“It’s déjà vu all over again.” This tax season, Yogi Berra’s observation certainly applies to the Federal Income Tax Code. Because The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended all the Bush tax cuts only through 2012, we once again find ourselves planning for a future increase in tax rates. Significantly, on January 1, 2013, the top income tax rate will increase from 36% to 39.6%, qualified dividends will become subject to ordinary income tax rates, and the maximum tax on long-term capital gains will jump from 15% to 20%, with the addition of the 3.8% Medicare surtax. While we can always hope Congress will grant another last minute extension, our nation’s steep deficit makes a tax hike of some kind seem inevitable.
While plenty is uncertain about the future of the American tax code, viewing your tax situation through a multiyear lens can reduce your current tax bill and position your portfolio for higher future taxes. Consider these strategies:
- Harvest portfolio losses. It’s been a volatile year in the market. While many investors give up on tax loss harvesting, or selling losing positions, in years when they have not registered significant portfolio gains, the exercise is never a waste of time because in addition to offsetting portfolio gains, up to $3,000 of remaining net capital losses can be deducted from your ordinary income on your tax return for this year. What’s more, losses above that $3,000 can be carried over to future years and used to offset future portfolio gains. These stockpiled losses could be especially valuable if tax rates increase in 2013.
- Accelerate gains. Because it’s likely the capital gains tax rate will increase to 20 percent or more by the end of 2012, you may want to take gains at the maximum rate of 15 percent now. This is especially true if you have a low basis position and have specific expenses, such as college tuition, coming up in the next year or two. That said, because the tax tail should never wag the dog, this advice doesn’t apply to buy and hold positions.
- Use taking gains as an opportunity to diversify. Maybe you have inherited a security that has been in the family for years. Accelerating gains with the sale of a single stock is almost always a smart thing to do from a risk management perspective. This year, making the decision to sell a concentrated position not only eliminates the volatility typically associated with a single stock and reduces overall portfolio risk, but today’s tax bill likely will be more favorable than 2013’s.
- Diversify retirement savings from a tax standpoint. Having taxable and non-taxable accounts to draw from in retirement makes even more sense in an uncertain tax environment. While pre-tax savings accounts, such as 401(k) accounts benefit investors who have a lower income in retirement; after-tax savings accounts, such as a Roth IRA, can be advantageous in the event an investors’ income increases in retirement. Because we are looking at higher tax rates in the future, it is possible that your income could decrease in retirement, but that the tax brackets might be adjusted such that you would be paying higher taxes on that lower income. Therefore, for added flexibility at distribution time, it may be wise to fund both taxable and non-taxable retirement accounts.A Roth IRA, where after-tax dollars grow tax-deferred and qualified distributions are tax-free, is a great way to diversify. While Roth’s income limits prevent many investors from opening an account, on January 1, 2010, the income limits for converting traditional, rollover, SEP, SIMPLE IRAs, and 401(k) or other workplace savings plans with former employers to a Roth IRAs were removed. Before this change, only investors—single or married and filing jointly—with modified adjusted gross incomes of $100,000 and below could convert. Although there are still income limits for contributing to a Roth IRA, today anyone—regardless of their income—can convert retirement assets from a traditional IRA to a Roth.
- Preserve wealth through increased gift exclusions. Through 2012, the gift exclusion has been increased to $5 million, and the estate and gift tax rates are set at 35 percent. The benefits of gifting assets you won’t need are two-fold. Your gifts get the future appreciation out of your estate and you get to enjoy helping family members now. This opportunity may be short-lived. Unless Congress acts, the gift exclusion will drop back to $1 million and the estate tax rate will increase to 55 percent on January 1, 2013.
- Donate or gift appreciated stock. Gifting appreciated stock instead of cash to your favorite charity has long been a solid tax strategy, but the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 left the window open, through the end of this year, for an estate planning opportunity. Because the Act extended the 0 percent capital gains rate on long-term investments for taxpayers in the 10 and 15 percent tax brackets, you might consider gifting appreciated stock to any adult children in these low tax brackets. If your child is married filing jointly this year, he can have taxable income up to $68,000, or $34,000 for individuals, and not have to pay capital gains tax.
- Consider non-cash charitable contributions. If you donate your old clothes and unused household goods to charity, you’ll enjoy a de-cluttered home, feel good about helping others and benefit from a tax deduction. Just make sure you follow the IRS’ new rules about receipts. The IRS stipulates that contributions of $250 or less need a receipt for the charity. Donations valued between $250 and $500 need a written receipt as well as a more detailed record of the name and address of the charity and a written description of the goods that notes their condition. If you donate property valued at more than $500, you must follow the previously described rules and fill out Form 8283. If your donation exceeds $5,000, you will need a written appraisal to attest to its value. Similarly, if you donate art, you’ll need a signed appraisal and photo to attach to IRS Form 8283.
- Sweat the paperwork. Because marriage, divorce, the birth of a child, or a change in salary can alter your tax situation, you should check in with your employer to ensure your withholding is correct if you recently experienced any of these life events. Also, last January, the Patient Protection and Affordable Care Act specified that over the counter medication drugs can no longer be reimbursed from flexible spending accounts, so remember to make any necessary adjustments to your account. Finally, regulations governing basis and sales reporting by securities brokers were finalized in early 2011. Notably, because you now have the right to choose the method used to determine your security’s basis, you have additional flexibility in determining the gain or loss when you sell securities.
Current uncertainty in the tax arena makes it even more essential that we evaluate your portfolio through a multi-year lens. Accordingly, we recommend that you consult your financial advisor to discuss these opportunities in greater detail and to consider others that may pertain to your unique situation.
At Bernhardt Wealth Management, our investment decisions are never driven solely by tax rates. Rather, we conduct the broad analysis required to ensure our clients are in the best shape this April 15th and that your portfolio is optimally positioned for the long-term.