Time to Get It Together (Tax Planning, That Is)

By Morningstar
December 11, 2014 Updated: December 11, 2014

Video Transcript

Christine Benz: Hi, I’m Christine Benz for Morningstar.com. As the 2014 tax year winds down, what key planning items should investors have on their radar? Joining me to discuss this topic is Tim Steffen; he’s director of financial planning for R.W. Baird. Tim, thank you so much for being here.

Tim Steffen: Great. Thanks, Christine.

Benz: You put out a terrific comprehensive piece about year-end tax planning. There were a lot of items in it. But let’s start with the headline: When you look at the tax year 2014, what should investors have in mind as they start thinking about some tax planning?

Steffen: I think the big theme this year is that there’s not a lot new to talk about. Quite frankly, this has been one of the quietest years, from a tax-legislation standpoint, that we’ve seen in quite a while. There was no significant new legislation this year, so it’s a lot of the same things we dealt with last year. What I have been telling our clients is that you may not like the system we have right now, but at least we know what it is. And it’s going to be consistent this year as it was to last year, so you’ve got some opportunity to kind of plan around. You know what the rules are going to be.

When we have something like this where there’s no big changes in the law from one year to the next, we kind of look at the general theme, which is in most cases–all things being equal–defer your income into a later year, accelerate your deductions into the current year. Push the tax liability off as long as you can, bring the benefit of deductions in sooner.

Benz: So, those overarching rules of thumb we should keep in mind. But let’s take it category by category. I would like to look specifically at capital gains, and there are some strategies that folks can employ depending on their capital gains tax rate. So, let’s start with the folks who are in that zero percent capital gains tax band. There is a strategy that you espouse that folks should look at, and that is potentially selling out of securities that have appreciated and rebuying them potentially at a later date. Let’s talk about the benefits of that strategy and who should consider it.

Steffen: Normally, we wouldn’t recommend for somebody go to sell something, realize a gain, and then buy it right back again. That doesn’t make a lot of sense, usually.

Benz: Right.

Steffen: But if you can do that at no tax cost, then there are some real advantages to doing that. So, there is a zero percent capital gain rate out there that applies to any individual or couple who is in the 15% bracket or lower. For a married couple, you are looking at taxable income of roughly $74,000 or so, and that’s taxable income. So, on a gross-income basis, you are talking even more than that.

So, there is some opportunity there if you’re below those thresholds that realize gains on a tax-free basis. It’s not all gains; it’s only up to that threshold, and any gain over that would be taxed at next rate, which is 15%. But if you are in those lower thresholds, there’s an opportunity to sell stocks or sell funds or whatever it might be, realize a gain at no tax cost perhaps, and then buy it right back again.

Benz: So, as a point of clarification, this is just within taxable accounts. You don’t want to be engaging in this with other types of accounts.

Steffen: Within an IRA, you can buy and sell and there is no tax cost to doing that, but there’s not the opportunity either. You may be incurring fees to sell and buy back again, so then there is not the advantage. So, you’re correct–it wouldn’t necessarily be something you’d focus on there. You do need to take a look, though, just to verify there is no tax impact to you on some of those things.

For example, the tax rate on the capital gain may be zero percent, but there are a lot of other things that go into your tax rate or your effective rate that are independent of the rate on the income itself. For example, recognizing capital gains might not be taxable on themselves, but it could trigger a tax on maybe Social Security benefits. A retiree who’s got a lower level of income might be able to realize capital gains tax-free, but it would turn their Social Security benefits into taxable income–meaning that the capital gain really wasn’t tax-free. So, you’ve got to look at it on more of a macro basis than just focusing on that capital gain and what the tax rate is on that gain itself.

Benz: So, folks in the middle-income tax brackets will pay a 15% capital gains rate. Let’s talk about that top echelon–the people who will be paying a 20% capital gains rate as well as potentially that Medicare surtax. Let’s talk about some strategies that people in that situation might consider.

Steffen: The top rate on capital gains is 20%; that applies to married couples with income at roughly $450,000–a little more than that, actually, for this year. That’s taxable income. And then the Medicare tax you mentioned, that’s part of the [Affordable Care Act] that kicks in for adjusted gross income for married couples at $250,000. That, by the way, is not inflation-adjusted, so that number is going to be hard-coded for a while, and more and more people may be subject to that over time.

Benz: You mentioned that some people may be in for a nasty surprise. They weren’t subject to it last year. They may be this year because of that lack of inflation adjustment.

Steffen: Most numbers are inflation-adjusted these days; that’s one of the few that’s not. So, if you are somebody who is realizing a capital gain that’s going to push you over that threshold, keep in mind what the marginal tax rate is going to be on that. Your rate may be higher than you expected. In those cases, then, you look at the other losses that you could incur or realize to offset that gain to minimize the tax cost of that–or just anything else you can do to keep yourself below those thresholds.

As with all capital gains things, we really like to focus on the investment aspects first–and these should be investment decisions first. Let the tax come after that. There are cases where you really need to focus on the tax side, but make sure it’s an investment decision first.

Benz: So, don’t run around taking tax losses if you didn’t want to sell for some fundamental reason.

Steffen: Correct. You’ve got wash-sale issues to be aware of. If you sell something at a loss, you can’t just buy it right back again, whereas with a gain you can. It doesn’t usually make sense to do it, but there are cases. If you are going to sell something at a loss, you’ve got to be [sure] that you really want to be out of that position.

Benz: So, let’s turn our attention to income tax planning. I thought you had a great point in your piece about multiyear planning–that you shouldn’t just be thinking of this on a year-by-year basis. You should actually look out a couple of years. For whom is this sort of planning the most important?

Steffen: So, we talked at the beginning about how–all things being equal–defer income, accelerate deductions. If you are an individual whose income fluctuates year to year, maybe you are a self-employed person whose income can fluctuate significantly from one year to the next or you’re in sales where you’re commission-based. Retirees are the big ones. So, you go from a full year of income to maybe a partial year of income to a year of no income other than investments and maybe some IRA withdrawals. Your tax rate is going to change pretty significantly over that period, and so you’ve got to really look at what the impact is of moving income or moving deductions from one year to the next. Move the deductions into the year when your income is going to be higher; maybe in a year when your income is falling, that’s the year to look at realizing a capital gain, or maybe even doing a Roth conversion on those lower-income years, taking advantage of that lower rate that you are in.

Benz: I sometimes hear from people who are retired but in their pre-RMD years, where they are not yet taking the required minimum distribution. It seems like there is some wiggle room to do some planning in those years, specifically.

Steffen: Exactly, because you’ve got more control over what your income is going to be in that particular year, because you are not forced to take money out of the IRA. So then, you can decide whether you want to take money out of the IRA, Roth IRA, the taxable account–where does it make the most sense? So, from a tax standpoint, you never want to look at one year in a vacuum; you’ve got to look at it over a couple-year period and just see what strategy is going to give you the lowest tax cost over that multiyear period.

Benz: You also had some tips for folks in the realm of retirement planning and the way that it intersects with tax planning. Let’s talk about some key tips for folks who are still accumulating for retirement, as well as people who are already retired and drawing from their portfolios.

Steffen: So, as you are building for retirement, the easy one is to make sure you maximize your retirement-plan contributions. Get your 401(k), your [Simplified Employee Pension plan], your IRA, your Roth IRA contributions–and you’ve got a little bit more time on some of the IRA things, you can go into next year on those. But with 401(k)s and some of those others, you do need to have those done by the end of the year. So, make sure you’ve got those maximized.

Then, when you are in retirement, you want to look at where you’re taking money from, for example, to manage the tax liability. Do you go into the taxable account or the IRA or the Roth, which one makes the most sense from a tax standpoint? And balancing those, maybe take a little bit from each one. This whole concept of tax diversification–take a little bit of each and manage the overall tax liability.

Benz: Where do you recommend people go for guidance on that? I assume some financial advisors specialize in that sort of planning, but is an accountant a good person to turn to?

Steffen: You’re going to want somebody who can really get into the weeds on the tax side of things, because you’re getting into the nitty-gritty on some of these from a tax-calculation standpoint. Not all advisors are capable or have the tools to do that kind of thing. So, you are probably looking at more of a tax advisor or a CPA, somebody in that realm. But the concepts can certainly be talked about by any advisor, and then the actual calculations you need to go to an accountant for.

Benz: And how about Roth conversions? I know this is on a lot of investors’ minds. But I think about balance as being elevated right now. Is that potentially a headwind if you are thinking about converting some of your IRA assets to Roth?

Steffen: It could be. Remember, when you are doing a Roth conversion, you get to choose how much you want to convert. So, if the account is up, maybe you don’t convert the entire IRA. You are not required to convert your entire account; you can choose how much you want. So, maybe just don’t do as large of a percentage of the account as you could have in other years when the balance is down. And overall, account values being up is a good thing, right? But it may cause it to be more expensive to do a conversion, so you just do a smaller piece of it this year and do more the next year.

Benz: Tim, thank you so much for being here. Some great tips here. We appreciate it.

Steffen: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz for Morningstar.com.

*Image of “declaring taxes” via Shutterstock