It almost feels like it was yesterday that you were ringing in the new year, thinking of 2019 and what would be to come and setting your resolutions. One of the things that was a hot topic as we rolled into the new year was the new tax plan and what might await us come the filing deadline. Now make no mistake, taxes are a part of investing, but they frequently are thought of as something that comes hand-in-hand with investing that we have no control over. Although we can’t control the markets, investor behavior, fear and many other parts of what can come along with investing we can have some control and influence over how taxes affect your investment portfolio. Today we will cover some tips on what you can still do before year end to help your tax situation.
Check on your deductible account contributions
As we’ve covered in some of our previous discussions, there are ways for you to put money to work while sheltering/avoiding the tax bill at this time. These are most commonly seen in the form of an employer’s 401k, where you are able to have money taken from your income before taxes put away for your retirement future. The contributions to these accounts also lowers your taxable income because of the redirection into these accounts rather than payment out to you in the form of a check, so if you’ve had an event that may be adding to your taxes consider incrementally or aggressively increasing your contribution rates to these accounts. This can be a good way to redirect that money from your taxable income and into some additional retirement savings, also making that money shielded from taxes for years until you take it out. Other places to consider for re-directing would include HSA/FSA accounts, traditional IRAs (check to see if your income and filing status allows for a deductible contribution) or for those with a family member who has special needs look into an ABLE account. Here are some of the 2019 contribution limits, check with your accountant or the IRS website for deductible IRA contributions or ABLE Accounts.
Harvest the losses
One of the many ways that an investor can help to offset tax considerations is to review taxable investment accounts for losses. What this means is that if an investment is made in a taxable investment account and the value of the holding is less than what it was bought for it can be sold for a loss. Note that the investment has to be sold at the loss in order to harvest that benefit, the fact that you still hold an investment and it has lost money doesn’t allow for you to “realize” that loss in your tax filing – you must sell to lock in that loss for tax purposes. Also beware, once you’ve sold for the loss you cannot buy right back into that investment or a substantially identical holding or contract to buy a substantially identical holding within 30 days: see the SEC Wash Sale Rule. In practice, this can help to take some of the bite our of some of your taxable gains that you’ve had for the year, lets take an example of an investor that has a long term capital gains tax rate of 20% and sold a position for $10,000 in profit (or gains). If they sold the position and took no additional action, they would pay the 20% rate on the $10,000 or $2,000 in taxes. Now, lets say that same investor had a few positions that haven’t produced a return and could be sold for combined long term capital losses of $6,000: if they sell the position they can deduct all $6,000 against the gains ($10,000 gains – $6,000 losses = $4,000 taxable gains). In this instance, you as the investor can take the previous $2,000 tax bill down to $800 ($4,000 cap gain x 20% tax rate = $800) and save $1,200 from that harvesting of losses. Why is this so important? Morningstar conducted a study that showed the average investor is giving up approximately 2% of performance to taxes in their accounts. This is often referred to as tax drag within and account and is in many ways like an additional hidden fee against your investments. For example, lets remember that our investor who sold for the $10,000 gain had to give up $2,000 of that to taxes, the account will only show for the performance of that gain but never factors in what you are paying in taxes behind the scenes. Therefore, in the instance of someone who has a 2% drag on a 5% average rate of return would have a net return of only 3% after taxes.
Watch for Mutual Fund Distributions
Have you ever noticed at the end of the year your mutual funds seem to have a big payout that hits? Many investors we have worked with over the years have taken this to be a large dividend payment however it’s actually a capital gains distribution. This is one of the ways that you can (and may have) ended up with a surprise tax bill from your investments. The reason this is a surprise to most investors is because you took no action in triggering the capital gain (unlike our previous example where it was your sale of the position that triggered the gain) it is the fund accounting for the gains they have realized in the underlying holdings over the course of the year and distributing those gains to you per their obligation. Again, as mentioned before these have no impact on you if these take place in tax deferred accounts but they will be on your tax forms in taxable investment accounts. Dependent on the size and scope of your mutual fund investments these capital gains distributions can add up quick and make noticeable differences in your tax situation.
Assess your Charitable Giving and Consider Your Options
If you are already charitably inclined or have been considering becoming more philanthropic be aware of the ways that you can use these good deeds to benefit your taxes. Charitable giving can be done in cash or via donation of securities. Where this can benefit you as an investor is considering the math behind each way you give those same funds to these charities. Let’s say that we are looking at the same investor we previously outlined with the $10,000 capital gain from sales of a holding and assume the overall value of those securities from the sales are $15,000. Now, if you are someone who gives $5,000 a year in combined donations via cash or check that money has had to go through taxation via payroll, income tax etc and therefore it has taken more dollars altogether for you to donate that $5,000 whereas if you were to donate $5,000 in appreciated securities you are not only having a potential write-off but you are also completely averting the capital gains tax we previously spoke about (and therefore this can be a great path if you don’t have losses to offset the gains). With the new standard deduction and SALT caps you may be in a place where the same $5,000 isn’t used in itemization for your taxes and this can be a chance to “bundle” your giving. What this means is that you can use things like donor advised funds to put the full $15,000 into an account that gives you the full write-off at the time of contribution but allows you to invest and distribute the funds to qualified non-profit charities at your own pace (e.g. you can continue to do your $5,000 per year charitable giving with the funds while having the potential to appreciate the value over that time as compared to cash donations). Work closely with a financial planner and accountant to determine what’s best for your situation.
Take your required distributions
Have a retirement account and you’re over the age of 70 ½? The IRS requires that you take out a percentage of these accounts if they are pre-tax and you are not an active employee in that account’s plan – miss out on this distribution and they could put a penalty of 50% on the amount they requested you take. This also applies to non-spousal inherited retirement accounts. Should you not be sure if this applies to you take the time to speak to a financial planner who can guide you on the requirements of your accounts. In conjunction, they can work directly with your accountant to partner on what your plan is and how both specialists (the planner and the accountant) can help to provide you the best guidance and actionable items that pertain to your unique situation.
Consider where and how you’ve been saving or taking money
As we have outlined in this post, the ways you are putting money away as well as how you may be distributing money from your accounts all has an impact on your situation. Be mindful and have a plan on what vehicles will make the most of every dollar on the way into the accounts, while being held in the accounts, and how/where they are withdrawn from your accounts. A comprehensive financial plan and wealth management planning will help to make the most of all three phases of your journey. As always, partnering with a financial planner as well as a tax professional is highly advised to give the most holistic approach to your unique situation.
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