Regardless of whether your investment objective is growth or capital preservation, maximizing your after-tax return should be a primary goal. One of the best ways to increase after-tax returns is to implement tax bracket management. This is a strategy utilized to reduce taxes in high-income years by possibly realizing additional income in lower income years if you expect to receive higher income in future years.
With tax bracket management, you usually aren’t eliminating income, but simply deferring income into another period. So it’s crucial that you consider when and how the realization of the deferred income will be taxed. If done poorly, short-term decisions may actually result in higher taxes at a later date. Therefore, we believe it is important to work with your CPA or tax advisor to develop a long-term plan that optimizes your cash flow while minimizing your tax liability.
Strategies During High-Income Periods
In general, we recommend considering the following strategies during high-income periods.
Take necessary withdrawals from after-tax asset accounts.
These include Roth IRAs (if the five-year and age tests are met), savings and individual or joint investment accounts. Generally, you are not taxed on the money withdrawn from these accounts. However, you could be taxed on any net realized gains, taxable interest income and dividends. Therefore, it is important to generate the funds for withdrawal as tax-efficiently as possible.
Note that long-term capital gains tax rates are usually lower than ordinary income tax rates in higher income years. If you are subject to high-income tax, it should be more tax-efficient to realize long-term gains than withdraw funds from pre-tax accounts.
Sell positions whose current value is below the purchase price first to realize a loss.
Commonly referred to as tax-loss harvesting, this strategy can be used to offset realized gains and potentially eliminate any taxes due on sales. If you have capital gains, especially gains that are taxed in the highest bracket and subject to the net investment income tax, harvesting losses reduces your tax liability. Note that if you repurchase the stock too close to the sale date, the loss could be deferred, so you should discuss this with your investment advisor before taking action.
Estimate the potential capital gains and income distributions from mutual fund investments.
These distributions, which usually occur toward the end of the year, represent taxable income even if the shares aren’t sold. Mutual funds don’t pay taxes and all realized gains and income are passed to the shareholders who are responsible for paying the associated taxes. The projected taxable distribution may justify selling the fund prior to the distribution if the current unrealized gain is less than what is projected to occur. Generally, mutual fund companies provide distribution estimates in November and the distributions occur in December.
Defer discretionary income and avoid taking gains.
One of the easiest ways to defer income is to delay a distribution from an IRA or 401(k) account, as long as you have satisfied the Required Minimum Distribution (RMD) rules for the year.
Self-employed individuals may also have the ability to defer collection of income or withdrawal of funds from their business. Delaying income could be beneficial if income in the following year is projected to be lower than the current year. Keep in mind that when you receive a check, that amount is considered to be income during the year it is received — even if the check is not deposited or cashed until the following year.
Meanwhile, if you have stock options that are expiring and must be exercised in a specific year, it may be advisable to increase retirement plan deferrals or pre-tax contributions to a deferred compensation plan. In these situations, it is better to defer income if you will be in a lower or similar tax bracket when the income is eventually realized.
Maximize efficiency with your charitable donations.
Consider donating appreciated securities that have been held for more than one year, rather than selling securities and donating cash. You will still receive the benefit of a tax deduction of the security’s full fair market value, while the charity is not subject to capital gains tax upon sale. In situations where a large one-time gain occurs, it may be advisable to establish a foundation to receive the tax benefit of the donation in the high-income year while making distributions to charities over many years.
Another strategy to consider is making a qualified charitable distribution from an IRA. If you are going to make charitable donations consider directing all or a portion of your annual RMD directly to charity. This allows fulfillment of your charitable desires without taxation on the income that is withdrawn.
Strategies During Low-Income Periods
In general, we recommend considering the following strategies during lower income periods.
Perform a Roth IRA conversion.
This might make sense if you have substantial tax-deferred holdings and want more flexibility with respect to generating tax-free income or bequeathing appreciated accounts. A well-timed Roth IRA conversion is a great way to increase your non-taxable portfolio, especially if you have substantial pre-tax retirement balances.
Note that there is a five-year waiting period after the conversion before you can withdraw the funds fully tax-free. But if this time frame fits into your retirement withdrawal strategy, a Roth IRA conversion can be very advantageous. In addition, unlike a traditional IRA, you are not required to take RMDs from Roth IRAs since the accounts include after-tax dollars.
Make withdrawals from traditional IRAs or 401(k) accounts.
These withdrawals can be made to fulfill spending needs or simply to move funds tax-efficiently from a pre-tax account to a post-tax account. Distributions taken during low-income years will be taxed at a lower rate and can be utilized in the future with little or no tax implications.
Taking distributions could potentially reduce the balance of the tax-deferred accounts and may lessen the RMDs that must be taken in the future. This is particularly advantageous if you experience a lower income year, but expect income to increase in the future and are over or near the age when RMDs commence (70½).
Harvest long-term capital gains and rebalance your portfolio.
Rebalancing and harvesting long-term capital gains is a good way to take gains in lower income years as well as possibly increase the cost basis of holdings and reduce taxes on sales in future years. If you have a position you don’t want to sell but it has a large gain, you may consider selling a portion of the position and buying it back. This increases the cost basis but doesn’t reduce exposure to the holding. In addition to the lower tax brackets allotted to long-term capital gains (15% or 20%), there is also the elusive 0% rate. If your highest tax bracket is 10% or 15%, then long-term capital gains could be taxed at the 0% rate.
Short- and Long-Term Planning Are Essential
Determining which of these strategies might be most useful for you will depend on your specific financial circumstances. Engaging in both short-term and long-term planning should help yield the most advantageous after-tax results. By proactively managing your tax bracket, you can be sure that you are keeping as much money as possible and proactively managing your cash flows.
This post was originally published on November 7, 2017. It was updated on February 15, 2018 to provide you the most current information.
Aldrich Wealth, LP, (“Aldrich Wealth”) is an investment advisor registered with the U.S. Securities and Exchange Commission. Aldrich Wealth Advisors provides wealth management services where it is appropriately registered or exempt from registration and only after clients have entered into an Investment Advisory Agreement confirming the terms of the client relationship, and have been provided a copy of Aldrich Wealth ADV Part 2A brochure document. The information contained in this document is provided for informational purposes only, is not complete, and does not contain material information about making investments in securities including important disclosures and risk factors. Under no circumstances does the information in this document represent a recommendation to buy or sell stocks, bonds, mutual funds, exchange traded funds (ETF’s), other securities or investment products.
The technical information in this newsletter is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. Please be advised that, based on current IRS rules and standards, the information contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty assessed by the IRS.