As 2014 comes to a close, proper tax planning will help savvy investors reduce what they pay on investment gains, as well as take advantage of tactics that might not be available in the future.
1. Tax Loss Harvesting and Selling in Lower Tax Brackets
The idea of selling securities (such as stocks or mutual funds) that have gained significant value may seem foolish for most; but, for individuals wanting to take advantage of current “tax loopholes,” selling may not be such a bad idea. Tax loss harvesting is essentially leveraging a well-performing stock or mutual fund account with an underperforming account.
Joe is in a 25% tax bracket and invests $25,000 in 4 different stocks (for a total of $100,000). The current status of each stock is as follows:
- Stock A has increased $2,000;
- Stock B has decreased $6,000;
- Stock C has increased $3,000;
- Stock D has decreased $9,000.
At this point, Joe decides to sell and can offset his gains (Stock A and C increased a total of $5,000) with his losses (Stock B and D decreased a total of $15,000) for a total capital loss of $10,000. Joe can use up to $3,000 to offset his ordinary income for the current year, resulting in a tax savings of $750 ($3,000 capital loss x 25% tax bracket = $750). On top of that, he can carry the remaining $7,000 loss to his future tax returns (repeating the same step for the next couple of years).
For those in a higher tax bracket (above 15%), selling securities with significant losses to offset taxes on gains of appreciated assets can be the difference in paying 23.8% or 15% on dividends and long-term capital gains. In 2014, that translates to taxable income over $406,751 if you’re filing single; $457,601 for married couples.
If you’re in the 15% or less tax bracket, you will pay 0% on long-term capital gains (subject to certain exclusions) making the sale more appeasable. In 2014, that translates to taxable income of $36,900 or less if you’re filing single; $73,800 or less for married couples.
Note: IRS wash-sale rules disallow you to claim a loss if you purchase a similar investment within 30 days.
2. Preparing for Potential Higher Taxes
Contributing to your tax-deductible employer-sponsored plan or IRA might make sense for now, but does it make for the future? This depends on whether you believe taxes will decrease, increase, or stay the same. If investors think they will increase, then a Roth IRA will be in their best interest. If decrease or stay the same, then contributing to a tax-deductible plan makes most sense, especially when in the top tax bracket. For those in a lower tax bracket, a Roth is always best because the long-term reward (tax-free) outweighs the short-term gain (a small tax deduction).
Converting to a Roth IRA
Years ago, only individuals with an adjusted gross income (AGI) of under $100,000 were eligible to convert a traditional Individual Retirement Account into a Roth IRA. Today, anyone can convert, and if you have the money to pay the tax now, it might be worth it. With a Roth IRA, individuals pay taxes on their contributions now and make tax-free withdrawals later on; a traditional IRA works the other way around. Also, if tax rates are lower today than they will be tomorrow, it is better to get them out of the way now, which is the purpose of the Roth. All in all, the Roth is the solution for most.
3. Giving to a Charity
Throughout 2012 and 2013, retirees age 70 ½ or older could directly assign their Required Minimum Distributions (RMDs) to their favorite charity and not report it as income (up to $100,000). This accomplished a few objectives such as: taking the mandatory distribution; not having to report the income on the retiree’s tax return; and not dealing with a Schedule A, which requires time and money (if you’re paying an accountant). Known as the Qualified Charitable Distribution (QCD), this little-known technique expired on December 31st, 2013 and hasn’t been reinstated since.
For more information on Qualified Charitable Distributions, please reference the IRS.gov section on their website titled “Charitable Donations from IRAs”.
Even though QCDs aren’t available at the moment, make sure you take advantage of the following:
For gifts of $250,000 or more, a charitable trust probably makes sense. There are two types of charitable trusts; charitable-lead and charitable-remainder.
With a charitable lead trust, payments go the charity every year and whatever is left goes to your beneficiaries (typically family members). As the gift-giver, you are eligible to take a deduction for value of the interest passing to charity, but cannot take an immediate deduction for the whole contribution. Also, this may eliminate capital gains from highly-appreciated assets (such as stocks and mutual funds). Charitable lead trusts also reduce the estate taxes due upon death because they are not subject to current capital gains tax.
The charitable remainder trust is exactly the opposite. A properly structured charitable remainder trust gives your beneficiaries payments first and whatever is left goes to the charity. Tax benefits include: trust assets not being counted for estate tax purposes; appreciated assets are exempt from current capital gains tax; and qualify for an income tax deduction on the estimated present value of the interest going to the charity.
Note: Charitable trusts are irrevocable and assets cannot be withdrawn once either trust is formed.
For gifts over $1 million, you may want to setup a private foundation.
Charitable deductions are based on your Adjusted Gross Income (AGI) and depend on the organizations to which the contributions were made. Usually, the deduction is up to 50% of the individuals AGI, but 20% and 30% limitations apply in some cases.
For most, 2014 has been a prosperous year. Adding these tax-savvy moves will assist in not having a bounty on your tax return by the IRS.