Are your holdings organized for tax savings?
Now that your 2012 taxes are filed, it's time to re-examine your investments to determine if a different strategy would save you money on taxes.
This post is by Andrea Coombes of MarketWatch.com.
Planning for taxes is complicated, of course, and will vary depending on your situation. Consulting an expert makes sense, and now that the annual April 15 filing deadline is past, some tax pros may have more time to chat about a long-term strategy.
And don’t forget you’re at the whim of Congress, which can mean smaller changes are better than drastic ones.
"You don’t want to make a huge decision today that you think is going to be this great tax move and have the tax law change in 10 years," said Scott Halliwell, a certified financial planner with USAA, a financial-services firm for military personnel, in San Antonio. "With taxes, everything in moderation is better than all or none,” he said.
Here are eight strategies to consider.
People often argue over whether a traditional 401k or IRA, on one hand, or a Roth IRA on the other is best for retirement savings. But many financial planners say it’s smart to go with each kind of account, and possibly a taxable account, too.
"The people that have all three of these buckets give us the most flexibility to manage their taxes later in life," said Scott Cramer, president of Cramer & Rauchegger, a financial planning firm in Maitland, Fla.
For example, each year retirees could pull just enough taxable income from their IRAs to avoid bumping into a higher tax bracket, and use after-tax income from the Roth for the rest of their needs.
In addition to gaining flexibility, you mitigate against tax uncertainty. Savers are often told the best vehicle for them depends on their retirement tax bracket. But given tax-law uncertainty,
"It’s almost an absurd thing to try to figure out," Halliwell said. "If you went all in in the pretax [traditional IRA] and it turned out your tax bracket in retirement was higher, that’s not going to do you any good."
You’ve come up with your asset allocation — but now how do you divvy up your chosen mix of stock, bond and alternative holdings into various investment locations, depending on tax status?
Even the professionals disagree on what’s best. And what’s best for you will depend on your tax bracket, how long you’ve owned the asset before you sell, and other factors.
Mitchell Freedman, of MFAC Financial Advisors Inc., in Westlake Village, Calif., said he often puts the majority of his clients’ bond holdings in tax-deferred accounts such as 401ks and IRAs, to delay the income-tax hit on the interest.
He said he often puts stocks into taxable accounts, where many investors enjoy a 15% long-term capital gains tax rate. (Investors in the bottom two tax brackets generally pay zero on those gains currently.)
For his part, Brett Horowitz, a certified financial planner and principal at Evensky & Katz in Coral Gables, Fla., said: "Any kind of high-yielding bonds or income-yielding stocks — all those investments that would cause taxes to be high — those go to the top of the list in terms of assets that should be sheltered or put in an IRA."
Tax-exempt municipal bonds, stock index funds that don’t pay out large annual capital gains and similar tax-efficient investments “would go in taxable accounts,” Horowitz said.
Organizing your money for maximum tax efficiency is easier if you’re sitting on cash and can divvy up your money into different accounts. It’s harder if your money is already invested. You run the risk of owing a big tax bill as you sell and reinvest your money on the path to tax efficiency.
"It can be done, but it’s got to be done carefully, sometimes over the course of years," Halliwell said.
A good time to focus on tax efficiency? Each time you rebalance your portfolio.
Sometimes there’s no easy fix for a tax-inefficient portfolio. Halliwell described a couple whose retirement portfolio was built almost entirely on one company’s stock — shares purchased 40 years earlier, now worth millions of dollars.
The problem? They invested in that stock through their IRA, all distributions from which are taxed at ordinary income-tax rates rather than the lower long-term capital gains rates they would have enjoyed in a taxable account.
In the end, the couple divested a small amount of their holdings each year for several years so as to avoid a single big tax hit. But if they’d originally invested in a taxable account, they likely would have paid only a 20% capital-gains tax rate, versus the 35% they owed. (Still, Halliwell said, that’s "a good problem to have.")
If you rely on interest from bonds for a big chunk of retirement income, it may make sense to shift into tax-free bonds.
"The yield on municipal bonds tends to be lower than the yield on taxable bonds, but [investors] may get more after-tax return," Freedman said. Freedman adds that such a move can also increase a portfolio’s diversification.
Whether the move makes sense depends on your tax bracket. If your tax rate dropped when you retired, you may want to shift from tax-free bonds to higher-yielding taxable bonds.
For example, assume tax-free bonds yield 3% and taxable bonds yield 4%. “If you’re under the 25% tax bracket, you’d rather have the higher paying taxable bond even after paying the taxes,” Horowitz said.
When they first retire, retirees often immediately withdraw a large lump sum from their retirement accounts, Cramer said, maybe to pay off a mortgage or buy that longed-for boat.
If the money you withdraw is taxable, it can push you into a higher tax bracket.
"People need to think about the long-term impact," Cramer said. If you pay off a 5% mortgage but the taxable IRA distribution bumps you up into the 25% tax bracket, you’ve made a bad move.
Everyone has a unique financial situation that can affect the possible ramifications of their money moves. And your health, in particular, can change that situation.
Freedman described an elderly couple who had a large taxable portfolio invested in a handful of blue-chip stocks with low cost basis.
You’d think this elderly couple should immediately diversify, right? Not so. Given their poor health, the couple was likely to bequeath their estate fairly soon. If they sold their holdings, they’d face a large capital-gains tax hit. But if they bequeathed those holdings, their heirs would enjoy a step-up in cost basis to the value on the date of death.
"If people are older, if their health is questionable, they may want to avoid selling securities that have a very low basis," Freedman said.
For some, the early years of retirement present a Roth conversion sweet spot. "We have in our case a lot of clients who maybe just retired, they’re now in a lower income stage and they haven’t yet hit 70 where they’re [required to take] IRA distributions," Horowitz said.
That is, their tax rate is relatively low — making it a good time for small, periodic conversions over a few years, since the amount converted is subject to tax.
Converting a portion of an IRA to a Roth can make sense for two reasons, Horowitz said.
First, he expects Congress to hike tax rates eventually, so many retirees are paying lower taxes now than they would later. Two, this strategy reduces retirees’ total holdings in taxable IRAs, so retirees’ future required distributions will be smaller, helping to keep taxes lower, including possible taxes on Social Security benefits.
If you know your tax bill in a particular year is going to be lower than usual — for example, if you’ve got a lot of short-term investment losses you’re writing off — and you’ve got a traditional IRA, consider it an opportunity to convert a portion of that account to a Roth IRA.
"If something is going to bump you down in a tax bracket, you might consider filling that tax bracket back up with a Roth conversion," said Stephen Horan, head of private wealth at The CFA Institute.
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"If you know your tax bill in a particular year is going to be lower than usual — for example, if you’ve got a lot of short-term investment losses you’re writing off — and you’ve got a traditional IRA, consider it an opportunity to convert a portion of that account to a Roth IRA."
You cannot offset IRA conversion income with "a lot of investment losses". You can only offset investment gains with investment losses. Only 3K of regular income can be offset.
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