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Tax Planning and Preparation Tips for Investors Thumbnail

Tax Planning and Preparation Tips for Investors

Ever feel like your day just slips away? Like your to-do list keeps growing, no matter how hard you work at it? I felt that way a few years ago and decided to do something about it. Using the 100 Blocks Method, I charted how I was spending my days to learn where my time was going. 

My personal time audit revealed a lot of, well, wasted time. Too much social media, too much news, too much multitasking. I claimed back my minutes by charting my ideal day and trying to live by it as best I could. My wife thought I was crazy – building a daily schedule, ten minutes at a time. But for me, at least, it helped me refocus and prioritize what I wanted to accomplish. 

The same principle applies to your income, your investments, and your taxes. Sure, you might be investing in your 401(k), but are you really optimizing you overall tax picture? Are you letting your hard-earned dollars slip away without knowing where they go? We want to pay the IRS what they are due, but we don’t want to tip them.

Utilize these tax tips to minimize your tax bill and ensure you are getting the most out of your investment choices. 

1. Defer Income with Retirement Accounts

One of the easiest ways to reduce your current income tax bill and take advantage of tax-deferred investment growth is to contribute to retirement savings accounts. Though there are many types of retirement savings accounts, the two broadest categories are employer-sponsored plans and IRAs

Employer-sponsored plans are plans offered as part of a benefits package through your employer. The most popular examples include 401(k), 403(b), and 457(b) accounts. In a traditional 401(k), employee contributions reduce taxable income in the year contributed, but withdrawals are taxed (and may be subject to a penalty if withdrawn prior to age 59 ½). Employers can contribute to an employee’s 401(k) as well, though there are strict rules to ensure that the plans are not compensating top employees too heavily. 

Additionally, there are annual contribution limits for employer-sponsored plans. The contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan is $19,500 (in 2020). The catch-up contribution limit for employees ages 50 and over who participate in these plans is an additional $6,500. Further, the combined employer and employee contribution limit is $57,000 (in 2020).

IRAs are another type of retirement savings vehicle. There are two basic types: traditional IRAs and Roth IRAs. In traditional IRAs, funds are contributed on a pre-tax basis but taxed when withdrawn. Like 401(k)s, traditional IRAs allow for tax-deferred investment growth. They also may be subject to a penalty for early withdrawal. In Roth IRAs, funds are contributed on an after-tax basis but qualified withdrawals are tax-free. The rules governing eligibility, contributions, withdrawals, and other provisions for IRAs are very complicated and we recommend speaking with a tax or financial advisor. 

2. Cover Healthcare Costs Effectively

Proper and comprehensive healthcare coverage for you and your family should always come first. And while we wouldn’t recommend letting the tax tail wag the healthcare dog, it is worth understanding the tax implications of your healthcare choices.

Health savings accounts (HSAs) are the gold standard for tax-advantaged accounts. Funds contributed to an HSA are tax-deductible, grow tax-deferred, and can be withdrawn tax-free for qualified medical expenses. To contribute to an HSA, you need to be enrolled in a high-deductible healthcare plan (HDHP). The contribution limits are $3,500 for an individual and $7,000 for a family. HSA holders ages 55 and older can contribute an extra $1,000, for a total of $4,500 for an individual and $8,000 for a family.

A bonus (and often underappreciated) feature of HSAs is that they turn into a pseudo-retirement account once you turn 65. Withdrawals after 65 for non-qualified medical expenses are not subject to penalty, though they may be subject to taxes. 

Ideally, you would contribute to an HSA and allow the funds to compound, tax-deferred (or even tax-free) for years. The funds could then be used for health needs later in life, like a long-term care event. However, even if you don’t have the ability or desire to save in this manner, you can contribute to the account today and withdraw immediately for qualified medical expenses. This effectively means you get a discount on those medical expenses equal to your marginal income tax rate.

Another tax-advantaged healthcare account is the healthcare flexible savings account (or FSA). The healthcare FSA is a pre-tax account that’s used to pay for eligible medical, dental, and vision care expenses. For 2020, employees can contribute $2,750 to health FSAs.

Two things to note about healthcare FSAs: First, you cannot have both an HSA and a healthcare FSA (though you can have an HSA and a dependent-care FSA). Second, FSAs are “use it or lose it” within a plan year. Any unused funds left over at the end of the plan year are forfeited.

There are two options to ameliorate this, though plans are not required to offer either of them. Under current law, plan sponsors have the option of allowing employees a grace period of up to two and a half months after the year ends to use remaining funds for qualified FSA expenses. Additionally, employees who participate in FSA programs that do not include a grace period now are allowed to roll over up to $500.

3. Bunch Your Deductions

The Tax Cuts and Jobs Act of 2017 changed many facets of income tax planning. With the removal of personal exemptions and the increase in the standard deduction, almost 9 out of 10 households will simply take the larger standard deduction.

This change in filing strategy had the unintended consequence of reducing, or even eliminating, your ability to claim certain itemized expenses, like medical expenses, mortgage interest, or charitable deductions, against your income. For instance, if the combination of all your potential itemized deductions is less than $24,400 in 2019 (for Married Filing Jointly (MFJ) filing status), you would simply take the standard deduction and get no tax benefit for your donation.

All is not lost, however. A popular strategy to clear the standard deduction hurdle is to bunch several years’ worth of donations into a single year. Let’s look at an example to illustrate the power of bunching:

The Millers are a married filing jointly household that typically makes $10,000 of charitable donations each year. Now assume their other potential itemized deductions — things like interest on their primary home mortgage and state and local taxes — total another $12,000. The total of all of the Millers’ potential itemized deductions ($22,000 in this case) is below the $24,400 standard deduction level. So, in any given year, the Millers would take the standard deduction since it’s larger than their itemized deductions.

But now let’s look over a multiyear horizon. If the Millers bunch together three years’ worth of charitable donations in one year, they can now itemize their deductions in year one and take the standard deduction in years two and three. Total deductions over this three-year span equal $30,000 (bunched charitable donation in year one) + $12,000 (other itemized deductions in year one) + $48,800 (standard deduction in years two and three) = $90,800. Simply taking the standard deduction over those three years would equal $73,200. At a 24% federal bracket (ignoring state tax), the Millers would save $4,224 in taxes by using the bunching strategy.

4. Manage Your Taxes On Investments

Understanding the risk and return expectations of your investment choices is paramount. We advocate for a low-cost, long-term, and diversified investment approach.

That said, your investments should also be viewed through a discerning tax lens. What are the tax consequences if you sell that security in your taxable brokerage account that you just bought last week? Or what if you want to finally get rid of that underperforming stock after years of watching its value decline?

Selling securities at a loss allows you to offset realized capital gains in your portfolio. In addition to offsetting realized gains, you also can deduct up to $3,000 of realized investment losses annually. This strategy, called tax-loss harvesting, is a nice complement to other maintenance investment strategies like rebalancing. However, you need to be mindful of IRS rules on wash sales and the nature of the gains and losses realized (short-term, long-term).

Further, if you realize investment losses over and above your realized capital gains and the annual $3,000 limit, you can carry forward your losses to offset future realized gains. 

The timing of your investing choices matters, too. Gains on securities held for less than twelve months are taxed at your regular income tax levels. Long-term gains, or gains on securities held for over twelve months, are subject to more favorable rates of 0 percent, 15 percent, and 20 percent. Note, though, that a portion of your realized gains could also be subject to an additional 3.8 percent Medicare surtax.

 5. Choose Tax-Efficient Investments

The types of investments you choose, as well as the category of account that holds them, will also affect your overall tax picture.

Mutual funds, the investment vehicle of choice until the recent growth of ETFs, have interesting tax considerations. Mutual funds distribute their earnings of interest, dividends, and capital gains every year. You may incur a tax liability if you are an owner of a mutual fund on its record date and you hold the mutual fund in a taxable account.

Note, if you choose to reinvest mutual fund distributions back into the mutual fund, these distributions remain taxable even though you never received the cash in hand. However, these reinvested distributions can be used to increase the cost basis of your holdings.

Exchange-traded funds (ETFs) generally are more tax efficient than mutual funds, though the investment style and mandate will affect the overall tax efficiency for both types of investment vehicles. For instance, passive funds tend to create fewer taxable events than more actively managed funds. There are also different tax considerations for equity versus fixed income ETFs and mutual funds. 

The tax treatment of individual securities also varies. Municipal bonds, for instance, are often exempt from federal taxes and may, in some cases, offer unique state tax benefits. Other investment choices like real estate investment trusts (REITs) and individual bond interest payments are taxed as ordinary income. Further, qualified dividends on equity securities are subject to the same tax rates as long-term capital gains, which are lower than ordinary income tax rates.

Another important piece of the investment tax puzzle is optimizing the types of securities across the different categories of investment accounts. We cover this topic in more detail in another blog post, but properly diversifying your account types and where your assets are located could add anywhere from 0.20 percent to 0.50 percent, annually, to your return, according to two different studies from Morningstar and the Journal of Financial Planning.

Tax Planning with Harbor Crest Wealth Advisors 

Proper tax planning can seem complicated, but the tax tips laid out in this article can help simplify the process. If you would like to discuss our approach to tax planning, please contact us and we will happily speak with you about how to optimize your overall tax picture.