Breathe Easier Next Tax Season with These Planning Strategies

Every year, most of us smile when we see April 15th in the rearview mirror. The completion of our tax returns being filed marks the beginning of a nine month period where we don’t need to think about funny acronyms and form numbers. Most of us enjoy the period of time from the beginning of summer through the holidays without a thought about our tax situations. While it is easy to understand why we do this, it may be costing us money and adding to our tax anxiety, or tax-iety, if you will. A little bit of effort and forward thinking during our summer and fall months will lead to a much more palatable and, potentially, financially advantageous tax season the following year.

The reason for this is quite simple – tax planning requires actual planning. The popular strategies employed by many individuals and families, such as Roth IRA contribution and conversion moves, charitable giving options and maximizing employer benefit accounts, all require some level of forethought and design to be executed correctly. It is imperative to have coordination between you, your financial advisor and your tax preparer to ensure that the strategies are implemented efficiently.

Popular Tax Planning Strategies

Roth IRA Conversions

In simple terms, a Roth IRA conversion is the act of transferring (converting) pre-tax assets to a Roth IRA account. This will make the converted amount taxable in the year that you transfer the assets into a Roth IRA. One consideration of executing this strategy is how to cover the tax liability on this conversion.

Benefits: All future growth on the converted amount will be tax free, assuming that you follow the established Roth IRA rules. Converting pre-tax assets into a Roth IRA will also allow you to lower the amount of your Required Minimum Distributions as the tax will already be paid on that portion of your assets.

Drawbacks: It is recommended that the tax liability generated by the conversion be paid with funds outside of the converted amount. While this isn’t required, withholding the tax liability amount from the conversion somewhat defeats the purpose of the strategy.

Timing: This can be done anytime during the year, but many prefer the last couple of months to better understand their overall tax situation. Plan a meeting with your tax advisor well in advance.

Backdoor Roth IRA Contributions

A backdoor Roth IRA contribution is utilized when an investor is over the income limit to make a standard Roth IRA contribution in a given year. In this case, a non-deductible contribution is made to an IRA, then converted to a Roth IRA. Beginning in 2010, Roth IRA conversions became available to every income level, thus making backdoor Roth IRA contributions a viable tax strategy.

Benefits: Backdoor Roth IRA contributions have allowed a huge segment of the US population the ability to once again fund Roth IRAs annually.

Drawbacks: For a backdoor Roth to be most tax-efficient, the investor has no pre-tax IRA balance. If you have a pre-tax IRA balance, and then make a nondeductible IRA contribution followed by a conversion, you will have a portion of the conversion taxed subject to the pro-rata rules.

Timing: Backdoor Roth IRA contributions can be made and converted at any time during the year. There are differing opinions on how much time should lapse between the contribution itself and the act of converting it to Roth assets.

Selling Appreciated Securities

A lot of people hold onto an appreciated stock due to the fact that they don’t want to realize the gain and then subject themselves to paying taxes on the gain. There are many reasons that one might want to continue to hold the stock (gift from a grandparent, inherited from a family member, the simple fact that the stock has “done well”, etc.), but there comes a point where it could make sense to part ways with the stock. One of the reasons to consider could be taxes.

Benefits: Some people find themselves between jobs or in early retirement and they don’t have much taxable income. They might find themselves in a lower capital gains tax bracket, or in some cases people are surprised that they may even be in the 0% capital gains bracket. This could be an incredible opportunity to sell an appreciated position. Another benefit is that you could use the funds to do something that you’ve been putting off for way too long (vacation, anyone?). Sometimes it takes a little nudge to take some investment wins and do something with the proceeds.

Drawbacks: You might miss out on future growth potential.

Timing: You can sell any time during the year, but doing so later provides a clearer picture of your income and capital gains bracket.

Donating Appreciated Securities

For those that are charitably minded, you can donate your appreciated stock/mutual fund etc. directly to a qualified charity.

Benefits: You won’t have to pay capital gains on the position (you’re not the one selling it, after all). Furthermore, you can get a tax deduction for the donation, assuming you itemize your deductions.

Drawbacks: You could miss out on potential future growth, and the donation is irrevocable.

Timing: You can donate any time during the tax year. Many people wait until the end of the year for their giving, whether it be for tax reasons, the holiday spirit, or the fact that they are procrastinating. I’d encourage you to consider donating any time throughout the year. Chat with investor relations’ representatives at the charities you support; they may have various needs throughout the year and would be happy to get some financial support outside of the “typical” giving seasons. 

Revisiting Tax-Deferred vs. Roth Contributions

Nowadays most defined contribution plans (i.e. 401(k), 403(b) etc.) offer both tax-deferred and Roth contributions. As an employee, you have the choice as to how you’d like your contributions taxed. “Traditional” contributions are tax-deferred while Roth contributions are taxed upon making the contributions. It isn’t an all-or-nothing decision; you are able to make both pre-tax and Roth contributions if that makes sense for your personal situation.

Benefits: You may be able to be more tax-efficient with your contributions to your 401(k), 403(b), etc.. If you had a significant jump in income that pushed you into a higher tax bracket, it might make sense to focus more on tax-deferred contributions opposed to Roth contributions. On the flip side, if you anticipate a lower income / lower tax bracket it could make more sense to make Roth contributions.

Drawbacks: You could get it wrong! By choosing tax-deferred vs. Roth you are essentially playing a little game of tax bracket arbitrage: Can I tax the money while in a lower tax bracket or can I defer taxes while in a higher tax bracket. However, tax brackets change, income changes, and circumstances change. You could end up deferring taxes on your contributions now but end up in a higher tax bracket in the future when you ultimately take a distribution.

Timing: Ideally earlier in the year. The earlier you make the changes, or shortly after filing your prior year tax return, the more contributions will be subject to your tax-deferred or Roth election. For example, if you waited until December and realized that you wanted to make Roth contributions instead of tax-deferred, you may only get one or two pay periods worth of Roth contributions and it won’t have much of a tax impact in that year.

Exercising Options

Exercising your employer stock options can be an incredibly complex decision. There are many factors outside of taxes that must be considered: Bullishness on the company, liquidity, option expiration, and more. From a tax perspective, you’ll first have to understand if you own a nonqualified stock option (NQSO) or an incentive stock option (ISO).

Benefits: In lower earning tax years, realizing some income by NQSO exercise could make sense. By doing so, you could potentially tax the bargain element, or compensation element, at a lower income tax rate. For an ISO, you can “start the clock” on owning the stock from a capital gains perspective. ISOs have favorable capital gains treatment when a qualified disposition occurs.

Drawbacks: You could potentially exercise a NQSO, pay income taxes on it, and still ultimately lose money if the stock price decreases. Similarly, you could pay money to exercise an ISO, subject yourself to the Alternative Minimum Tax (AMT), and ultimately lose money if the stock price decreases. By exercising an ISO and following it up with a disqualifying disposition (selling within a year of exercise) you could pay ordinary income tax on the bargain element and forgo the preferential capital gains tax treatment. Lastly, whether you’re exercising a NQSO or ISO, you can give up the embedded leverage and time value of holding an option.

Timing: For NQSOs, later in the year could make sense since you would have a better idea of your taxable income for the given tax year. For ISOs, exercising earlier in the year gives you time to hold the stock for a year before potentially having to sell some stock to cover AMT. Reiterating a point mentioned above about the many factors to consider when managing your options: Exercising options can be complex, especially if you own a combination of company stock outright, have RSUs, NQSOs, and ISOs. This typically requires careful coordination between you, your financial advisor, and your accountant.

Tax Loss Harvesting

Tax loss harvesting is the concept of selling investments in taxable accounts at a capital loss to make the loss realized, therefore, allowing it to offset realized gains or ordinary income in a given year, up to $3,000. This is an active strategy that does require understanding the current capital gain or loss status of each position within the portfolio.

Benefits: Tax loss harvesting can be a single-year or multi-year strategy depending on the makeup of the portfolio and performance of the investments. We are also allowed to accumulate losses in a single year that can be used over future years.

Drawbacks: The downside to tax loss harvesting is that we do need to sell the losing positions and accept that we will not participate in a rebound in those positions, should one happen. We also need to be aware of “wash sale rules”, which limits the ability to sell a position and buy it again within 30 days.

Timing: Typically investors look to tax loss harvest towards the end of the calendar year. That said, we recommend using this strategy throughout the year as markets can obviously fluctuate and eliminate the opportunity if we wait until the close of the year.

Adjusting Withholding

Most people do not think about their tax withholdings once they have finished the hiring process at a new employer. However, as incomes go up and tax laws change, it is smart to periodically review your withholding amounts. Our tax situations can also be altered by life changes such as the birth of a child or purchase of a home. 

Benefits: Confirming that the correct amount of tax is being withheld from our paychecks makes it much less likely that we will face tax negative surprises in the future. It also solidifies that we are not withholding too much in tax payments, which means we lose the ability to use that money during the year. For those on a fixed income, it is a good idea to review your withholding from Social Security, pensions, and IRA distributions.

Drawbacks: There are very few drawbacks to verifying and adjusting tax withholdings. The only real drawback is the time it takes to confirm your blended tax rate and matching that to the amount withheld from your paycheck. This is a small price to pay for having confidence that we will receive money back from the IRS and not having to write a check with our returns.

Timing: We would recommend that you check your withholdings sooner versus later. The impact of any change to withholding will go down as the year progresses, because we receive less paychecks as each month goes by. For maximum effect, make any adjustments as close to the beginning of the year as possible.

Conclusion

This list of tax planning strategies is, in no way, a comprehensive list. There are many more things that people can do to improve their situation. This is a handful of the more popular and most-often utilized tactics. We strongly recommend that before making any of these decisions or changes, consult with your financial advisor and your tax professional as different tax situations can yield different results. Please let us know if you have any questions regarding these ideas as we would be happy to discuss them further.