Tax considerations affect virtually all areas of a comprehensive financial plan. Optimal choices in retirement planning, education planning, investment planning, risk management, insurance planning, and estate planning all need to consider taxation. In this post we review the use of some tax planning tools, including tax-loss harvesting, retirement accounts, 529 plans, charitable donations and distributions, depreciation of capital investments, and others.
All information in this post is provided for illustrative and educational purposes only and should not be considered tax or investment advice, or a recommendation to buy or sell any type of securities.
As the year is coming to its end and you start setting up holiday decorations, we know you may be thinking about the close of the 2019 tax year (just don’t do it while you are on a ladder with Christmas lights). You’d like to find ways to keep more of your hard earned money. We hear you, and we have a few ideas to share. As always though, we challenge you to think beyond today or this year. Good tax planning is a key component of a comprehensive financial plan, and should therefore take a long view. Much larger gains can be achieved by taking consistent tax planning actions every year than trying to find an additional deduction this year. Some of our suggestions may not result in a reduction of 2019 taxable income, or may not apply to you, but acting today in some of these areas can mean reducing your taxable income for years to come: when retiring, when paying for college expenses, or when transferring wealth to your loved ones or your favorite charity. Talk to us or your tax professional if you want to know more about tax planning.
Harvest Gains and Losses
When you look across your investments, chances are some have increased in value while others have lost value, relative to the initial cost of the investments (or cost basis). In a taxable account, selling investments that have lost value can help you reduce your taxable income. Why would you need to sell? Maybe you need liquidity for planned expenses, or are revising your asset allocation. Selling only appreciated assets will generate capital gains, and a tax liability. You can use losers to reduce that tax liability or even turn it into a deduction against ordinary income. Once you netted your realized gains and losses, you can use up to $3,000 in losses to reduce your taxable income this year. If your loss is greater than $3,000 you can carry the additional amount to future tax years, indefinitely, until the entire loss is used up.
Review your asset allocation, and for each investment with losses ask: Do I need this investment in my portfolio? Even if the answer is yes, you can still harvest the loss if there is a close substitute. The simplest example is index funds. You can sell an index fund from manager A that has experienced losses and buy a fund that tracks the same index from manager B. Your asset allocation hasn’t changed, but your taxable income is. You have realized a loss from a tax perspective but not from an investment perspective. Notice since losses can occur any time of the year, there is no reason to wait until year-end, like many investors or advisors do. You or your advisor can harvest losses this way throughout the year.
Avoid the surtax if you can
Besides reducing your modified adjusted gross income (MAGI), capital gains can also reduce your investment income. For example, capital gains are included in the calculation of investment income to which the 3.8% Medicare surtax is applied. This surtax affects households with income above the thresholds defined here.
Harvest gains too
In a year when you have a lower taxable income, it may be a good time to harvest your gains, not just losses. Capital gains tax rates depend on income. Suppose your income is below the 0% capital gains tax rate ($78,000 for married filing jointly), then it may make sense to sell your appreciated investments this year since you have no tax liability. If your investment has a close substitute, like funds A and B above, then you can reduce your future tax liability.
Contribute to tax advantaged accounts
Start by making sure you have contributed to your 401(k) or similar plan to take advantage of the employer match. Contributing any amount up to the $19,000 limit (plus an additional $6,000 if you are 50 or older) will lower your adjusted gross income. Don’t just focus on reducing your taxable income this year though. If you are in a low income bracket and can contribute to a Roth IRA, consider doing so. In a Roth account, you contribute after tax money, and your savings is never taxed again. If you are in a low tax bracket, consider contributing to a Roth. Your tax rates may go up in the future, either because the 2017 Tax Cut and Jobs Act (TCJA) ends or because you will make more money, and having tax-free savings in a Roth account can help you generate greater wealth in retirement.
Fund your Health Savings Account
If you have a health savings account or HSA, a great tax saving strategy is to fully fund the account for the year. You can contribute up to $3,500 (single) or $7,000 (family) of pre-tax money. Contributions to an HSA are free of federal income tax and social security and medicare taxes. In previous posts, we have talked about how the HSA can be a key element of a retirement plan. If you are enrolled in a high deductible plan that meets HSA requirements, you can open an HSA whether or not your employer offers one. In addition, regardless of when you become eligible for the HSA in the year (as late as December 1) you are eligible for the entire year, so you can make the full yearly contribution to it. Fully funding your HSA is a great way to lower your taxable income and get ahead on your retirement plan.
IRA Planning
We suggested contributing to a Roth account if you are in lower tax brackets. Doing so will reduce future taxation and help you keep more of your growing investments. On the other hand, contributing to a traditional IRA can help you lower your taxable income this year, which may be useful for people in higher income brackets. Everyone with earned income can contribute to an IRA. If you don’t have earned income but your spouse does, you can still contribute to an IRA. Your contribution is fully deductible if you are not an active participant in an employer plan, like a 401(k). If you are an active participant, part of the contribution may be taxable. In that case, it is better to only contribute the deductible portion to a traditional IRA and the taxable part to a Roth IRA. After tax contributions are always better in a Roth account than in a traditional IRA. The combined IRA (traditional + Roth) for 2019 is $6,000 plus an additional $1,000 if you are 50 or older.
Consider back-door Roth contributions
Roth contributions are phased out at higher levels of income, so all you have left may be a taxable traditional IRA contribution. Making the contribution can still save you on future taxes, because your money grows tax-deferred in the account. But there is something else you can do: use the traditional IRA and then convert that non-deductible contribution to a Roth IRA. When you convert an IRA to a Roth IRA, you pay taxes on any amount that is converted that is above your basis. If you have other IRA accounts, your basis must be calculated using a pro-rata formula. All IRA accounts are aggregated and your conversion will be part non-deductible and part deductible (if you have deductible contributions in your IRAs), so you may have a taxable event when you convert. The upside is that that money will never be taxed again!
Fully fund your college plans
As an estate planning strategy, 529 plans are a great way to use your annual exclusion to pass your wealth out to loved ones without gift or estate tax consequences. Using the annual gift exemption, you can donate up to $15,000 (if single) or $30,000 (if married) per individual recipient. As a parent who is planning to send their kids to college, 529 contributions allow you to take advantage of tax exempt growth and future withdrawals for qualified expenses. So while not a tax reduction today, a tax reduction in the future for acting today.
Give it away
A donation to a qualified charity can reduce your taxable income as an itemized deduction. But it can help you in other ways too. For example, consider donating appreciated investments instead of cash. Say you want to donate $20,000 to a charity and are on the 15% capital gain tax bracket. You need more than $20,000 to raise $20,000 in cash with appreciated assets. For example, if you have $10,000 in capital gains, you have a tax liability of $1,500. By donating directly, you save the $1,500, and since charitable institutions do not pay taxes on appreciated property, the charity gets the full $20,000 value. Your investment custodian can help you donate your investments. See, for example, the various ways you can do it with Betterment. There is a limit on donating appreciated property, typically 30% of your AGI.
Make qualified charitable distributions (QCD)
If you turn 70 and ½ or older in 2019 and have traditional IRAs, there is one more way to benefit from charitable donations. Consider donating part or all of your required minimum distribution (RMD) from an IRA. Such distributions (QCDs) can be made directly to charities from the IRA and the amount of the contribution directly reduces your adjusted gross income (AGI). Reducing your AGI reduces your taxable income and can reduce the taxability of your Social Security benefits.
Make a capital investment
Business owners should consider making a planned capital investment in 2019. If you have been planning to purchase depreciable property in the near future, consider whether it is worth making the purchase before the end of the year. Section 179 of the tax code allows a deduction of up to $1,020,000 of the cost of certain property placed into service in 2019 as an expense, with phase out at $2,550,000. After you apply section 179, the tax code allows for an additional special deduction called bonus depreciation, before you apply regular depreciation to the remaining amount, if any. The Tax Cut and Jobs Act (TCJA) increased the bonus depreciation percentage temporarily to 100 percent for qualified property acquired and placed in service after Sept 27, 2017, and before Jan 1, 2023.
Business Vehicles
There are limits on section 179 and bonus depreciation for passenger vehicles and heavy SUV. Heavy is defined as having a manufacturer weight rating of more than 6,000 pounds. For passenger vehicles (with a weight rating of less than 6,000 pounds) placed into service in 2019, the greatest allowable depreciation schedule is $10,000, $16,000, $9,600, $5,760, for years 1, 2, 3, 4 and after, respectively. If claiming the special depreciation, the first year depreciation can be $18,000. For heavy SUVs, section 179 is limited at $25,000, but the 100% bonus depreciation applies in full for vehicles purchased and placed in service in 2019.
We are not saying you should make capital expenditures or buy an SUV for your business for the sake of getting the deductions. What we are saying is that together, section 179 and special depreciation create an incentive to make planned investments.
Standard or itemized
Because of the higher standard deduction contained in the TCJA and the new limits on state income taxes, more people are opting for standard deductions. But if you have planned itemized expenses, consider bunching them together. For example make a multi-year charitable donation this year. Or consider pre-paying for deductible expenses that you know you will incur in 2020, such as medical expenses. If you have planned any surgery or larger medical expense for 2020, consider paying before the end of 2019.
Do a tax projection
When it comes to taxes, no one likes bad surprises, like having to pay more than they were expecting. Consider doing a tax projection, and adjust your tax withholding for the rest of the year. This will allow you to reduce or eliminate the chance of an underpayment penalty. The IRS hosts a withholding estimator here. Use the YTD section of your last paystub to help you go through the questions. The more questions you can answer the more precise the estimate. At the end of the process, the estimator will suggest the number of allowances to claim on your W4 form to get on track.
We tried to list some of the more common items that can have a larger impact on your taxes throughout your life. Not all of these may apply to you, and the ones that do may not lead to a tax saving this year, like a Roth contribution. But you should see tax planning as helping you keep more of what you earn throughout your life not just this year. Finally, a warning. The tax code is complex and each situation is unique. Make sure you consult with a tax professional to see if and how any of these ideas apply to your situation.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
