Mutual fund distributions, IRA contributions, asset location — these and other elements of clients’ finances factor into popular tax planning strategies. But are you taking full advantage of the tools at your disposal? Financial Planning consulted with several advisors about the tax-minimizing tactics that they employed. Here’s what they had to say about five of the most common techniques:
1. Tax-conscious asset location
A general rule for minimizing taxes on investments is to put taxable bonds in tax-deferred retirement accounts such as traditional IRAs and 401(k)s, and to put stocks and tax-exempt municipal bonds in taxable accounts. But that’s just the start of strategic thinking about tax-smart placement of assets.
Unless a client has specific current income needs, it may be advisable to put not just taxable bonds, but also dividend-paying stocks, in a tax-deferred account, says Divam Mehta, founder of Mehta Financial Group in Glen Allen, Virginia.
Indeed, placing assets other than bonds in tax-deferred accounts may save more money than putting fixed-income securities there, says Dave Bensema, regional leader of planning, Illinois, at BMO Wealth Management.
“Try to first fill the deferred accounts with the assets that have the greatest difference in after-tax values,” Bensema says citing REITs, commodities, and actively managed stocks as examples. Then, he says, put passively managed investments, such as stock index funds or buy-and-hold stock portfolios, in taxable accounts. “Afterwards,” he says, “fill in the bonds after these asset classes have been properly placed.”
Advisors need to tell clients in advance that the performance of their accounts will likely differ because of the way assets are spread across their taxable and tax-deferred retirement accounts, says Claudia Mott, the principal of Epona Financial Solutions in Basking Ridge, New Jersey. A retirement account that mostly holds a client’s fixed-income allocation won’t benefit from potential stock market appreciation, while a taxable account that is largely equity investments could suffer greater losses in a market decline than an account holding bonds as well.
An asset location strategy may need to be re-examined for clients who are either approaching retirement or in it already, says Anjali Jariwala, founder of FIT Advisors in Chicago.
“If a client has a taxable account, rollover IRA and a Roth IRA, the typical ordering of distributions is to draw down the taxable portfolio first, then the rollover IRA and finally the Roth IRA,” Jariwala says. “If all fixed-income instruments are in the tax-deferred accounts, it may make sense as the portfolios are drawn down to structure each account to include both equity and fixed income.” That, she says, will help keep the client’s overall portfolio in balance.
2. Rebalancing with cash flows
If a taxable gains resulting from a scheduled portfolio rebalance will cause adverse tax consequences, then you might want to rebalance using cash flow derived from dividends and/or interest, Mehta says.
Tax columnists George Jones and Mark Luscombe of Wolters Kluwer put together a list of important changes from this year that will carry over into the next.
“The important caveat is that the advisor needs to be made aware by the client of these tax situations,” he says. “In addition, while there may be a tax consequence from selling existing positions, it may still be beneficial long-term to the client if the rebalancing is occurring to capture market dynamics.”
Raising cash can also be an opportunity to rebalance the portfolio back to targets and prioritize selling shares that have a high basis relative to their current prices, Jariwala says. This helps keep capital gains as small as possible. If positions in the portfolio have decreased in value, an advisor can harvest capital losses when raising cash for the client.
Rebalancing through cash flows will often make sense — but so does automatic dividend reinvestment, says Kevin Meehan, regional president of Wealth Enhancement Group in Itasca, Illinois.
“The majority of custodial firms offer automatic dividend reinvestment without transaction fees,” Meehan says. “So if your rebalancing bands are wide enough to avoid being triggered several times per year, the automatic dividend reinvestment approach may make more sense as a way to cut down on transaction costs.”
3. Early IRA contributions and conversions
If a client contributed $5,500 to a traditional IRA at the beginning of January in 2016 and put the money in an S&P 500 index fund, the investment would be worth about $6,160 by the end of that year, Jariwala says.
The possibility of positive returns like that in future years explains why she suggests front-loading annual IRA contributions. “You may miss out on some of the growth if you only have $2,000 to start with and add each month, instead of having the full amount available right away,” she says.
Clients will benefit from the extra months of tax-deferred growth — or tax-free growth in a Roth IRA, Mehta says. And that benefit can add up over time.
Indeed, in 2014 Dan Egan, managing director of behavioral finance and investing at Betterment, found a significant payoff to early contributions when he simulated investment performance over every 10-year period since 1928. In one hypothetical scenario, he invested $5,500 in the S&P 500 index on January 1 every year for 10 years. In another scenario, he invested the same amount for each of those years, but waited to do so until April 15 of the following year, mimicking the behavior of a tax filer making a last-minute IRA contribution.
“On average, investing as early as possible resulted in a $14,507 higher account balance,” Egan writes. “Considering we’ve invested just $55,000 in both scenarios, that amounts to an additional 26% on the invested principal, as compared to the next-year-at-tax-time strategy.”
Doing a Roth conversion early in the year is another strategy that makes sense, says Bud Kahn, managing principal of Wealth Management Strategies in Greensburg, Pennsylvania. He points out, however, that one problem with an early conversion arises if the value of that newly converted Roth drops because of a stock market correction. In that case, the client would be taxed on the amount converted at the beginning of the year even though that investment’s value is much lower later on.
“Good news: The investor gets a do-over,” Kahn says. “He or she can re-characterize the Roth conversion back to a traditional IRA — within certain deadlines — as if the Roth conversion never occurred.”
Clients converting a traditional IRA to a Roth don’t have to convert or unconvert the entire amount, Bensema points out. They can target staying with certain a tax bracket by intentionally over-converting and then pulling some money back to stay in their desired tax bracket. Bensema also suggests evaluating doing Roth conversions during the early years of retirement, after wages stop but before required minimum distributions from retirement accounts kick in.
4. Timing mutual fund investments
Mutual funds typically distribute realized capital gains close to year-end, so clients should be careful to never “buy the dividend,” Kahn says. Clients would have to pay taxes on the distributions of the capital gains, even though they didn’t enjoy the gains during the year, because gains realized earlier in the year are included in the fund’s net asset value when an investment is made later in the year.
“An investor should always wait until after capital gains have been distributed to buy a fund,” says Bud Kahn, managing principal of Wealth Management Strategies.
“This may be one of the unintended consequences of adhering to a strict rebalancing schedule, he says. “An investor should always wait until after capital gains have been distributed to buy a fund.”
For an investor considering purchasing a mutual fund, determining the holder-of-record date before making a purchase could reduce the tax bill come the following April, Mott says. Purchasing a fund just prior to the date of record, she explains, would subject the shareholder to the tax consequences of upcoming distributions even though he or she might not have participated in any of the market appreciation that may have created the gains, or enjoyed any growth of reinvested shares resulting from the fund’s dividend or interest income. Alternatively, an individual could use capital losses from other investments to offset the capital gains reported by the mutual fund.
Clients should also consider the consequence of reinvesting year-end dividends into a fund if they might have to liquidate some of that fund to pay taxes in April, says David Levi, senior managing director at CBIZ MHM in Minneapolis.“I often advise people to take those dividends in cash, and then, if it makes sense — and after factoring in the potential tax cost of those dividends — repurchase,” Levi says. “This can also be an opportunity to rebalance.”
5. Managing the Alternative Minimum Tax
For clients who can control the timing of their income, AMT strategies can create tremendous tax savings, Levi says. Especially important is managing incentive stock options, since decisions about exercising them and selling stock purchased with those options can make a huge difference in tax bills.
If you are subject to AMT, you may want to accelerate income into that year — perhaps by converting part of a traditional IRA into a Roth — “so you are paying on your regular income tax and not AMT,” Jariwala says.
Put another way, instead of paying AMT and having nothing to show for it, it’s probably better to boost your ordinary income, and pay your ordinary income tax (and not the AMT tax), and receive some after-tax money in return.
“In the AMT years, you may want to hold off on doing large charitable donations like contributing to a donor-advised fund,” says Anjali Jariwala, founder of FIT Advisors.
Keep in mind that the US taxing system imposes a dual tax and you pay on the higher of your ordinary income tax or AMT. “In the AMT years, you may also want to hold off on doing large charitable donations like contributing to a donor-advised fund, as you may not receive the full benefit for it. The AMT tax rate is usually 28% so if you have a year where you are in a much higher tax bracket, you will receive more benefit from the charitable donation. ”
Clients can also reduce their AMT bill by maximizing contributions to their retirement plans and health savings accounts, and avoid ownership of private activity bonds that pay interest, which is exempt from regular income tax, but not AMT, Kahn says.
“Unfortunately, more taxpayers find themselves subject to AMT because the income threshold for AMT hasn’t been adjusted for inflation,” he says.
