The goal in retirement savings is to sock away as much as you can reasonably afford to. Elective deferrals to company plans provide a mechanism to save money for retirement and defer income tax.
Elective Deferrals are amounts contributed to a plan by the employer at the employee's election and which, except to the extent they are designated Roth contributions, are excludable from the employee's gross income. Elective deferrals include deferrals under a 401(k), 403(b), SARSEP and SIMPLE IRA plan. https://www.irs.gov/retirement-plans/plan-participant-employee/definitions
One issue with investing a percentage of your bonus, especially if you are a higher-income employee maxing out your 401(k), is that it might cause you to hit your annual contribution limit, currently, $19,500 ($26,000 if you are 50 or older), before the calendar year is up. And if you hit the $19,500 cap too early in the year, you could miss out on company matches in the later months.
Here is an example, let's say you earn $200,000 and you are under age 50 (not eligible for catch-up contributions). By contributing 10% of your annual salary, you can stretch your contributions all the way into December. If you contribute any amount less than 10% you will not have contributed up to the $19,500 maximum by December. If you contribute more--let's say 15%--you will have already maxed out your $19,500 maximum contribution somewhere around the beginning of August, so you would miss out on collecting more than four months' worth of employer match. In the example above, 10% is the sweet spot in terms of 401(k) contribution percentage, where (depending on your salary) you are not exceeding the annual IRS contribution limit before the end of the calendar year, which will also allow you to also nab the full employee match. But also be aware that not all plans work this way--some plans match after-tax contributions or include provisions that "true-up" or reconcile the employer contribution to make sure employees get the maximum potential match. If you're not sure how your plan works, ask your benefits department or consult the plan document.
Historically, many Financial Advisors and Money Managers have linked a portfolio’s turnover ratio with being an indicator of how tax-efficient a portfolio, such as a mutual fund, might be. The common thought was a high turnover meant higher taxation. While this can certainly lead to higher taxes, if the portfolio is selling positions at a profit, it does not necessarily mean that the portfolio is tax inefficient or that it is a good measure of tax-efficient management. It may be a better indicator as to why a fund's internal management expenses are higher than other funds and may be more appropriate for measuring the cost-effectiveness of the portfolio manager and not tax efficiency. To understand this let’s look at what portfolio turnover is first.
The portfolio turnover ratio indicates the number of a portfolio’s positions that have been replaced over the course of a given year. Actively managed mutual funds typically have more portfolio turnover vs. index funds and exchange-traded funds (ETFs). This is because these types of funds rely on a manager’s decision making on portfolio positions and whether to hold them or sell them, depending on the mandated management strategy of the fund and market conditions. Index Funds and ETFs tend to have smaller turnover because these types of funds are attempting to mimic an index of securities or a specific theme of investment in securities. Indexes typically only reposition the portfolio of securities once a year. Thematic baskets of securities tend to remain consistent based on the theme of the investment, not the performance of the actual underlying securities in the investment. This supports the notion that index funds and many exchange traded funds tend to have lower turnover than actively managed mutual funds. An example of how turnover works is that a fund holding 100 securities and replacing 75 of them for one year would have a 75% turnover ratio. This could lead to higher taxation, but not always. It is important to also know that a turnover ratio can exceed 100% if the manager of the fund holds the positions for less than a year.
One might believe that higher turnover means higher taxation, but that is not definitively true and has been somewhat overused as an indicator of tax efficiency over the years. Taxes only occur if there are realized profits. That said, stocks that are sold at a loss in the portfolio are counted in the turnover ratio but reduce taxation by offsetting gains in other stocks that are sold. Therefore, a portfolio manager tasked with being more tax efficient can have a higher than expected turnover ratio with a low tax liability. It is important to note that a buy and hold strategy-low turnover will likely produce a more tax-efficient portfolio, but there are many other portfolio management techniques’ that can greatly reduce tax impact. We will not get into the portfolio management technique’s in this article, but other common techniques are loss offset trading, continual loss harvesting, gains-tilted investing and tax lot accounting.
It is important to remember that taxes are only paid on realized gains. That said, effective turnover is a more accurate indication of a portfolio’s tax efficiency. Effective turnover is a measure based on the percentage of accumulated unrealized capital gains that are realized and distributed on an annual basis. For the taxable client, total turnover (turnover ratio) is not as important as the frequency at which capital gains are realized. It is often difficult to find this statistical reference point for a fund, but if provided, it is a better way of evaluating tax efficiency of a portfolio.
Many mutual funds will provide their tax efficiency ratio on their websites and marketing materials. A tax efficiency ratio is calculated by dividing the annual tax-adjusted earnings by pre-tax earnings. Lastly, Morning Star often provides a Tax Cost Ratio for most funds it provides analysis on. This ratio measures how much a fund’s annualized return is reduced by taxes investors pay on distributions. This ratio is indicated from 0% to 5%. 0 % shows the fund did not have taxable distributions for the time and 5% indicates the fund was significantly less tax efficient.
Turnover Ratio is only a part of the tax efficiency equation of a portfolio. Looking at more direct ratios will provide a better insight into the tax efficiency of a portfolio or fund. The first place to look would be the fund manager’s mandate. Are they tasked with being tax efficient? Then looking at the turnover ratio, along with the other measures we discussed, will give you a better idea of the efficiency of the fund or portfolio.
Investors are often faced with having to take a potential capital gain on a highly appreciate stock, ETF or mutual fund investment when that investment begins to underperform and increases the risk in a taxable portfolio. This phenomenon often creates conflicting emotions as many investors seek to minimize tax or avoid them all together. Recently there are many examples of this due to a long bull market that appears to be entering its later stages and companies such as Facebook where headline issues have caused the stock to pull back significantly. The first instinct often is to sell the investment to reduce the risk and exposure. However, the realization that a large tax bill will accompany this transaction often will make an investor hesitate or not act at all. So, what can one do or how should one go about managing this issue.
First the good news is that paying capital gains tax means the investor has made money and that is ultimately the goal. In these situations, the tax treatment is typically long-term capital gains tax which is taxed at substantially lower rates than short term capital gains. A couple of ways to reduce the potential tax liability is to look for other positions to sell that may be at a loss either long term or short term. Those losses will be netted against gains and hopefully reduce tax liability. Carry over losses may also be applied if the investor has them.
Other strategies are to donate the investment to a charity or donor advised fund and take a charitable contribution to reduce taxation and eliminate the investment from one’s portfolio. The investor in this case does not have the asset for personal use or the proceeds from a sale to use but they will get a tax deduction. The tax deduction will be for the Fair Market Value of the stock. The limitation on the amount of the deduction taken in the year donated will be 30% of Adjusted Gross Income (AGI) for a public charity or 20% of AGI for a private charity. Any amount left over can be carried forward for 5 years.
Two other strategies are to set up a capital gains budget by selling enough shares equaling an amount of capital gains the investor is willing to absorb and/or an amount of capital gains that can be absorbed by the investors current capital gains bracket without pushing them into the next higher tax bracket. Be careful to also consider the 3.8% Medicare surtax triggers at the higher income tax bracket levels. Lastly a Staggered or Staged Selling strategy may be used. This is where the investor agrees to sell at certain predetermined prices with a commitment from the investor to do so ahead of time regardless of market conditions. This is a more disciplined approach that requires the investor to understand that future growth in the investment can be lost in order to reduce potential tax burden's and further diversify the portfolio in order to reduce risk.
The new tax plan will impact investors in many new ways. We will cover some of the more important aspects of the act and opportunities for 2018 tax year.
Rates, Exemptions and Standard Deductions
The new tax brackets for 2018 vs. 2017 are as follows:
There has been some rate savings at the top 6 brackets and the income ranges that correspond with them have gone up which should help lower potential tax liabilities over all income ranges. The $4,050 tax exemptions have been eliminated for the taxpayer, payer’s spouse, children and other dependents. The standard deduction has almost doubled from $6,350 to $12,000 for single filers, $12,700 to $24,000 for joint filers. 90% of the people who will claim the standard deduction will likely see a lower tax bill and complete simpler tax returns. However, their opportunities for tax planning will also be limited to self-employment, fringe benefit and some credit strategies. One example many are talking about is the tax filer with a home in the $200,000 or so range and a mortgage of $160,000 will likely claim the standard deduction now eliminating the need to itemize deductions and reducing the tax incentives of home ownership.
Many itemized deductions have changed.
Deductible medical expenses have a new threshold of 7.5% of taxable income down from 10%. This threshold was lowered for tax years 2017, 2018 and 2019 under the act. This may create and opportunity to schedule discretionary medical procedures to 2018 and 2019 under this new threshold.
State and Local Income, Sales, and Real and Personal Property Tax
The deduction on a filers federal return has been limited to $10,000. For high tax states like California and New York this will impact filers negatively. States such as California are exploring ways to help minimize the impact of the state and local tax deduction cap with restructuring how tax payments are characterized to include the portion that is more than the cap as a charitable contribution.
Mortgage Interest Deduction
Existing mortgages are grandfathered in and subject to the previous cap on interest expense on acquisition indebtedness of up to $1 million dollars. Under the Tax Act new interest indebtedness for up to two homes is capped at $750,000 for loans from December 15, 2017 through 2025. Interest on home equity loans is no longer deductible after 2017 through 2025. This also adversely effects tax filers in high property value states such as California.
The deduction for charitable contributions remains unlimited but the amount deductible in any given year is subject to certain percentages of Adjusted Gross Income (AGI) depending on the type of property contributed. Any excess remaining is carried forward to be used in future years. Charitable cash contribution limitations have increase from 50% to 60% of AGI under the new law.
Tickets and Seating
The deduction for payments connected to the purchase of tickets and preferential seating at athletic events has been repealed.
Casualty and Theft Losses
The deduction allowance for casualty and theft losses is now allowed only for presidentially declared disaster areas.
Miscellaneous Itemized Deductions
Tax preparation fees, investment expenses and unreimbursed employee expenses after 2017 are now disallowed. Filers with significant unreimbursed cost for things such as employee expenses, mileage, internet and phone charges and education expenses are recommended to request an excludable working conditions fringe benefit arrangement or accountable plan from their employer.
Phase-out of Itemized Deductions
The phase out of deductions after higher levels of adjusted gross income levels has been eliminated under the new plan. For filers who are single and married with itemized deductions close to standard amounts a “bunching” strategy with discretionary deductible expenses may provide a tax planning opportunity. Discretionary expenses may include charitable contribution, medical expenses and the state and local taxes below the new $10,000 capped amount.
Alternative Minimum Tax (AMT)
2017’s AMT exemption is $54,300 for unmarried individuals and $84,500 for married individuals filing jointly. This exemption was phased out at $120,700 for unmarried individuals and $160,900 for married individuals filing jointly. The new tax act significantly increases these exemption amounts to $70,300 for unmarried individuals and $109,400 for married individuals filing joint returns. The phaseout thresholds have also been raised significantly. New threshold levels are $500,000 for unmarried individuals and $1,000,0000 for married individuals filing jointly. The effect of this is that many filers who have lost out on deductions, especially due to the state and local tax deduction cap, may pay more regular tax but may pay less total tax because they will now avoid the alternative minimum tax.
Child and Family Credit
The child tax credit increase to $2,000 per qualifying child under the new plan. $1,400 is refundable. It also adds a $500 nonrefundable credit for other qualifying dependents. The phase out ranges for this tax credit have been greatly increased from $110,000 to $400,000 for married filers filing jointly and from $75,000 to $200,000 for all other taxpayers.
The “Kiddie Tax” and Trust and Estate Tax
The new tax act completely changed the tax on unearned income of children. No longer does the parents income or the income of sibling’s factor in. Earned income is taxed at unmarried taxpayer rates. Net unearned income is taxed according to more unfavorable rates that are applicable to trusts and estates. Trust and Estates earning from $0 to $2,550 are tax at 10%, $2,550 to $9,150 at 24%, $9,150 to $12,500 at 35% and more than $12,500 at 37%.
Section 529 Savings Plans
The utility of the funds in these plans has changed to now include the use of up to $10,000 per year for a child’s elementary and secondary education for public, private or religious schooling.
Estate, Gift and Generation-Skipping
Under the new tax act, the exemption for estate, gift and generation-skipping tax has gone from $5.6million to $11.2million per individual. For couples it is now $22.4million. The income tax basis step-up or step-down at death remains.
No longer can an individual reverse a Roth conversion by re-characterizing it. A person can continue to contribute to their Roth IRA and re-characterize those contribution to a Traditional IRA if it happens before the due date of their individual tax return for that year.
The new law makes alimony and maintenance payments no longer deductible to the payor spouse or includible in the income of the payee spouse. Divorce settlement structures will certainly be impacted going forward.
The deduction for moving expenses is suspended under this law except for those in the Armed Forces (and their spouse and dependents) who are on active duty and move due to military order to a permanent change of station.
Before acting on any of the aspects discussed here, tax filers and investors should check with their accountants and advisors to make sure that their situation and needs are evaluated and proper advice specific to them is given.
Make sure your beneficiary designations are up to date and accurate.
- Check that the person or persons listed on all accounts that have beneficiary designations are the people you intend them to be.
- Make sure that the percentages given to these individuals are how you want them.
- Understand the type of designation you are making and what happens if one of your beneficiaries passes away before you do.
- Lastly, make sure that the beneficiaries on all of your accounts are coordinated properly with your wishes and other estate planning documentation.
This chart comes from the College for Financial Planning and provides a quick reference guide for those wondering if they need estate planning.
Ultimately everyone can use some degree of estate planning weather it is simple Wills and Powers of Attorney to more sophisticated Trust structures designed to avoid taxation and provide instruction on who gets what and how they receive it upon death.
|Client Situation||Primary Concern|
|Clients with minor children||Need to provide for the personal and financial care of the minors in the event both parents die prior to the minors’ attaining the age of majority|
|Clients owning assets in multiple states||Need to avoid ancillary probate so as to avoid increased administrative costs and estate shrinkage|
|Small-business owners||Interest younger family members in the business; assure marketability of the owner’s interest if the interest is to be sold at retirement or death|
|Clients who have sufficient wealth to leave a taxable estate at death||Ensure sufficient estate liquidity to pay taxes without having to sell estate assets|
|Clients who want specific assets (or a specific amount of assets) to pass to a specific beneficiary at death||Need to avoid intestate distribution when property is not disposed of by will or will substitute|
|Clients in high-risk occupations, such as a doctor||Need to protect personal assets from the claims of potential creditors|
|Clients who have non-U.S. citizen spouses||Need to provide for spouse’s financial well-being after client’s death, but keep estate taxes to a minimum; the marital deduction is available only in limited circumstances|
|Clients who may become disabled in the future||Need to appoint decision maker for medical and financial decisions; possibly qualify for Medicaid|
|Clients with domestic partners||Need to avoid intestate distribution when property is not disposed of by will or will substitute|
Roth IRAs have a specific advantage vs. Traditional IRAs when it comes to distributions.
For a Traditional IRA all distributions are deemed to consist of both contributions and earnings. This makes the entire distribution taxable becasue the contributions where made with pretax money.
Roth IRA potential distribution advantages over a Traditional IRA are based off of the order of distributions. There are three types of distributions that occur with Roth IRAs:
1) Return of Contributions: Principle is returned first, and there is no income tax or 10% penalty assessed on this portion.
2) Return of Conversion Amount: If there was a conversion of Traditional IRA money to a Roth IRA this money will not be subject to income tax, since it was taxed when converted. If the individual is under age 59 1/2 it will be subject to the 10% early withdrawal penalty if the funds have not been in the Roth IRA for at least 5 years from date of conversion.
3) Return of Earnings: Earnings come out last. They will not be taxed if it is a qualified distribution. Qualified Distribution is a distribution of money for an individual attaining 59 1/2 and the five year holding requirement has been met. If it is not a qualified distribution, then it will be subject to income tax and the 10% early withdrawal penalty for individuals under 59 1/2 years old.
Being able to distribute contributions first and avoid taxation is a big advantage of Roth IRAs.
Social Security offers three distinct types of benefits for retired workers and/or their spouses:
- Retired Worker benefit, which is based on his or her own earnings record.
- Spousal Benefit, which provides a worker’s spouse with a benefit once the worker has claimed his own benefit.
- Survivor Benefit, which provides a surviving spouse with a benefit after a worker’s death.
Taking time to get a complete understanding of a family’s total financial picture is key to developing strategies to effectively manage taxes. Taxes are inevitable and after tax returns are crucial to achieving wealth planning goals.
One strategy called Asset Location is a technique that can greatly enhance the amount of return that is kept and not paid out in taxes. Asset Location refers to how an investor distributes their investments over taxable accounts such as a Trust brokerage accounts, tax-deferred accounts such as IRA’s and 401ks, and tax-exempt accounts such as Roth IRA’s and Roth 401k’s. Allocating assets that pay the lower long term capital gains tax rates to your taxable accounts and allocating assets that pay higher income tax rates to tax deferred and tax exempt accounts allows investors to keep more of the return they make.
One simple example: An investor with $1 million in an IRA and $1 million in a Family Trust may have an asset allocation of 50% Equities and 50% Fixed Income. If currently both portfolios are situated with this allocation, shifting the assets that are taxed as ordinary income, 39.6% Federal rate, to the tax-deferred IRA and shifting assets that are taxed at the more favorable long term capital gains rates of up to 20% Federal to the taxable trust account could generate tax savings. The potential shift may be to move the taxable fixed income assets over to the retirement account and move the more tax favorable long term capital gains taxed assets, such as equities and ETFs intended to be held for longer than a year, to the taxable account. This will change the allocation percentages inside of each account; however with proper execution the overall 50% Equities, 50% Fixed Income allocation will remain constant in order to achieve the desired total investment allocation and risk profile.
Shifting assets in this way must be looked at and executed carefully. It may take time to implement in order to keep fees generated low and to minimize the unnecessary triggering of a realized tax liability.
In order for this type of strategy to work requires viewing all investment portfolios through one asset allocation strategy that all the accounts make up. Having the ability to get consolidated performance reporting for all of your accounts from your advisor no matter where they are held is important to monitoring the success of this strategy.