Do you only think about taxes after the year’s over and/or when you start gathering the data for the prior year’s tax return? If you want to save on taxes, it helps to plan. Tax planning means thinking ahead. This week’s blog suggests five tax planning ideas to consider before year-end.
I often say that taxes and investing are joined at the hip. In other words, we should consider the tax implications of our investment-related decisions. We don’t necessarily want the tax tail to wag the dog, but if we pay attention to the tax implications, we can lower our tax bill. That leaves us with more money to spend either today or in the future.
It’s hard – if not impossible – to implement most tax planning ideas after the year ends. Summer just ended. Year-end still seems far away. But it’s closer than we think. We have a little more than three months left in 2022.
As we discussed last week, investors have had a tough year. Some of the ways we can reduce our tax bill involve taking advantage of the market’s decline. Here are some tax planning ideas to consider before the ball drops:
- Tax-Loss Harvesting
- Optimize Charitable Contributions
- Watch out for Mutual Fund Distributions
- Consider Roth Conversions
- Fund Your Tax-Preference Accounts
Let’s take a closer look at each of these tax planning ideas:
In 2022, almost every asset class has declined. If you have a taxable brokerage account, you can turn some of your portfolio’s lemons into lemonade. Your portfolio likely includes some stocks, bonds, mutual funds, or ETFs that have declined in value.
When looking for tax-loss-selling candidates, think about investments that no longer fit your strategy, have poor prospects for future growth, or can be easily replaced by other investments that fill a similar role in your portfolio.
You should focus on short-term losses over long-term losses because short-term losses provide the greatest benefit. Short-term losses are first used to offset short-term gains – and short-term gains are taxed at a higher marginal rate. (For tax purposes, short term means a year or less and long term means longer than a year.)
The key difference between the two relates to the applicable tax rate. Short-term capital gains are taxed at your marginal tax rate as ordinary income. The top federal marginal tax rate on ordinary income equals 37%. For those subject to the net investment income tax, this rate could increase to as much as 40.8%.
For long-term capital gains, the capital gains tax rate applies. This ranges from 0% to 20%.
The tax rules allow you to offset realized capital gains and losses of the same type against each other. (A realized loss results when you sell a security. If you continue to hold a security, you have an unrealized loss. Unrealized losses do not get reported on your tax return.)
You can only deduct $3,000 of net realized losses annually. Any excess losses get carried over into the future. There is no limit on how long you can carry them forward.
Watch out for Wash Sales
What happens if you still want to own securities that have tumbled this year? You can consider selling them and repurchasing them. But you must keep the “wash-sale” rule in mind. If you don’t your loss could be disallowed.
A wash sale typically results when you sell stock or other securities at a loss and buy the same – or “substantially identical” securities within 30 days before or after the sale. You also can’t sell a security in a taxable account and repurchase it in a tax-deferred account such as your IRA. Again, if you sell the security in a taxable account and purchase it in a tax-deferred account within thirty days before or after that date, a wash sale will result.
If you have a wash sale, then your loss gets disallowed. What does that mean? Typically, you add the disallowed loss to the cost of the new securities you purchased. That means you will still get the benefit. But not until you sell the security.
Keep in mind that if you reinvest your dividends, the reinvested dividends could cause your loss to be disallowed.
Optimize Charitable Contributions
Many people don’t start thinking much about charitable contributions until later in the year. Oftentimes, they wait as late as December 31st to make the actual contributions. It can pay to think ahead.
Making an exceptionally large donation in one year can provide a bigger benefit than making annual donations. How? Let’s look at an example using a married couple. In 2022, they get a standard deduction of $25,900. The annual deduction for state and local taxes plus any real estate taxes is limited to $10,000. Say that they also paid $13,000 in mortgage interest. We can also assume that between cash and goods their annual donations amount to $5,000. That’s a total of $28,000 ($10,000 + $13,000 + $5,000). If we compare that to $25,900, it means they can deduct an additional $2,100 ($28,000 – $25,900) from their taxable income this year.
What if they make a $15,000 contribution this year? Their itemized deductions will sum to $38,000 ($10,000 + $13,000 + $15,000). That results in an additional $12,100 deduction this year. For the next two years, they can still claim the standard deduction.
If they claim the same contribution each year, they end up with total itemized deductions of $84,000 ($28,000 x 3). But if they contribute $15,000 in year one and nothing the next two years, their total contributions will be $89,800 ($38,000 + $25,900 + $25,900). That’s an additional $5,800 of deductions on their federal tax return. If they are in the 32% tax bracket, that equates to a tax savings of $1,856.
Note that the standard deduction typically increases each year, so the benefit could be even greater.
Charitable Gifts – Appreciated Stock
You should also consider how you make your charitable gifts. For example, consider donating shares of appreciated stock that you have owned in a taxable account for more than a year rather than cash. You can deduct the market value of the stock. You also don’t have to pay any capital gains taxes.
For example, say you bought 100 shares of XYZ company 10 years ago at $50 per share. Even with this year’s decline, assume those shares are worth $100 per share. You can use these shares to fund $10,000 of charitable contributions. You won’t have to pay long-term capital gains taxes on your $50 gain per share. That will save you as much as $1,000 ($50 x 100 x 20% capital gains rate). But you still get to deduct the same $10,000.
This strategy can also provide a tax-efficient way to reduce your allocation to long-term holding that has grown too large relative to your overall portfolio.
Make sure you allow enough time to donate appreciated shares. The process can take longer than you expect.
Charitable Gifts – Qualified Charitable Contributions (QCDs)
If you’re at least 70 ½ years old, you can make qualified charitable donations (QCDs) directly from your IRA to a qualified charity. You can make up to $100,000 of QCDs annually. You exclude QCDs from your taxable income. Once you turn 72, you can even use QCDs in place of some – or all – of your required minimum distribution. If you file a joint tax return, your spouse can also exclude up to $100,000 of QCDs from their income as well.
If you make a QCD, you can’t deduct the amount as a charitable contribution on your federal income tax return. Don’t worry though. It still works to your advantage. Remember that you don’t have to report the income amount. That means the amount isn’t taxable. You don’t have to worry about trying to bunch charitable contributions as noted above if you make QCDs either.
Not including the QCD as part of your taxable income has other benefits, too. You don’t have to include the QCD as part of your income when determining whether you owe higher Medicare premiums. (See this blog for more information about the Income Related Monthly Adjustment Amount (IRMAA) that can increase your Medicare premiums.)
As we age, our healthcare expenses can also increase. We can only deduct medical expenses on our federal tax returns to the extent that they exceed 7.5% of our adjusted growth income (AGI). Making QCDs keeps our AGI lower. That makes it easier for expenses to exceed this 7.5% threshold.
Watch out for Mutual Fund Distributions
Do you hold mutual funds in a taxable account? If you purchase mutual funds before year-end, you could have an unexpected tax bill. Be on the lookout for funds that are poised to make sizable year-end capital gains distributions. Many funds make their distributions in November and December. Unfortunately, these distributions are typically taxable even if you purchased the fund just before the record date.
While it’s too soon to know for sure whether a particular mutual fund will make a capital gains distribution, it’s not uncommon for this to happen when the market has a tough year. You can also look at the fund’s prior history of making capital gains distributions. Once we get to October, this website typically provides estimates of future capital gains distributions.
You can take some steps to avoid this issue. For example, consider waiting to invest until after the fund you want to purchase has set the date that holders are eligible to receive such distributions. You could also consider investing in that fund through a taxable account, such as an IRA.
Consider Roth Conversions
I have discussed the benefits of Roth conversions as a tax planning idea in the past. (See here, here, and here.) A down market can make Roth conversions more valuable. Having money in a Roth IRA provides several tax-related benefits:
- No required minimum distributions
- No taxes on qualified withdrawals
- Lower taxable income
Some benefits can also accrue to your surviving spouse and/or your heirs.
If we assume that the market will ultimately recover – a reasonable view for investors to take – then a Roth conversion at depressed prices will lower the ultimate cost of withdrawing money from your retirement accounts. For example, say that at the beginning of the year you owned $100,000 of an S&P 500 index fund. It’s fallen by 20% this year and is worth $80,000 today. You complete a Roth conversion using those shares. You only pay taxes on the $80,000. Assume that you keep the money in your Roth IRA for 10 years and it earns an average annual return of 8%. Its value would exceed $170,000 at that time. That makes the amount you can withdraw from your Roth more than $90,000 higher than it was when you completed the conversion. You only paid tax on the $80,000.
Roth Conversions – Other Considerations
You should try to make sure you pay the taxes on the conversion from dollars outside the traditional IRA. If you don’t, you reduce the amount you can convert. Even worse, if you’re less than 59 ½, you pay a 10% early withdrawal penalty.
You also want to consider your tax rate – current and future – when evaluating a possible Roth conversion. Ideally, you want to complete the conversion when you’re in a lower tax bracket than you expect to be when you take the money out of the account. One of the best times to do this is when you’re in the period between when you stop working and when you start collecting Social Security. This means you don’t have any wage income and your RMDs also haven’t kicked in. That allows you the most control you can have over your taxable income.
Fund Your Tax-Preference Accounts
You must fund some tax-preferred accounts before year-end. This applies to a workplace retirement account such as a 401(k) or 403(b). Self-employed individuals must open these accounts by December 31st. You can make contributions up until the day taxes are due for the year. The same rule applies to contributions to other accounts for self-employed individuals such as a Keogh or a SEP-IRA. But you can still open these accounts after the year ends.
You can make contributions for 2022 to your IRA, Roth IRA, or Health Savings Account up until April 15, 2023.
Keep in mind that if you’re adding money to the market, a declining market works in your favor. It allows you to buy shares at a lower price. As long as you have a positive long-term outlook, you should want to buy when prices are lower. That allows you to capture greater gains.
I hope you find these tax planning ideas valuable. If you have questions about any of them or would like some help please schedule a free call. I’ll gladly answer any questions and assist in whatever way I can.
I’ll be back next week with “Apprise’s Five Favorite Reads of the Week.”
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.