There is not much you can do about lowering your 2018 tax liability just a few days before the April 15th filing deadline, but, since taxes are on everyone’s mind, it seems like a good opportunity to think about moves you can make to affect the outcome of your 2019 and 2020 tax return. While we are not CPA’s, as financial advisors, we keep a keen eye on how things flow to the tax return. We hope the following list of tactics might prove to be helpful to your individual situation and reduce your tax bill.
Capital Gains
If a stock or fund is sold for more than you paid, a capital gain is created. If the stock was held for less than a year, the sale creates a short-term gain and is taxed at ordinary tax rates. If the security is held for more than one year and sold a long-term gain is realized. These long-term gains are taxed at preferred tax rates of 0%, 15%, 18.8%, or 23.8%. So, clearly holding on to your investments for more than a year is usually beneficial, especially if you are in a higher tax bracket. If a security is sold for less than you paid, a capital loss occurs. Up to $3,000 of losses can be used each year to offset ordinary income. Anything above that can be carried forward to future tax years to offset gains. This is called tax-loss harvesting and can be an effective tax strategy in bear markets. We did it for some at the end of 2018 when the market went haywire.
Qualified Dividends
Qualified dividends are paid by US companies and qualifying foreign companies. Qualified dividends are a tax efficient item. They are taxed like capital gains either at 0%, 15%, 18.8%, or 23.8%. So, clearly if you are in a low tax bracket (income less than $78,750 for married couples) you might possibly escape taxation of qualified dividends entirely. If you a lucky enough to make a lot of money and are in the top 37% tax bracket, the most you will pay on qualified dividends is 23.8%. There are some holding period requirements for stocks and mutual funds you will want to check to qualify for this special treatment. Ordinary dividends on-the-other hand are taxed at your regular tax rates. So, if you are a high wage earner, those qualified dividends are looking very appealing.
Tax Location Management
So now that we know that qualified dividends and long-term gains are beneficial to investors, you might want to think about where you place assets that generate them. If you put the qualified dividend generating US stock or index fund in your IRA or 401(k), you are going to pay ordinary tax rates when you make a distribution from the account or when you are required to at age 70 ½. But, if you hold the US stock or index fund in a non-retirement account, the qualified dividends will likely be taxed at lower rate. A lower rate doesn’t always apply, so it helps to perform some tax projections so you can make an educated decision. If it looks like the strategy would work, then put the bonds and other ordinary dividend producing asset classes in the qualified retirement plans.
Also, remember that most mutual funds pass any capital gain distributions to their investors whether you want them or not. You have no control on the investment activity of the fund manager. An index fund is different though. Since the companies don’t change inside the index, there are no capital gains unless a company is replaced by another in the major index. But, even then, there is a loophole called a heartbeat that negates any gain in that situation. That is a topic for another day. Since you lose tax control with actively managed funds, they too are best held in a qualified plan.
Municipal Bonds and MLP’s
There are two exceptions to putting bonds and high dividend payers in the IRA account. One is municipal bonds since they pay tax-free dividends. The other is individual master limited partnerships which offer tax-deferred dividends. Those are best held inside a non-retirement account since they offer the most tax benefits to an investor. This doesn’t mean that everyone should own them as there are positives and negatives depending on the type of investor you are and your tolerance (or NOT) for risk. Perhaps we should dedicate a future blog to muni’s and MLP’s as they are both interesting as well as complicated asset classes.
Itemized Deductions
The Tax Relief Act of 2018 changed everything. The biggest change aside from lower tax rates was that now most taxpayers will file using the standard deduction since it was raised ($24,400 in 2019) plus another $1,300 for each taxpayer over age 65. No more can you assume that things like mortgage interest expense or charitable contributions are going to help you, unless they are big numbers. Even then, the mortgage loan cap is now limited to $750,000 in order to get the interest deduction. Any debt incurred above that does not qualify for a tax deduction. Plus, real estate tax and state tax deduction is capped at $10,000 which is especially painful for those in states like New Jersey where residents pay higher property and income taxes.
But, for those who don’t have much mortgage debt, pay low real estate taxes, and little state income tax, the new standard deduction is a real bonus, despite losing the personal exemptions.
Qualified Retirement Plan Contributions
Contributing to your 401(k) or IRA is a great way to reduce your current tax bill since you are effectively lowering your taxable income by the amount of the contribution. If you participate in a 401(k) plan you can contribute up to $19,000. And, if you are over age 50, you can sock away another $6,500. If you don’t have a company plan option you can invest in an IRA account up to $6,500. Whether that amount is deductible depends on your income level. If you are married and your adjusted gross income is less than $102,999 you are able to deduct the full $6,500 contribution. There are partial deductions for those who earn more.
Self-Employed
Don’t forget to use the new 20% pass-through deduction. The pass-through was created to for business owners since the corporate tax rates were reduced under the new tax code. There is a lot to use of this deduction that goes way beyond the scope of this blog, however, business owners need to know of its existence and can do some special income planning to take full advantage of the deduction.
Social Security Timing
Remember, you can file as early as 62 or wait until age 70. When you do ultimately file, 85% of the benefit (for most) will be taxable. So, you will want to expand the scope of the decision beyond a simple life expectancy/break even analysis to looking at it’s impact on the tax return. Could it affect how your qualified dividends and capital gains are taxed? Yes. Could it affect qualifying for the Affordable Care Act health insurance tax subsidies? Yes. Could it affect other areas where income limits count? Yes.
So, remember pulling one lever just might trigger another tax in another part of your tax return which is reason to keep your eyes wide open when making important financial decisions. We are just touching the tip of the iceberg in this blog. There is a lot to know and many more details and rules. We are not advocating for making all financial decisions based on the impact to the tax return solely but hope the more knowledge you have about which levers exist will help you make better investment and tax related decisions. As always, we are available for any clarification or questions you might have as you plan for the next tax year which always seems to arrive very quickly!
