David L. Garcia, CPA, CFP®, ADPA® Principal, Wealth Manager
Most folks hate to think about paying taxes, let alone end-of-year tax planning strategies. Unfortunately, ignoring tax planning can lead to paying Uncle Sam more than is required. The last four years have seen the introduction of new income-based Medicare premium increases along with increases in the top income tax, capital gains, and dividend rates. Starting to plan as early as possible is crucial since most strategies need to be completed prior to year end. Depending on your situation, it may make sense to either accelerate or delay deductions and income. This blog post briefly discusses some of the most often used tax planning strategies, but is by no means an exhaustive list. Tax planning strategies can be complex and should always be considered in close consultation with your accountant and financial advisor to make sure decisions are made with your unique tax situation in mind.
Harvesting Losses
At first glance, it may seem silly to intentionally sell an investment for a loss. However, opportunistic tax loss harvesting can boost after-tax returns. Suppose you have a $50,000 investment in the U.S. stock market via a broad market index fund that loses 10% of its value this year. You can sell this index fund and turn around at the same time and buy a very similar U.S. index investment, losing no market exposure but banking a $5,000 loss for tax purposes. This can be a beneficial tool for reducing taxes while maintaining your asset allocation and risk/return profile. Even if you do not have any gains to apply the loss to in the year of sale, up to $3,000 can be used against ordinary income items such as wages. Further, any excess unused loss is carried forward to be used in future tax years.
There are some important limitations to tax loss harvesting that should be kept in mind. The IRS will not let you sell an investment and at the same exact time buy back that identical investment just to create a tax loss. IRS rules state you must wait 30 days to purchase the identical investment sold for the loss or you violate what is commonly referred to as the “wash sale rule.” A wash sale disallows the loss for tax purposes. However, IRS rules do allow you to purchase a very similar investment, preferably one that is highly correlated with the investment sold for a loss, without breaking the wash sale rule. For example, selling the S&P 500 SPDR and replacing it with the Vanguard total stock market index would give almost identical market exposure while not violating the wash sale rule.
The bottom line is that actively managing capital gains and losses near year end can increase after-tax returns over time. Just be sure to consult with your accountant or investment advisor to make sure you do not run afoul of any limitations.
Medicare Premiums for High-Income Earners
In 2016, some Medicare recipients began to see an additional 16% base premium increase set into motion by two different laws. One law says that ordinary recipients can’t have their standard premium go up by more than the Social Security cost of living increase for that year. Since there was no cost of living increase in 2016, this benefited about 70% of beneficiaries. Unfortunately, another law shifted the burden of increasing Medicare costs onto the remaining 30% of beneficiaries. This unlucky 30% includes folks who don’t deduct Medicare premiums from their Social Security checks, those who didn’t receive Social Security in 2015, and high-income earners.
If that wasn’t bad enough, on top of the 16% base increase, Medicare also penalizes about 5% of high-income beneficiaries with premium surcharges. The surcharges begin at adjusted gross income levels above $85,000 for singles and $170,000 for married folks filing jointly. To make matters worse, the income thresholds are currently not indexed for inflation, so more people will be affected by the surcharges in coming years. Tax planning can help reduce the bite of surcharges.
The Medicare surcharges are determined by a taxpayer’s modified adjusted gross income (MAGI). For most folks, this is adjusted gross income plus tax-exempt interest. This number is calculated before itemized deductions, so the usual deductions like charitable donations and mortgage interest won’t help. However, if you are charitably inclined, there is one strategy that might help reduce your MAGI. If you have to make a required minimum distribution (RMD) from your IRA every year, the distribution goes on your 1040 as ordinary income and increases your MAGI. The IRS allows you to give up to $100,000 of your RMD to charity and have it avoid your 1040 all together, thereby directly reducing your MAGI. Other strategies beneficiaries may want to consider include harvesting capital losses to offset gains that increase MAGI, moving forward or putting off income events in the current tax year, and utilizing Roth accounts for income. The bottom line is that a little planning could save you a lot in Medicare premiums.
Roth Conversions
In 2010 Congress repealed the income limit on Roth IRA conversions affording taxpayers, regardless of their income, the opportunity to pay off the embedded tax liabilities in their IRAs. Taxpayers who take advantage of Roth conversions should consult with their tax professionals and financial advisors to make sure converting to a Roth IRA makes sense for their particular situation. Even though converting traditional IRA assets to a Roth IRA creates current income tax, there are several situations where it may make sense to perform a Roth conversion. Perhaps you have retired recently and find yourself in a low tax bracket, making a Roth conversion less expensive. Many people convert IRA assets because they want to create a tax-free retirement asset for their heirs or to use up operating losses from their business. Whatever your reason, your future tax bracket, time horizon, estate plans, and whether you have cash outside of your IRA to pay the conversion taxes should all figure into your decision.
Conclusion
Tax planning is an important part of everyone’s financial plan. Most people approach tax issues in a reactive manner instead of being proactive. By starting to think about your current tax circumstances before year end, you may save yourself taxes and take advantage of opportunities on which you may otherwise miss out.
Feel free to contact David Garcia with any questions by phone 305.448.8882 ext. 224 or email: DGarcia@EK-FF.com.
Kitces, Michael E. “Planning for the New 3.8% Medicare Tax on Unearned (Portfolio) Income.” Nerd’s Eye View. N.p., Apr. 2010. Web. <www.kitces.com>.
“Medicare Premiums: Rules for Higher-Income Beneficiaries.” Social Security Administration. N.p., Jan. 2016. Web. <www.socialsecurity.gov>.
“Advanced Tax Strategies Using a Roth IRA Conversion.” Putnam Investments. N.p., n.d. Web. 19 July 2016. <www.putnamwealthmanagement.com>.
Cubanski, Juliette, Tricia Neuman, Gretchen Jacobson, and Karen E. Smith. “Raising Medicare Premiums for Higher-Income Beneficiaries: Assessing the Implications.” Kaiser Family Foundation. N.p., Jan. 2014. Web. <www.kff.org>
Evensky & Katz / Foldes Financial 