Five End-of-Year Tax Tips
Since we’re approaching the end of another fiscal year, this is a good time to start developing your tax strategies. Here are five tips to consider.
- Try to avoid selling investments that you have held for less than one year. The gains on such investments are taxed at the short-term capital gains tax rate, which is your marginal ordinary tax rate. In 2013, that rate ranges from 10% to 39.6% depending on your Adjusted Gross Income (AGI). The long-term capital gains (LTCG) tax rate – for investments held for more than one year – is only 0%, 15%, or 20%. Be aware that there is an additional 3.8% net investment tax applied to all investment gains for taxpayers with AGI greater than $200K (single) or $250K (married filing jointly or MFJ).
- If you plan to make any charitable contributions this year, it’s better to contribute highly appreciated investments such as stocks or funds rather than cash. You can deduct the fair market value of the investments and at the same time avoid paying taxes on the LTCG (since you never actually sell the investments). However, a caveat is that such contributions are limited to 30% of your AGI (rather than 50% if you were to contribute cash).
- Consider a Roth conversion. If your marginal tax rate this year is expected to be lower than when you will be in your seventies, then a Roth conversion – which involves transferring assets from a tax-deferred IRA or 401(k) to a tax free Roth – may be worth making. You would pay taxes this year on the conversion to avoid paying presumably higher taxes in later life, maximizing your overall lifetime wealth. A Roth conversion may be especially beneficial to married couples with a wide disparity in ages. After the first spouse dies, the surviving spouse’s filing status will change from MFJ to Single. Assuming the surviving spouse inherits the deceased spouse’s tax-deferred accounts, the Single filing status will result in a higher tax rate for the required minimum distributions from the IRAs or (401)ks as compared to the previous MFJ filing status. And unless the surviving spouse remarries, the new higher tax rates will apply for that spouse’s remaining lifetime.
- Consider tax loss harvesting. This involves selling assets with embedded losses in order to offset the taxes you will have to pay on gains from other assets. Even if you don’t plan on selling any investments this year, it’s important to keep in mind that mutual funds and ETFs do have end of year distributions that will be taxable to you. Note that this strategy applies only to investments in taxable accounts, not to those in tax-deferred or tax-free retirement accounts.
- If you are planning to purchase mutual funds or ETFs, you might consider waiting until after any end of year distributions have occurred. Otherwise you will end up having to pay taxes on those distributions in 2013. Ultimately you will get the paid taxes back when you sell the funds, since such distributions increase your cost basis in the investments. The reverse might make sense, however, if you expect to be in a higher LTCG tax bracket in the future and want to take advantage of the lower LTCG 15% rate (or avoid the 3.8% net investment tax) this year.
There are numerous other tax strategies to consider when approaching a tax year transition. Be sure to discuss them with your tax professional or financial planner, preferably well before the end of the year.