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Taxing Thoughts About Year-End Planning

| November 30, 2016
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Taxes, Investments

An Investec Wealth Strategy...

“You must pay taxes. But there’s no law that says you gotta leave a tip.”–Advertisement

“I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money.”–Arthur Godfrey

No one wants to pay more in taxes than necessary. As we approach year-end, focus shifts to what we can do to minimize taxable income. Marginal tax rates have risen over the last 30 years or so. As a result, tax planning has become an even more important part of how we assist clients in building and preserving wealth. We cannot predict what tax rates will be in 2017, but you may wish to consider some of the following tax planning techniques to reduce your 2016 tax burden:

  • Maximize the use of tax-deductible retirement plan contributions. The 401(k) annual contribution limit is now $18,000. If you're age 50 or older, you can contribute another $6,000 for a total of $24,000. Some retirement plans allow for additional after-tax contributions, which while not tax-deductible, may generate tax-deferred earnings. If you have self-employment income, you may be able to set up a self-employed retirement plan to shelter some of that income.
  • Donate appreciated securities held for more than one year to charities or to a charitable donor-advised fund. Donors of appreciated securities receive two types of tax benefits for their generosity to charity: First, you receive a deduction of the fair market value of your gift. At a tax rate of 39.6%, a $10,000 gift of appreciate stock would generate a tax benefit of $3,960. Second, you eliminate any tax on the built-in appreciation above cost.
  • Consider shifting deductions into the tax year when you are likely subject to the higher marginal tax rate. Certain income and deductions (such as business income receipts, business expenses, charitable donations, mortgage payments and property tax payments) can be moved between tax years, allowing you to choose the year for which you'll receive the greater after-tax benefits. But be cautious—taking disproportionate deductions on items such as property taxes can trigger Alternative Minimum Tax.
  • Consider a Roth IRA or Roth 401(k) conversion. Converting all or a portion of an IRA or a 401(k) to its Roth counterpart can be an effective technique to minimize taxes on investment earnings. Though an upfront tax is due when you make the conversion, none of the future earnings inside a Roth vehicle is subject to income tax, provided you meet certain holding period and age requirements before accessing the funds. A conversion is particularly effective if you can do it in a low-income-tax-rate year, or if you can calculate how much you can convert without increasing your marginal tax rate.

Tax Efficiency in Investment Portfolios

We regularly look for opportunities to maximize our clients' after-tax returns and build long-term wealth. You may wish to consider using some of these techniques for any money you manage for yourself and your family:

  • Hold investments for more than a year before selling them so the long-term capital gains rate applies. Although taxes should not outweigh other investment considerations, the maximum federal long-term capital gains rate is approximately 20 percentage points lower than the top short-term capital gains rate. Extending your holding period before selling an asset may subject you to potential investment return risks, but savings in taxes should be evaluated.
  • Consider selling positions with built-in losses to offset realized capital gains and capital gains distributions from mutual funds. Proceeds can be used to purchase comparable investments, but avoid "wash sales" by not buying identical securities.
  • Asset location can improve after-tax returns. Consider holding interest-earning assets (taxable bonds, REITs, etc.) in tax-deferred accounts like IRAs or 401(k) plans, where the income can be sheltered from tax until it is distributed. Using tax-exempt bonds or bond funds as a portion of your bond portfolio in your taxable accounts provides additional diversification while avoiding federal taxes.
  • If you are selling securities to raise cash or reallocate your assets, sell those positions or individual lots with the largest tax losses or least taxable gain.

Final Thoughts

Paradoxically, an investor can be too tax-efficient, and the strategy can backfire. Postponed capital gains could ultimately drive you into a higher tax bracket when finally realized. Investing disproportionate savings in a tax-deferred account like an IRA or a 401(k) plan could result in significant taxes when Required Minimum Distributions eventually come due. We encourage clients to discuss their tax situation with us, and we work with clients' tax advisors to optimize their after-tax returns. We suggest you consult with your tax advisor before implementing any of these tax planning techniques.

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