Believe it or not, yesterday, October 15th (not April 15th), was the actual deadline for filing individual tax returns. We know there’s a temptation to put off thinking about taxes until next winter, but if you do, almost all your money-making opportunities will be lost. If you can find the time to work on tax planning, you just might realize some meaningful rewards. As always, we’ll help you every step of the way, so don’t worry if you’re not sure what to do.
For people between the ages of 55 and 70 1/2 (soon to be 72 if pending legislation passes), tax planning is a full contact sport. That age range is where the IRS generally allows you to do what you want to do to optimize your tax situation. People in this age bracket owe it to themselves to begin thinking long-term as it relates to their tax planning and how it might impact their family’s long-term wealth.
For a more complete list of year-end tax-planning opportunities, click here.
For this week’s blog, we thought we’d go into a little more detail on the two strategies that seem to yield benefits most often to HCM clients. These include tax bracket management and loss/gain harvesting. As always, if you have any questions, please contact us at your convenience.
Tax Bracket Management
Do you know what your effective tax rate is or which marginal tax bracket you’re in? According to surveys, about half of American taxpayers don’t. If you’re one of them, don’t feel too bad.
Bracket management is one of the most effective planning tools. It involves managing your income away from spikes and potholes so that you are always funding your lowest ordinary income-tax brackets and then meeting the balance of your annual cash flow needs with long-term capital gains, qualified dividends, return of capital, and tax-free income. In order to accomplish this, tax planning must look beyond next year to focus on a multi-year horizon.
There are three basic scenarios for which you can manage:
- You expect your income to be lower in the future, incurring higher taxes now. This is often the case for those in their highest earning years, planning retirements in the foreseeable future.
- You expect your income to go up in the future, leaving you with higher taxes then. This is often the case for younger people who are in the growth stage of their career. This can also be the situation for retirees who have large, tax-deferred balances that will face required minimum distributions in the future.
- You expect a stable income situation with taxable income at about the same level for the foreseeable future. The planning opportunity here normally focuses on managing the timing of itemized deductions and the character of income that is recognized.
Those who expect income to decrease should save in pretax retirement accounts, such as a traditional IRA and/or an employer sponsored 401(k). In this way, they can take deductions in their higher tax bracket now and pay tax at lower rates in the future. These are ideal investment vehicles for people in these income situations because their assets can grow and compound tax-deferred for years. 401(k) plans often have the added bonus of receiving an employer match, which means free money and much higher effective returns on your contributions.
You should also consider funding your Flexible Spending Account, Dependent Care Flexible Spending Account, or your Health Savings Account, all of which allow you to decrease your current taxable income. HSAs have the added benefit of growing tax-free and providing tax-free distributions if spent on qualifying health related items, making them triple-tax advantaged. It can also be useful to defer your income to the future when you expect to be in a lower tax bracket.
Once you have moved as much income as possible into the future, you should also look at your options to accelerate itemized deductions into the current year to lower your effective and marginal tax rates, as well as the amount of tax you will actually pay. This has gotten trickier following tax reform; however, with an appropriate long-term view, there are often benefits that can be garnered here.
Those who expect their incomes to rise, resulting in higher taxes in the future, should think long-term to minimize overall lifetime tax liability and maximize family wealth. This can be done by making Roth 401(k) or Roth IRA contributions or conversions. Rather than getting a tax advantage when you contribute, as you would in a traditional 401(k) or IRA (when managed correctly), a Roth allows you to withdraw your retirement savings, and its earnings, tax-free. This will help decrease your tax burden in future years when your tax rate is higher. In that same vein, you can convert a Traditional IRA to a Roth IRA, even if your income exceeds the IRS prescribed amount for contributing to a Roth IRA. This gives you the same benefits of tax-free accumulations and withdrawals that regular Roth IRAs bestow, but can also give you the power to engineer the income you want to optimize your planning. Great care must be taken when planning conversions so that you do not violate the rollover rules or trigger unexpected income on the conversion. Talk to your advisor to learn more.
Tax Loss/Gain Harvesting
Other important tactics in year-end tax planning include gain and loss harvesting. Tax loss harvesting is the process of realizing an investment loss by selling assets in order to offset other gains. The process involves some fancy footwork, but it goes something like this:
The Investor buys $100,000 of a stock, which then falls in value to $90,000. He then sells that stock and reinvests the money in a similar, but not “substantially identical”, security. He’s similarly situated in the market, but he’s harvested a $10,000 loss that can be applied against any other capital gains. If his capital losses are larger than his capital gains that year, he can use up to $3,000 of his net capital loss to offset ordinary income.
Tax gain harvesting involves a similar methodology, but you sell winning investments specifically to capture capital gains. This may sound crazy, but it makes perfect sense in a sophisticated multi-year tax plan. You may be in one of three potential capital gain tax brackets depending on your income:
For Unmarried Individuals, Taxable Capital Gains Over
For Married Individuals Filing Joint Returns, Taxable Capital Gains Over
For Heads of Households, Taxable Capital Gains Over
In addition, a Medicare surtax applies to investment income when Modified Adjusted Gross Income rises above certain levels ($200,000 single and head of household and $250,000 married filing joint). As a result, you may find yourself in capital gain brackets of either 18.8% or 23.8% depending on your income.
When accelerating gains make sense:
- Let’s say we have a new retiree who has not started Social Security or taking money out of their retirement plans yet. Clients in this situation can often take tens of thousands of dollars in capital gains and pay NO federal tax at all.
- Let’s say we have another investor who knows they will have a spike in income next year, causing their income to rise above the threshold levels. By taking a gain this year, and keeping it in a lower bracket, the effective rate on that gain can be meaningfully reduced.
- Those paying Medicare premiums understand all too well the hazards of allowing your income to drift too high. Controlling gains can not only keep them in a lower capital gains rate, but also avoid the double whammy of the additional Medicare surtax and the Net Investment Income Tax (NIIT).
- Dividing a large gain between multiple years (by accelerating some of the gain into the current year) can also help avoid higher rates, sur-taxes and the NIIT. This can be accomplished by selling partial positions or entering into installment sales.
We hope you have a better sense of why it’s important to plan before the end of the year, not just before April 15th.
In our next blog we’ll be continuing this discussion by covering IRA distributions, Social Security timing, and the Medicare IRMAA.
Feel free to reach out to your advisor to discuss these topics further or schedule a tax planning meeting. If you don’t have an advisor, please reach out to Kimberly (kimberly@hcmwealthadvisors,com), 513-598-5120, or click here to schedule an introductory call.