Edited by Janet Novack
It can be expensive to be a saver: You owe federal income tax on your profits, plus, sometimes, a 3.8% investment surtax, plus, in most places, state income taxes. Tax-wise investors minimize these burdens. This survey will look at four varieties of tax wisdom.
Until this year, the basic rule was that you should defer gains and accelerate losses. You’d let your winners ride while capturing deductions by closing out losing positions. Capital losses can offset any amount of capital gains plus up to $3,000 a year of ordinary income like salaries. Unused losses can be carried forward indefinitely.
Loss harvesting must be done with attention to the wash sale rule, which puts off the deduction for a stock you buy back within 30 days of the sale. You can avoid this, while mitigating the risk of having the stock rebound during the month you’re out of it, by using a similar but not identical security as a temporary place holder. If a bank stock is under water, for example, you could sell it and buy a financial sector fund.
Most of the Trump tax cut is set to expire at the end of 2025, at which point the top federal rate reverts to 39.6%, the estate tax exemption and standard deduction get cut in half, and a surtax that goes by the name Pease comes back to life.
There is the distinct possibility of a sweep of Congress and the White House by Democrats, who promise to accelerate the sunsetting of the 2017 tax law. More ominously, they would tax long-term capital gains at the same rate as ordinary income, either for everyone or for those in high brackets. They propose to eliminate the step-up that exempts gains on assets an owner holds at death.
The prospect of a rate change can turn the timing rule on its head. If higher rates on capital gains are imminent, and you have appreciated assets that you are likely to sell within the next year or two, it might make sense to sell them in 2020. If you take that tack (decide in late November), you’d hold off on realizing losses until January. Those losses would become more precious in high-tax years.
Locate assets where they will be least damaged by the IRS. The basic rule is to put assets generating ordinary income in a retirement account and assets generating tax-favored income in a taxable account.
Ordinary income comes from bonds, especially those with high yields. It comes from many preferred stocks. Most of the dividend from a real estate investment trust is likely to be ordinary income.
Favorably taxed income includes long-term capital gains and most dividends on stocks that are neither preferred nor REIT shares. It includes the cash flow from directly held rental property, sheltered as that is by depreciation deductions.
It’s surprising how many investors fail to master the basic principles. “I’ve seen self-directed IRAs invested in real estate,” says Philip Ross, a CPA at Exencial Wealth Advisors. “Why put something tax-favored in an IRA?”
Foreign stocks are usually best left in the taxable account, where you can claim a federal tax credit for the withholding tax collected abroad. If they sit in an IRA you aren’t entitled to the credit.
To play the location game you need assets in different tax places: some in a taxable account, some in a pretax IRA or 401(k), some in an aftertax (a.k.a. Roth) retirement account. You can move money from pretax retirement into aftertax retirement with a Roth conversion, which entails prepaying income tax on a slice of your pretax IRA. The Roth conversion is likely to pay off if your tax bracket is destined to stay the same or go up between now and when you retire. Cover the tax bill out of your taxable assets.
You were maybe thinking your tax bracket would go down in retirement? Think again. What’s going to happen in 2026—or sooner if there’s a power shift in Washington? What’s going to happen when Congress notices the deficit?
Accountant Ross often finds himself urging a client to do a Roth conversion big enough to fill up a tax bracket; on joint returns, for example, the 24% bracket ends at $321,450 of taxable income. But don’t Rothify all of an IRA. Having retirement assets divided between pre- and aftertax accounts gives you maneuvering room later in life. Nursing-home bills might send your tax bracket to 0%, an ideal time to do a conversion.
It’s all about the deduction. You can be more generous if Uncle Sam is chipping in.
This year the standard deduction for a couple is $24,800. If you itemize instead, you are limited to a $10,000 deduction for state and local taxes. This means that if your mortgage is paid off the first $14,800 of charity does you no good at tax time. (Tiny exception: For 2020 only, non-itemizers are permitted to deduct $300 of charitable contributions.)
There are three ways to enhance the tax benefit from giving.
One is to bunch several years of giving into one year. If you are donating $10,000 a year, you could put $50,000 into a donor-advised fund now, then use that fund to continue your giving plans for five years. You would be effectively generating a deduction of $35,200 (more than that, if you have a mortgage). A further tax enhancement would come from using appreciated stock to fund the gift; if you’ve held it for more than a year, you escape capital gain tax on the appreciation.
The next method is to use your pretax IRA to make gifts. Once you turn 70-1/2, you can direct the custodian to deliver up to $100,000 a year from the account to charities. Since this asset is destined to become taxable income (for you or for heirs), sending it off to a cause effectively makes the gift tax-deductible. A further benefit comes when you turn 72, at which point the donated IRA money counts toward your mandatory annual withdrawal.
The last technique is one that Ross is recommending to very prosperous clients. This year only, the ceiling on the deduction for charitable giving rises to 100% of adjusted gross income. So it can make sense to combine a very large gift with a very large Roth conversion. Unfortunately, the 100% ceiling is limited to cash gifts (no appreciated securities) and cannot be used with a donor-advised fund.
Come 2026, the federal estate tax exemption shrinks by half to a sum that will be, with inflation adjustments, about $6 million per decedent, or $12 million for a couple. Some important politicians favor trimming the exemption further, perhaps to $7 million for a couple.
Apart from the exotic estate tax dodges involving trusts (which might also come under a political ax), there are some simple methods that people can use to reduce death tax. For the most part, they are effective against not only federal tax but state tax in the 17 states that still tax bequests.
First is the annual gift tax exclusion, now $15,000 per person. A married couple can give $180,000 per year to six descendants (including in-laws) this way.
Next is to prefund 529 college savings accounts with five years of excludable gifts. A couple can use this technique to get $150,000 per grandchild out of their combined estate. If they end up needing the money (because of nursing bills or other misfortunes) they can grab it back, suffering only a modest tax penalty.
The third item on this list is that all-purpose tax dodge, the Roth conversion. Prepaying income tax on an IRA is a gift to whoever inherits the account, and that gift appears nowhere on any estate or gift tax return.
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