Did you mail out those checks to charities before year-end? Did the beneficiaries of your annual tax-free gifts cash their checks? Did you sell those energy stocks and use the losses to offset gains elsewhere in your portfolio?
There are plenty of tax-smart strategies that required action before the end of the year, but it’s never too early to think about managing your taxes and minimizing the hit to income. In a low-yield environment, tax-efficient investing and sensible tax planning is all the more valuable. Financial advisors are always on the lookout to save their clients money on their tax bill.
Here are some things to consider when it comes to taxes in 2015.
Know your income thresholds
Much of tax planning over the last two years has been about adjusting to the changes resulting from the American Taxpayer Relief Act of 2012 and the Affordable Care Act. The first created a new top marginal tax rate of 39.6 percent for taxpayers earning more than $400,000 ($450,000 for married couples) in 2013. It also increased the capital gains tax rate for those taxpayers from 15 percent to 20 percent. The brackets are indexed for inflation, meaning the top rate now applies to income over $413,200 for 2015.
The higher tax rate likely applies to about 1 percent of the population. However, the new 3.8 percent investment income tax and additional 0.9 percent surtax on income that is helping to finance the President’s health-care plan hits a lot more people.
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The taxes apply to individuals making more than $200,000 ($250,000 for married couples) annually, and that threshold is not indexed for inflation.
“It’s going to get tougher every year, and it’s going to hit more and more people,” said Jim Heitman a certified financial planner and owner of Compass Financial Planning.
Carol Kroch, managing director of wealth and philanthropic planning at Wilmington Trust, predominantly advises ultra-high-net-worth clients who are far beyond the new tax thresholds. However, for clients at or near those thresholds, she suggests they pay attention to details that can save them taxes.
“People can do some nipping and tucking to their advantage,” Kroch said. “It’s not a huge tax, but over time it has an impact, and some taxpayers can time a number of things to avoid higher taxes.”
Timing gains and losses
One opportunity available every year is timing the gains and losses in your investment portfolio.
For example, if your income is close to the $200,000 Obamacare threshold or the higher figure for the top tax bracket, consider waiting until next year to sell positions that will push you over the threshold. There is market risk to the strategy, but it’s worth considering.
Harvesting tax losses on investments is another option. While there haven’t been a lot of opportunities on that front in the last several years, the recent uptick in volatility in the stock market and turmoil in the energy sector specifically presents some chances.
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“It’s been hard to find losses over the last several years, but the recent pop in volatility has allowed us to capture some losses,” Heitman said. Investors can offset capital gains with losses and up to $3,000 in ordinary income as well.
Other timing opportunities for taxpayers, depending on their expectations for income this year versus future years, include accelerating an interest payment on a mortgage or paying real estate taxes for the first quarter of 2016 in December.
“If you’re expecting higher income this year [versus next], accelerate your January interest payment into this year,” said David Plotts, director of financial planning at Glenmede.
Gifts that give
Charitable gifts are also a means to lower your income and possibly avoid higher marginal rates. Cash gifts are fully deductible by taxpayers up to 50 percent of their adjusted gross income. Gifts of appreciated stock are deductible up to 30 percent of AGI, with the added benefit of avoiding capital gains taxes on the shares.
Another opportunity that both Plotts and Kroch recommend to their clients is to take advantage of the $14,000 that taxpayers can annually gift to another individual tax-free. There is no carry-forward of the exemption, so if taxpayers don’t use it, they lose it.
“A married couple with $10 million in assets who have 10 grandchildren can transfer $280,000 tax-free from their estate to them without using up any of their lifetime exemption,” Kroch said. “It can add up to a lot.”
The estate-planning uncertainty was largely resolved by the American Taxpayer Relief Act, which pegged the exemption at $5 million (indexed for inflation) per individual and set the tax rate on estates above that threshold at 40 percent.
“There was a rush of estate planning at the end of 2012, and I think there was some buyer’s remorse.”
Many wealthy Americans set up expensive trust structures in 2012, expecting that the exemption would drop significantly. It didn’t. “There was a rush of estate planning at the end of 2012, and I think there was some buyer’s remorse,” Plotts said.
Trusts generating significant income face the highest marginal tax rate on income just over $12,300, as well as the investment income taxes.
Plotts is recommending clients revisit the planning strategies and structures put in place at the end of 2012. With interest rates still low, grantor-retained annuity trusts remain very good ideas for wealthy people, he suggested.
GRATs are fairly simple low-cost vehicles, as far as trusts go. They are set up as an annuity to the donor for a fixed term, with the donated principal expected to earn a rate of return determined by the Internal Revenue Service.
If the assets in the trust earn more than the theoretical rate of return, the remainder goes to the beneficiary tax-free. The applicable rate is currently 2 percent, meaning there’s a high probability that the assets will earn more than that and the beneficiary will get a sizable benefit tax-free.
“GRATs are still a top play,” Plotts said. “With a rate increase likely on the horizon, it’s a good time to get them in place.”