Get Ahead with a Head Start on Tax Planning

Paul K. Mutch, Senior Financial Planner, First Republic Investment Management

December 12, 2014

Ten Things to Consider When Planning for Taxes

Most people put off tax planning until late in the year when they have more certainty around their tax situation. However, in order to maximize the available benefits, year-end tax planning should start earlier. The following are some simple strategies that can be done before year-end to reduce or defer individual income tax and transfer wealth.

1. Maximize retirement savings

Income that you defer to a retirement plan is not taxed in the year it is withheld. In addition, it grows tax deferred until you withdraw the funds. Currently individuals may defer up to $17,500 in an employer-sponsored retirement plan. If you are age 50 or older, your plan may allow for an additional $5,500 of deferrals. If you are not on track to maximize your contributions before year-end, consider increasing your withholding. If you cannot afford to contribute more, contribute at least the amount that gives you the maximum employer match, if there is one.   

If you are self-employed, consider establishing a company retirement plan. Plans must be established by December 31 but do not have to be funded until the tax filing deadline, including extensions. Plans vary in terms of fees, complexity and funding; speak with a specialist in this area to determine which plan is best for you.

2. Contribute after-tax dollars

Contributions to a Roth 401(k) plan, if allowed by your employer, are made with after-tax dollars and provide no current tax savings. However, the contributions and earnings grow and are distributed income-tax-free as long as you reach age 59½ and satisfy the five-year rule. The best part is that, unlike traditional 401(k) plans where minimum distributions are generally required at age 70½ and are taxed at that time, minimum distributions are not required from a Roth 401(k) plan as long as you or your spouse is living.  After your deaths, the account can be left to your children, who can take tax-free distributions over the course of their lives.   

Whether you should contribute to a traditional 401(k) plan or a Roth 401(k) plan is based on two questions: 1) Will taxes increase, decrease, or remain the same in the future; and 2) Will your tax rate during retirement be higher or lower than your current tax rate? If you are unsure, hedge your bets and make contributions to both. 

3. Contribute to an Individual Retirement Account (IRA)

In addition to contributing to your employer’s retirement plan, you may also contribute up to $5,500 ($6,500 if you’re age 50 or older) to an IRA.

There are two types of IRAs: traditional and Roth. Roth IRAs are similar to Roth 401(k) plans and share many of the same benefits. Roth IRA contributions may be limited based on filing status and income.

Traditional IRA contributions may be tax-deductible. The deduction may be limited if you or your spouse is covered by an employer retirement plan and your income exceeds certain thresholds.

Even if you are ineligible to contribute to a Roth IRA and/or cannot deduct your traditional IRA contribution, consideration should still be given to contributing to a traditional IRA with after-tax dollars. There are no income limits, the growth is tax-deferred and only the earnings are taxed when distributions are taken.

Moreover, anyone may convert a traditional IRA to a Roth IRA because there are no income limitations; however, taxes could be due upon conversion. If all that is being converted is after-tax dollars and the conversion is taking place at the same time as the contribution to the IRA, there should be little or no tax due. On the other hand, if you have made deductible contributions to an IRA, have an IRA that consists of both nondeductible contributions and earnings, or have a rollover IRA from a former employer’s retirement plan, some tax will be due.  For the purposes of income tax recognition, you can’t choose which account or portion of the IRA money you want to convert to a Roth. The IRS looks at all IRAs as one IRA when it comes to conversions. The total balance is aggregated, and a calculation is performed on a pro-rata basis on all IRA money to determine the tax. You should do the calculation before you convert so you are not surprised when you file your return.

4. Accelerate deductions and defer income

In past years when there was uncertainty about tax rates, it made sense to accelerate income and defer deductions to take advantage of current rates and hedge against possible future increases. Now that there is “temporary permanency” with tax rates, the opposite strategy makes sense. Why pay tax now when you can pay it later? If you are a salaried employee, deferring income may be harder. Check with your employer if you can defer a year-end bonus or commission to January.

Consider bunching expenses that are subject to a floor, such as health care expenses, unreimbursed work-related expenses, investment expenses and tax preparation fees. By prepaying tax-deductible expenses in December, such as charitable contributions you expect to make early in the year or state income taxes that will be due when you file in April, you will have the opportunity to reduce your taxable income. Note, however, that itemized deductions are reduced by 3% up to a maximum of 80% for taxpayers whose incomes are above certain thresholds.

5. Review your portfolio

Don’t let the tax tail wag the dog, but make sure your portfolio is managed efficiently for tax purposes. Increased tax rates on ordinary income, qualified dividends and long-term capital gains as well as the 3.8% surtax on net investment income can reduce your investment return substantially. Review your asset positioning and make sure taxable accounts hold tax-efficient assets and tax-inefficient assets are held in tax-deferred accounts.

If your asset allocation is not in sync with your investment policy statement, sell some winners and losers to offset the gain. You can deduct up to $3,000 of capital losses against ordinary income and carry forward excess capital losses to future years.

Beware of the wash sale rule, which disallows a loss if you buy or sell a substantially identical security within 30 days before or after the sale. This rule does not apply to bonds bought or sold from different issuers.

6. Gifting

Individuals can currently gift up to $14,000 each year and pay no gift tax. Thus, parents may give $28,000 to a child, grandchild or anyone else. Want to do more? Each individual has a cumulative lifetime gift tax exemption of $5.34 million. Payments made directly to an institution for tuition or medical expenses are unlimited.

If you plan to make gifts before year-end, avoid using cash. Instead, use low basis, income-producing assets that you don’t need and you expect to appreciate in the future. If you want to gift cash, sell securities or other assets that are worth less than what you paid for. That way you can use the loss to offset other gains and ordinary income before making the gift.   

If your gift will fund future college education expenses, section 529 plans work well. You can make up to five years of annual exclusion gifts in one year. The earnings grow tax deferred and come out tax free if used for qualified higher education expenses. Better yet, many states offer a state income tax deduction for contributions to their state’s 529 plan.

7. To convert or not to convert?

Converting a traditional IRA to a Roth IRA may provide a long-term income tax benefit, but it is really a wealth transfer play. Like a Roth 401(k) plan, minimum distributions are not required from a Roth IRA, and a substantial income-tax-free (but not estate-tax-free) benefit can be left to your heirs. If you convert and then decide conversion was not a good idea, you can recharacterize the converted amount by the filing date (including extensions) for the tax year the conversion occurs. The downside to conversion: You have to pay taxes on the amount you convert. But you don’t need to covert 100% of the IRA; you can convert small amounts each year.

8. Watch for the alternative minimum tax (AMT)

AMT is a separate tax calculation. Adjustments are made to your income and deductions, and if AMT is higher than your regular tax, you pay the difference. Taxpayers with significant income from long-term capital gains or who reside in high income tax states are more likely to be subject to AMT. Therefore, year-end planning strategies may provide no benefit or may increase your AMT exposure. Reviewing AMT is a must before undertaking any planning.     

9. Stay tuned

There is legislation pending that may impact what strategies you undertake. Under current law, assets distributed from an IRA to charity must be recognized as income in 2014. Proposed Congressional bill, H.R. 4619, if enacted, will allow certain tax-free distributions from IRAs for charitable purposes.

10. Seek advice

Speak with your accountant and other trusted advisors. Prepare a tax projection before undertaking any planning to determine what strategies will work best given your situation.     

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