 0% capital gains rate. Further, since the wash-sale rules apply only to losses, not gains, the couple could immediately repurchase any sold stock, achieving a tax-free step-up in basis.
IRA contributions and suspended RMDs: Similarly, the temporary suspension of required minimum distributions (RMDs) in 2020 may create opportunities to recognize income at zero capital gains tax rates.
J, a single individual who was age 90 in 2019 with a $500,000 individual retirement arrangement (IRA) balance, has projected taxable income of $60,000, including an RMD, for 2020. The suspension of his RMD allows him to reduce his projected ordinary taxable income by $43,860 to $16,140 ($500,000 ÷ 11.4 (the applicable distribution period, IRS Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs), Table III)). As a result, he could recognize up to $23,860 in capital gains at a 0% capital gains tax rate ($40,000 (the maximum capital gains zero rate amount for a single filer in 2020) − $16,140).
Tax year 2020 is the first year for which working taxpayers older than age 70½ may contribute to traditional IRAs. The SECURE Act repealed the age limitation in Sec. 219(d)(1), effective for tax years beginning after Dec. 31, 2019. This change may affect a significant number of taxpayers working into their 70s. This provides another opportunity to create tax bracket space for the recognition of capital gains at a 0% rate.
A married couple, both age 73, have earned income of $20,000 in 2020 and, prior to making any IRA contributions, anticipate taxable income for the year of $80,000. If they contribute the maximum deductible amount of $14,000 to their IRAs for 2020 ($6,000, plus a $1,000 "catch-up" for each spouse), they can recognize the same amount of capital gains as their IRA contributions at a 0% tax rate.
Alternatively, for all three examples, if the taxpayers do not have unrealized capital gains, a potential benefit nearly as helpful might be to convert traditional IRAs to Roth IRAs to maximize the use of the 12% ordinary income tax bracket.
Nonqualified annuities: Nonqualified annuities, similarly to Roth IRAs, are not subject to RMDs. Therefore, taxpayers who anticipate that they will not be subject to a marginal ordinary income tax bracket greater than 12% may benefit from the use of nonqualified annuities, creating opportunities to open tax bracket space for the recognition of capital gains at a 0% tax rate and/orRoth conversions at a lower-than-usual ordinary income tax rate.
R, a single individual age 60, holds $500,000 in a fixed-income account projected to generate $15,000 in ordinary income for 2021. Due to pandemic-related hardships, she anticipates that she will be subject to a 12% ordinary income tax rate during 2021, which is lower than she expects it to be in the future, when she anticipates her business revenue will return to its previous higher levels. R closes her existing fixed-income account and, with the proceeds, purchases a nonqualified annuity (for which she pays the same $500,000 realized from the sale of the fixed-income account), which she expects similarly will generate $15,000 in income for 2021. By utilizing a nonqualified (as opposed to a qualified) annuity, she can defer the recognition of taxable income until the funds are withdrawn. As a result of this action, she creates $15,000 in marginal tax bracket space to recognize capital gains at a 0% tax rate (assuming her other taxable income does not cause her to surpass the zero capital gains rate ceiling) and/or recognize Roth conversion income at a reduced tax rate.
Taxpayers considering this strategy should, in addition to weighing tax factors, consider all the related ramifications of owning an annuity, including issues such as potential surrender charges. Further, for planning purposes, taxpayers considering this strategy should be reminded that distributions from the nonqualified annuity will be deemed to first come from taxable income unless the annuity has been annuitized, in which case part of the annuity payment will be income and part will be a return of capital. Also, it should be noted that this strategy may not be suitable for taxpayers contemplating taking distributions prior to age 59½, as such distributions would be subject to the penalty provisions governing early withdrawals of retirement income (absent an exception).
Qualified longevity annuity contracts: The key benefit of a qualified longevity annuity contract (QLAC) versus a traditional qualified annuity is that, unlike qualified annuities, which require that RMDs begin at age 72 for retirees, the holder may defer distributions of income until as late as age 85. An important distinction of QLACs versus many qualified annuities is that, other than an allowable inflation adjustment, there is no allowance of market-based performance factors. QLACs are purchased with funds from traditional IRAs or eligible employer-sponsored plans, such as a 401(k). The maximum amount that may be purchased for 2020 is the lesser of $135,000 (inflation-adjusted lifetime cap) or 25% of the qualified retirement balance.
S, age 75, has $600,000 in a traditional IRA. She converts $135,000 (maximum) before the end of 2020 into a qualified longevity annuity. Because of the conversion, her RMD for 2021 is reduced by $5,895 ($135,000 ÷ 22.9 (the applicable distribution period, IRS Publication 590-B, Table III)). If she is within the $0 capital gains bracket, this would allow her to potentially recognize an additional $5,895 in tax-free capital gains in 2021.
Note that QLACs cannot be purchased with funds from Roth accounts or defined benefit plans.
A consequence of the COVID-19-related market turmoil is that more investors, while still seeking to participate in the stock market, may also be seeking opportunities to mitigate their exposure to potential downside risk. Defined outcome/buffer exchange-traded funds (ETFs) may provide a practical, tax-efficient alternative for such investors to achieve varying levels of risk mitigation. While income from qualified annuities, for example, is subject to tax at ordinary income tax rates and may be subject to significant surrender charges for early redemptions, defined outcome/buffer ETFs are liquid and, when held for more than one year, their sale generates income that is categorized as being from a capital asset.
A defined outcome/buffer ETF is typically composed of a basket of options (e.g., Chicago Board Options Exchange FLEX options) that achieves a level of downside protection while providing capped upside opportunities. Investors who purchase on the first day of issue (or reset) will know, assuming they plan to hold the investment for the full one-year cycle, what their upside cap and downside buffer (e.g., the first 15% of losses) will be for the coming year. This buy-and-hold strategy may be attractive to an investor who is willing to accept a cap on earnings in exchange for some mitigation of risk.
US savings bonds
Investments in 30-year Series EE U.S. savings bonds provide opportunities to achieve a relatively high fixed rate of return, federal tax deferral, and exemption from state and local income taxes. Thirty-year Series EE savings bonds, if held for 20 years, currently provide a 3.5% annual real rate of return that is exempt from state and local taxation. EE savings bonds earn an annual fixed rate (0.1% for May through October 2020 issuances) and then, at the end of 20 years after issuance, if they are worth less than their face value (EE savings bonds are issued at a discount of 50% of their face value), Treasury will make a one-time adjustment to make them worth their face value — i.e., making their value double their cost (see TreasuryDirect at treasurydirect.gov). Thus, the real rate of return for investors who hold the bonds through their initial 20 years is approximately 3.5%. Thereafter, EE bonds continue to earn interest at the original fixed rate of return for the final 10-year period until maturity. Therefore, investors should plan on redeeming at the 20-year point. Purchase amounts are limited to $10,000 per person per year. In addition, for investors who as a result of the pandemic and/or other reasons find themselves with minimal investment capital, Series EE U.S. savings bonds have a low minimum purchase of $25, without any transaction fees or maintenance costs.
Series I U.S. savings bonds also provide competitive rates of return and, like EE bonds, offer tax deferral flexibility and exemption from state and local income taxes. Series I bonds pay a combined fixed rate and an inflation adjustment, which for bonds issued in May through October 2020 totaled 1.06%. Series I bonds redeemed after a five-year holding period are not subject to any reduction in the interest payout. Those held less than five years, however, are subject to a three-month forfeiture of interest and cannot be redeemed prior to the completion of a one-year holding period. Similarly to EE bonds, purchases are subject to annual limitations.
EE and I savings bonds also offer the possibility of excluding interest entirely from gross income if the interest is used to pay qualified higher education expenses for the taxpayer, spouse, or dependents. Eligibility for the exclusion is subject to a modified adjusted gross income phaseout. The bond must have been issued after Dec. 31, 1989, and the taxpayer must have been at least age 24 at issuance and must not have a filing status of married filing separately (Sec. 135(c)). Accrual-method taxpayers must report income from Series EE and I savings bonds currently; for cash-method taxpayers, the increase in redemption value is includible in income at redemption or maturity but may instead be reported annually.
YEAR-END PROJECTIONS AND TIMELY ACTION ARE KEY
During this pandemic era, it may be especially crucial to "run the numbers" through year-end tax projections, allowing sufficient time before year end to engage in a variety of financial transactions (e.g., a Roth conversion). The adviser's role here may be paramount, as many taxpayers may be unaware of opportunities to at least partially mitigate their losses of income and/or wealth. Critical timing issues may abound. Taxpayers, for example, who have available tax bracket space to recognize capital gains at a zero tax rate in 2020 but fail to utilize it receive no carryforward to 2021. Additionally, taking action at the start of the next year (e.g., immediate enrollment in an ESPP and/or purchase of maximum allowable Series EE U.S. savings bonds) may allow taxpayers to maximize investment benefits for 2021.
While many taxpayers have experienced substantial financial distress related to COVID-19, advisers who take the lead in providing a plan of timely strategic action may thereby provide valuable benefits for their clients in addressing and helping to mitigate what otherwise might be an unforeseen and deeply disruptive financial hardship.
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About the author
Seth Hammer, CPA, Ph.D., is a professor in the Department of Accounting at Towson University in Towson, Md.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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