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Preparing Your 2020 Taxes: Special Tax Issues that May Apply to You in the Year of COVID

How can we put a positive spin on the year 2020?  Perhaps we can characterize it as… unique?  Unforgettable?  However one describes it, this year presented several new challenges, and depending on your circumstances, you may need to add your 2020 tax return to that list.  Below are a few significant tax issues that may apply to you this year as a result of the pandemic.

Working in a Different State.  Many individuals working remotely during the pandemic chose to work in a different state than their principal residence and/or usual place of business for various reasons.  Whether they relocated temporarily to be closer to family, enjoy a vacation home, avoid paying unnecessary rent, or otherwise, this change may impact their state tax liability this year. 

Each state has its own definition of residency.  In Virginia, for example, any person who lived in Virginia or maintained an abode in the state for more than 183 days during the year is considered a resident—and therefore is subject to state income taxes.  Virginia does have reciprocity agreements with nearby states (DC, Maryland, Pennsylvania, West Virginia, and Kentucky), which could eliminate the need to file a Virginia return, but those who relocated from other states might not be as fortunate. 

At the very least, if you worked from a different state, you may have to incur the cost of filing an additional state tax return and paying the tax liability for that state out of pocket, unless you planned ahead and changed your state tax withholdings with your employer.  Your usual state of residence will generally give a credit for taxes paid to another state, but you will still have to file a return there too.  If this situation applies to you and you do not already have a tax preparer, this may be the year to hire one.

Working from Home.  Obviously, during the pandemic, millions of Americans turned into remote workers overnight.  Unfortunately, employees (those who earn W-2 income from an employer) are not eligible to take a home office deduction.  However, self-employed workers who had a dedicated workspace in their home and used that space as their principal place of business this year are eligible for that deduction. 

Receiving Unemployment Benefits.  Unemployment benefits, including any Pandemic Unemployment Assistance received this year, count as taxable income on your federal taxes.  Most states tax unemployment benefits as well, though Virginia is one of 6 states that exclude unemployment from taxable income.

Taking Coronavirus Distribution from IRA.  The CARES Act permitted individuals under age 59 ½ to take withdrawals from their IRAs this year of up to $100k without incurring the 10% early withdrawal penalty if the pandemic impacted their health or financial situation.  Those individuals still owe income tax on any withdrawals, but the tax can be spread over three years—or they can avoid the tax by putting the funds back into their IRAs within three years.  If this situation applies to you, think carefully about your expected income in the coming years as compared with this year.  If you were unemployed this year but expect to have significant income in future years, you may want to consider claiming more than one-third of the withdrawal on your 2020 taxes while in a relatively lower tax bracket.  If you are able to repay those funds into your IRA in the future, you can always amend your 2020 taxes.

Reversing RMDs.  The CARES Act also waived the obligation to take Required Minimum Distributions (RMDs) from IRAs and retirement accounts this year.  Some individuals had already taken their RMD by the time the CARES Act was passed, so Congress allowed them to reverse the RMD and put funds back into their retirement accounts (if they did not need the money).  If this applies to you, ensure that the custodian of your retirement accounts correctly reports no taxable distributions for the year on your 1099-R.  Also, if you generally use tax withholding from your RMD to cover your federal or state tax liability from other sources of income, note that the amount you owe on your tax returns might increase this year, even though your overall tax liability decreased.

Recontributing 529 Funds.  If your college-age child was sent home from college in the spring and you received a refund for any of their college expenses, hopefully you recontributed back to their 529 account (within 60 days) any funds that had been withdrawn from the 529 originally.  If not—and that beneficiary is still in college—you can use those funds for their tuition payment this month and still avoid penalty (since it is the same tax year), or you can use the funds to pay down their student loans.  If none of these options are viable, the funds will be considered a non-qualified distribution, and you will face a 10% penalty and tax on the growth in those funds on your tax return.

Harvesting Tax Losses.  If you have taxable account assets, you may have taken advantage of the market volatility in the spring to harvest some tax losses.  Note that any capital losses will first be used to cancel out capital gains for the year (including capital gains distributions from mutual funds this year).  If you still have net capital losses after that, up to $3,000 can be used to reduce your taxable income from other sources.  The remainder will be carried forward to future tax years.

In addition to these pandemic-related tax issues, 2020 is the first year in which the SECURE Act took effect, which could impact your taxes.  New tax provisions included in the CARES Act—in addition to those mentioned above—could affect you too, such as the $300 charitable giving deduction for those who do not itemize deductions.  Please reach out if you have any questions on how these changes in 2020 may affect your taxes or if you need a referral to a trusted tax preparer this year.

Over the past decade, investors have increasingly turned to Exchange Traded Funds (ETFs) as a favorable investment vehicle when looking for diversified, low-cost, passive investment options.  The ETF industry, which did not even exist 30 years ago, recently topped $5 trillion (yes, trillion!) in assets under management.  Last week, Dimensional Fund Advisors (DFA), which PFS has typically used for their mutual fund investment options, launched their first two ETFs, and they are planning to release 7 more ETFs over the coming year.  What are ETFs, what are their advantages as compared with mutual funds, and why is DFA moving into the ETF game now?  We provide some answers to these questions below.

The Differences between Mutual Funds and ETFs.  The core function of mutual funds and ETFs is the same—namely, to provide a diversified basket of stocks and/or bonds, so that investors can enjoy lower volatility and fewer unnecessary risks in their portfolios as compared with investing in individual stocks.  Technical differences* in how shares of mutual funds and ETFs are created and redeemed, however, translate into practical differences in how investors can trade the two investment options, which in turn impacts taxes and fees.

The Pros and Cons of ETFs Versus Mutual Funds.  Given the differences in how ETF shares are created and traded, ETFs have some advantages and some disadvantages as compared with mutual funds.

Pros of ETFs:

Cons of ETFs:

Why Is DFA Launching ETFs Now?  After nearly 40 years in the mutual fund industry, DFA is now branching into the ETF market for two main reasons.   First, there has been demand for a DFA-style ETF for many years.  Financial advisors who value DFA’s investment strategy have wanted DFA products available as ETFs due to their tax-efficiency and slightly lower fees.  Second, the SEC passed a key rule (Rule 6c-11) impacting the regulation of ETFs last year.  The new rule enables DFA to convert its tax-managed mutual funds into ETFs (without generating capital gains for investors) and also allows DFA to continue its flexible trading strategy in an ETF structure, which has been one of the hallmarks of how DFA aims to provide an edge over index funds in terms of investment returns.

Should PFS Clients Start Using ETFs?  In the past, PFS has chosen not to use ETFs in light of:  1) the inability to do automatic investing, 2) the resulting trade fees, and 3) the lack of ETF products following what we view as the optimal investment strategy.  However, two out of three of these reasons have changed in the past year, so our view on ETFs is changing as well. 

As mentioned above, when using ETFs, investors cannot set up monthly transfers to automatically invest or take withdrawals from the fund.  This represented a major drawback since most PFS clients take advantage of this option with their mutual funds.  It is possible for us to manually input small trades in or out of an ETF each month in the absence of an automatic trading option, but until the fall of 2019, this would have generated an intolerable level of trade fees for our clients.  At that time, however, several major brokerages (including TD Ameritrade and Schwab) dropped their trade fees on ETFs completely.  Additionally, in the past year and a half, two different companies launched ETFs that follow our preferred investment strategy—a new company called Avantis Investors and now DFA.  The inability to set up automatic investments still presents a logistical challenge on our part, but the elimination of trade fees and introduction of ETFs with a compatible investment strategy has induced us to begin using ETFs in taxable accounts to some extent, and this shift will continue in the coming year, especially as DFA expands its ETF offerings.

As always, please reach out to us with any questions.  We are happy to discuss ETFs in more detail and how they may add value for your portfolio in the coming years.

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*If you’re interested in the technical differences regarding the creation and redemption of mutual fund and ETF shares… With a mutual fund, investors buy and sell shares directly from the fund provider, who in turn buys and sells the underlying securities based on inflows to or outflows from the fund.  With an ETF, investors buy and sell shares directly from other investors on the secondary market.  Financial institutions called “Authorized Participants” buy and sell shares of the underlying securities (i.e. stocks or bonds) to ensure that the ETF shares are trading in line with the net asset value of the underlying securities.

This has been a very volatile year in the stock market, and with the election outcome uncertain and the pandemic unresolved, there may be more volatility still in store.  However, “conservative” investments—such as bonds, CDs, and money market funds—carry certain risks as well, especially if they comprise too much of your portfolio over the long-term.  Here we explain how inflation can affect the purchasing power of your investments over the long run, particularly in a low interest rate environment.

The PFS staff, like most red-blooded Americans, are big fans of ice cream, particularly Woody’s Ice Cream—a staple of Fairfax City.  Given our affection for ice cream, we will use this essential consumer product to demonstrate why it is safer to invest a portion of your retirement savings in stock funds, rather than sticking only to “conservative” alternatives such as cash and bonds.

Woody’s Ice Cream is owned by Woody, who retired from the auto business in 1996 and opened his ice cream store a couple years later.  Assume that when Woody retired from the auto business, he had $1,000 in savings.  At that point, Woody could afford to buy 375 half-gallons of ice cream.  However, the average price of ice cream increased from approximately $2.67 per half-gallon in 1996 to $4.82 at the beginning of 2020.  Therefore, if Woody had stashed his savings in cash under his mattress, he could only afford 207 half-gallons as of the beginning of this year—a significant decline in his ability to buy ice cream.

If Woody had invested half of his savings in U.S. bonds (represented by Barclays U.S. Aggregate Bond Index), he could afford 442 half-gallons of ice cream by 2020, a slight increase in purchasing power.  By comparison though, if he had invested his savings in a mix of cash (25 percent), U.S. bonds (25 percent), and equities (50 percent, represented by the S&P 500), he could afford 1,079 half-gallons of ice cream as of the beginning of 2020–almost a 200% increase in his ability to buy ice cream!

The lesson is clear:  while the risks of investing in the equities market may grab more headlines, choosing the “safe” bet of only (or predominantly) investing in cash or bonds may not be so safe over the long term.  You may have felt anxiety in light of the stock market volatility this year, but bear in mind that inflation trudges on, and it will erode the purchasing power of your savings (i.e. reduce your ability to buy ice cream) if you don’t invest in assets that will produce inflation-beating returns over the long term.

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