With the year end getting closer, we’re all looking for tax-smart moves to improve our current or future tax picture. To help with this task, I have created a list of key portfolio-related tips you can quickly sort through when making your year-end tax plans.
It’s obviously key to wait to see to what extent President-elect Donald Trump’s proposals to reduce income-tax rates, get rid of personal exemptions, increase the standard deduction and repeal transfer taxes come to fruition. Yet with a Republican-controlled Congress, it’s fair to expect tax reduction in 2017 and beyond.
Rest assured that the majority of the portfolio-related moves listed here can be considered without knowing the specifics of the tax breaks to come, as they are largely 2016 use-it-or-lose-it tax-reduction moves, or moves that prevent you from unnecessarily triggering taxes this year.
Here are some questions to ask yourself.
Did you work or did you have a working spouse in 2016? Consider maximizing retirement account contributions. Tax-deductible contributions allow you to save on a tax-advantaged basis and reduce your current income tax bill.
If you’re a higher-income taxpayer, retirement contributions might also reduce your income below thresholds that may currently subject you to an additional 0.9 percent payroll tax, a potential additional 3.8 percent tax on net investment income and potentially limit your personal exemptions and itemized deductions.
If you have an employer-sponsored plan, ask your payroll department what additional amounts you might contribute to reach the maximum $18,000 (or $24,000, if you’re age 50-plus) to a 401(k), 403(b) or 457(b) plan.
What if you are a nonworking spouse, you don’t have an employer-sponsored plan or you have a plan, but want to further reduce your 2016 taxable income? You need to talk to an advisor about funding a traditional individual retirement account up to the 2016 contribution limit of $5,500 (or $6,500 age 50 and over) before April 17, 2017.
Contributions to these traditional IRAs will be fully deductible if (1) neither you nor your spouse can contribute to a 401(k) or other employer plan and (2) if you’re eligible to contribute to your employer’s retirement plan but your modified adjusted gross income is less than $61,000 (or $98,000 for joint filers). Your traditional IRA will also be fully deductible if your spouse is eligible to contribute to his or her employer’s retirement plan and your MAGI is less than $183,000 (assuming you’re filing jointly). Note, though, that you can’t make contributions to a traditional IRA in or after the year you attain age 70½.
Do you invest outside a 401(k), IRA or other qualified retirement account, and have you realized significant gains in your portfolio or from other assets this year? If so, consider harvesting losses from your taxable accounts. Selling a security with an unrealized loss allows you to offset capital gains. Plus, to the extent you have losses beyond this year’s gains, you can use up to $3,000 of such losses to offset ordinary income and then carry forward any unused losses to successive years.
Next steps: Your advisor may contact you if you have realized significant gains in your portfolio and there are opportunities in your portfolio to harvest losses. Should you choose to harvest losses by selling other securities, avoid purchasing a “substantially identical” security 30 days before or after a loss-generating sale, as a “wash sale” prevents you from deducting the loss.
Do you invest in mutual funds outside of a 401(k) plan, IRA or other qualified retirement account? If so, review guidance from mutual fund managers regarding capital gain distributions. Funds may distribute gains recognized earlier in the year, which will be taxable to you as a shareholder.
Gain distributions may apply even if your return during the period for which you have held the fund is not positive. Next steps: Your advisor will/should consider year-end distribution guidance on mutual funds prior to making any purchase of mutual funds on your behalf in a taxable account. Your advisor may also be in touch if it makes sense to liquidate a mutual fund to avoid a taxable event.
Do you expect your tax rate in retirement to be higher than your current tax rate? If yes, consider converting some or all of your traditional IRA to a Roth IRA. Qualified withdrawals from Roth IRAs are tax-free, which may result in you paying tax at a lower rate today to enjoy access to tax-free income in retirement.
A Roth conversion might also reduce your taxable income in retirement years below thresholds that trigger higher Medicare premiums or other yet unknown additional tax or limit on deductions, exemptions or credits similar to those currently faced by higher-income taxpayers (e.g., the additional tax on net investment income or phase-outs in personal exemptions and itemized deductions).
Next steps: Ask your accountant if an IRA Roth conversion is wise, knowing your complete tax picture. A conversion often makes sense if you have funds outside of your IRA to pay the income tax on the conversion and you have 10 or more years before using the funds to allow for tax-free compounding .
It also makes sense if your estate will be subject to estate tax or you want to create an income tax-free fund for heirs. If the conversion makes sense, ask your advisor to assist with conversion in short order as to ensure completion prior to year-end.
Are you over age 70½, and do you have assets in a 401(k) plan, IRA or other qualified retirement account? If so, be sure to take your required minimum distributions before year-end to avoid a 50 percent penalty on the amount you should have withdrawn. If you turned age 70½ in 2016, you can defer taking your first RMD until April 1, 2017, but keep in mind that you’ll be required to take both your 2016 and 2017 RMDs in 2017.
“President-elect Trump proposes to repeal the gift and estate tax, so speak with your attorney before making substantial gifts, as assets removed from your estate won’t entitle your heirs to receive a step up in income-tax basis on assets outside of your estate at death.”
Have you inherited an IRA or other qualified retirement account? Be sure to take your RMD before year end to avoid a 50 percent penalty on the amount you should have withdrawn.
Do you plan on making charitable donations before year-end?Consider making your charitable gifts with appreciated securities instead of writing a check or using your credit card. Donating appreciated securities you’ve held for more than a year in your taxable account allows you to avoid the tax on capital gains you would otherwise pay when you sell the appreciated securities. And, if you itemize, you can claim a deduction for the full value of the securities, up to 30 percent of your adjusted gross income if the donation will be made to a public charity. Any excess charitable contribution that is not deductible this year can be carried forward for use over the next five years.
Next steps: If your accountant agrees that it’s a tax-smart move to donate appreciated securities, obtain specific instructions from the charity for receiving securities and let your advisor know as soon as possible to ensure enough time to make the transfer prior to year-end.
Do you have charitable plans and are you taking RMDs? Consider satisfying your RMDs by making a direct charitable rollover. If you still have RMDs to take for the year and plan on making charitable donations, you may benefit from transferring up to $100,000 of any 2016 RMDs directly to a public charity. Qualified charitable deductions prevent such funds from being included in income, while satisfying your charitable goals.
A direct charitable rollover might allow you to take a larger income tax deduction than you might otherwise be eligible to take with a direct gift to charity, given AGI limits on taking charitable deductions (deduction limited to 50 percent of your AGI if contributing cash) or if your charitable deduction is phased out given significant income. It might also allow you to lower your marginal tax bracket, reduce the taxable portion of your Social Security benefits, lower your Medicare premiums, qualify you for other tax deductions (e.g., medical and miscellaneous itemized deductions) or prevent the imposition of phase-outs on personal exemptions.