As year-end approaches, it makes sense to go through a checklist of potential actions that could help lower tax burdens. We work with our clients’ tax advisors to implement saving strategies and incorporate tax efficiency within the Clear Rock investment management process. Here are some tax minimization techniques worthy of consideration for clients to preserve and build wealth:
- If you have employment income, you should maximize the use of tax-deductible retirement plan contributions. This may include 401(k) contributions (now $19,000 per year or $25,000 if you are 50 or older) and SEP IRAs which allow contributions in excess of $56,000 per year. Income from consulting or serving on a corporate board of directors may also allow contributions through a self-employed retirement plan.
- Make annual or one-time gifts to family members. If you are in a position to do so, you can make annual gifts to your children, grandchildren, or other heirs up to $15,000 ($30,000 per couple) which is the annual exclusion amount. 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.
- Gift appreciated securities held for more than one year directly to charities or to a charitable donor-advised fund (DAF). If you are charitably-inclined and have low cost basis investments, consider using securities instead of cash as donations. Donors receive two types of tax benefits by gifting appreciated securities to a charity:
- A tax deduction for the charitable donation.
- The donor avoids paying capital gains tax on the built-in appreciation of the investment.
- 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 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.
The Clear Rock Approach to Tax-Efficient Client Portfolios
On an ongoing basis, we regularly look for opportunities to maximize clients’ after-tax portfolio returns. Here are some of the techniques we implement in Clear Rock client portfolios:
- In taxable accounts, we intend to hold investments for more than one year before selling them to avoid higher short-term capital gains tax rates. The top federal long-term capital gains rate is significantly 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 and return tradeoffs when deciding how long to hold an investment.
- We seek to take advantage of tax-deferred accounts (IRAs, Roth IRAs, etc.) by holding higher income producing investments that can be sheltered from tax. Avoiding paying tax on income allows the accumulated interest and dividends to compound at a higher rate. Funding Roth IRAs can also help avoid taxes by sheltering gains and income but also allowing withdrawals that 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 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 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.
- For taxable accounts held by clients in higher tax brackets, we generally recommend a core allocation to tax-exempt municipal bonds. Yields on tax-exempt bonds are often higher than after-tax yields on taxable bonds, particularly at the highest tax rates. Still, holding some taxable bonds can still be a prudent source of diversification.
We welcome the opportunity to discuss these tax-planning topics with you, and to coordinate with your tax advisor to determine the best techniques for your tax profile. Please contact us for more information.
Note: As with all tax planning, every person’s tax situation is different. We suggest consulting with your tax advisor before implementing any of these tax-planning techniques.
Royce G. Itschner