As we move closer to year-end, we start to focus on what we can do to optimize our clients’ tax situations and minimize their taxable income where possible. This tax planning is an important part of how we assist clients in building and preserving wealth. Below are a few of the planning techniques we consider for our clients, depending on each individual situation:
Maximize the use of tax-deductible retirement plan contributions.
• The 401(k) annual contribution limit per person is now $19,000. And, if you are age 50 or older you can contribute another $6,000 for a total of $25,000.
• Some plans allow for total contributions in excess of $56,000, so it’s worth checking how your plan is structured.
• If you have consulting income, you may have enough earned income to be eligible to set up a self-employed retirement plan and make contributions to shelter some of this income.
Make annual or one-time gifts to family members.
• If you are comfortable with fully funding your own retirement needs, consider making annual gifts to your children, grandchildren, or other heirs up to the $15,000* ($30,000* per couple) annual exclusion amount. To remove investment income from your portfolio and to reduce your potential taxable estate.
• If you would like to move additional assets from your estate to others, consider transferring money in excess of the annual exclusion amount. Gifts in excess of the annual exclusion amount count toward an individual’s gift tax exclusion amount of $11,400,000*. (*Note, these figures are for 2019; the recently enacted increase to lifetime exclusion amounts is set to expire at the end of 2025). This exclusion applies at the donor level and any gifts excluded due to the lifetime gift tax exclusion are counted against a donor’s estate tax transfer exclusion at death.
• Gifts not only reduce your estate’s value but can also reduce your family’s income tax liability by shifting assets and the related income generated to family members who may be in a lower tax bracket.
• However, because a portion of the investment income for children under the age of 25 may be taxed at a high rate, consider sheltering gifts that will be used to pay for college expenses in a College Savings Plan (AKA “529 Plan”). Income earned inside a college savings plan is exempt from income tax if used to pay qualified education expenses.
Gift appreciated securities held for more than one year directly to charities or to a charitable donor-advised fund (DAF).
If you have long-term investments (investments held for more than one year) with built-in gains (your purchase price is lower than the current market price) in your portfolio, consider using these securities instead of cash as charitable donations or charitable contributions. Donors receive two types of tax benefits by gifting appreciated securities to a charity:
• First, there can be tax benefits as a tax deduction for the charitable donation. For example, a donor in a combined federal and state 45% tax bracket making a $10,000 gift could receive a tax benefit of $4,500 ($10,000 x 45%) for the fair market value of the gift.
• Second, the donor avoids paying capital gains tax on the built-in appreciation of the investment. For example, if a donation of shares worth $10,000, purchased for $1,000, has a built-in gain of $9,000, and the combined federal and state top tax bracket could be 33% on long-term capital gains, the donation would help avoid paying capital gains tax on that $9,000 of appreciation and save the investor $3,000 ($9,000 x 33%).
Concentrate multiple years of charitable deductions into one year to maximize the tax benefits of giving, using the technique of “charitable bunching.”
• Thanks to the significant increase in the standard deduction amounts ($12,200 for individuals, $24,400 for married couples filing jointly), and the new $10,000 cap on the deduction for state and local taxes, some of our clients may no longer receive much, if any, tax benefit from their typical annual charitable contributions. Specifically, if the total amount of their itemized deductions (including charitable gifts) is less than the new standard deduction, then there would be no tax benefit for the charitable gift. One way we are planning to help our clients continue to receive a tax benefit from their philanthropic giving is to concentrate multiple years’ worth of gifts into one tax year, a technique we call “charitable bunching.”
• For instance, a married couple that has a standard deduction of $24,400 may take either that standard deduction or itemize, whichever is greater. If they have $19,400 of deductions from mortgage interest and state and local taxes, and make annual donations of $5,000 to charities, under the new tax law, they would not receive a tax benefit from this amount of charitable donations. That is because their total deductions would only match their standard deduction of $24,400. However, if they combine three years’ worth of their typical charitable contributions for a total of $15,000, then their total itemized deductions would be $34,400, reaching beyond the standard deduction of $24,400. Now they would receive a tax deduction for the amount over their standard deduction, or $10,000.
• Using a donor-advised fund (DAF) account is an easy and effective way to facilitate this larger deduction, because it allows you to bunch your charitable gifts into a single tax year by making the gift into the DAF, but then still have the flexibility to spread your individual grants to charities over current and successive years.
Consider a Roth-IRA or Roth-401(k) conversion if this will be a low-income-tax-rate year for you.
Converting an IRA to a Roth-IRA, or a 401(k) to a Roth 401(k), can be an effective technique to minimize long-term taxes on investment earnings. Though an upfront tax is due on conversions, all future income earned inside a Roth vehicle is income tax–free. A Roth-IRA can therefore provide an individual or family with decades of tax-free compounded earnings. A conversion is particularly effective if executed in a low-income-tax-rate year, so the additional taxable income from the conversion will be taxed at lower rates. If you will be in a lower tax bracket in a future year, such as 2020, consider delaying a conversion to next year.
Tax Efficiency in Client Portfolios
In addition to working with our clients to implement saving strategies, we regularly look for opportunities to maximize clients’ after-tax portfolio returns. We utilize these techniques in our client portfolios:
• We try to hold investment assets outside tax-deferred accounts for more than one year before selling them so that the long-term capital gains rate will apply. There is still a significant tax benefit to holding assets for longer than one year, as the top federal long-term capital gains rate is 17 percentage points lower than the top short-term capital gains rate (20% versus 37%). However, taxes should not outweigh other investment considerations. We always assess the potential risk or return tradeoffs that result from any decision to extend an investment holding period.
• We seek to place the interest-earning portion of your portfolio in tax-deferred accounts. With the top marginal tax rate being assessed on interest-bearing assets, current tax law favors holding these assets (taxable bonds, REITs, etc.) in tax-deferred accounts, such as IRAs, 401(k) plans, 403(b) plans, etc., where the income can be sheltered from tax until it is distributed. And we might be able to help you avoid taxes on the gains and/or income from some investments entirely by placing them in Roth- IRAs, where withdrawals are typically free from income taxes.
• We avoid selling investments with large built-in gains, unless the sale is justified by a higher expected return from an alternative investment or is necessary to maintain portfolio asset allocation objectives.
• When raising cash in your portfolio, we do so by selecting securities or individual lots of a security that have the largest tax losses (or least taxable gain).
• At year-end, we look to sell positions with built-in losses to offset any realized gains elsewhere in your portfolio. Proceeds can be placed in a comparable investment. For example, if we sell a fund to take a loss, we invest the proceeds in a comparable fund to keep your portfolio in balance.
We welcome the opportunity to discuss these tax planning topics with you to determine the best techniques for your tax profile. This is another way we strive to add value for you in addition to managing your retirement assets well.
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]