Tax Strategies Under Biden

Tax Strategies Under Biden

With the Presidential election next month, investors may be wondering about what might happen to their taxes if Joe Biden were to win. Let’s take a look at his tax plan and discuss strategies which may make sense for high income investors to consider. I am sharing this now because we might consider steps to take before year end, which is a short window of time.

Let’s start with a few caveats. I am not endorsing one candidate or the other. I am not predicting Biden will win, nor am I bashing his proposals. This is not a political newsletter. Even if he is elected, it is uncertain that he will be able to enact any of these proposals and get them passed through the Senate. The discussion below is purely hypothetical at this point.

My job as a financial planner is to educate and advise my clients to navigate tax laws for their maximum legal benefit. I create value which can can save many thousands of dollars. Some of Biden’s proposals have the potential to raise taxes significantly on certain investors. If he does win, we may want to take steps before December 31, if we think his proposals could be enacted in 2021. I would do nothing now. I expect no significant changes under a continued Trump administration, but I will also be looking for tax strategies for that scenario.

Other Biden proposals will lower taxes for many people. For example, he proposes a $15,000 tax credit for first-time home buyers. I am largely ignoring the beneficial parts of his tax plan in this article, because those likely will not require advance planning.

Tax Changes Proposed by Biden

1. Tax increases on high earners. Biden proposes to increase the top tax rate from 37% back to 39.6%. He would eliminate the Qualified Business Income (QBI) Deduction, which would penalize most self-employed business owners. He would limit the value of itemized deductions to a 28% benefit. For those with incomes over $1 million, he proposes to increase the long-term capital gains and qualified dividend rate to the ordinary income rate, an increase from 20% to 39.6%, plus the 3.8% Medicare surtax. He proposes to add 12.4% in Social Security payroll taxes on income over $400,000.

Strategies:

  • Accelerate earnings, capital gains, and Roth Conversions into 2020 to take advantage of current rates.
  • Accelerate tax deductions into 2020, such as charitable donations or property taxes. Establish a Donor Advised Fund in 2020.
  • Increase use of tax-free municipal bonds, and use ETFs for lower taxable distributions. Shift dividend strategies into retirement accounts.
  • Use Annuities for tax deferral if you anticipate being in a lower bracket in retirement.

2. 26% retirement contribution benefit. Presently, your 401(k) contribution is pre-tax, so the tax benefit of a $10,000 contribution depends on your tax bracket. If you are in the 12% bracket, you would save $1,200 on your federal income taxes. If you’re in the 37% bracket, you’d save $3,700. Biden wants to replace tax deductibility with a flat 26% tax credit for everyone. On a $10,000 contribution to a 401(k), everyone would get the same $2,600 tax credit (reduction). This should incentivize lower income folks to put more into their retirement accounts, because their tax savings would go up, if they are in the 24% or lower bracket. For higher earners, however, this proposal is problematic. What if you only get a 26% benefit today, but will be in the 35% bracket in retirement? That would make a 401(k) contribution a guaranteed loss.

Strategies:

3. End the step-up in cost basis on inherited assets. Currently, when you inherit a house or a stock, the cost basis is reset to its value as of the date of death. Under Biden’s plan, the original cost basis will carry over upon inheritance.

Strategies:

  • If parents are in a lower tax bracket than their heirs, they may want to harvest long-term capital gains to prepay those taxes.
  • Life Insurance would become more valuable as death benefits are tax-free. Or Life Insurance proceeds could be used to pay the taxes that would eventually be due on an inherited business or asset. Read more: The Rate of Return of Life Insurance.

4. Cut the Estate Tax Exemption in half. Presently, the Estate/Gift Tax only applies on Estates over $11.58 million (2020). Biden wants to cut this in half to $5.79 million (per spouse).

Strategies:

  • If your Estate will be over $5.79 million, you may want to gift the maximum amount possible in 2020. Alternatively, strategies such as a Trust could be used to reduce estate taxes. (For example, the Intentionally Defective Grantor Trust (IDGT) or Grantor Retained Annuity Trust (GRAT).)
  • Be sure to use all of your annual gift tax exclusion, presently $15,000 per person.
  • Establish 529 Plans, which will be excluded from your estate.
  • Shift Life Insurance out of your Estate, using an Irrevocable Life Insurance Trust (ILIT).

While we don’t know the outcome of the election, there could be valuable tax strategies under Biden. We will continue to analyze economic proposals from both candidates to develop planning strategies for our clients. When there are significant changes in tax laws, we want to be ahead of the curve to take advantage wherever possible.

CARES Act RMD Relief

CARES Act RMD Relief for 2020

The Coronavirus Aid, Relief, and Economic Security CARES Act approved this weekend eliminates Required Minimum Distributions from retirement accounts for 2020. If you have an inherited IRA, also known as a Stretch or Beneficiary IRA, there is also no RMD for this year. We are going dive into ideas from the CARES Act RMD changes and also look at its impact on charitable giving rules.

Of course, you can still take any distribution that you want from your retirement account and pay the usual taxes. Additionally, people who take a premature distribution from their IRA this year will not have to pay a 10% penalty. And they will be able to spread that income over three years.

RMDs for 2020

Many of my clients have already begun taking their RMDs for 2020. (No one would have anticipated the RMD requirement would be waived!) Can you reverse a distribution that already occurred? Not always. However, using the 60-day rollover rule, you can put back any IRA distribution within 60 days.

If you had taxes withheld, we cannot get those back from the IRS until next year. However, you can put back the full amount of your original distribution using your cash and undo the taxable distribution. You can only do one 60-day rollover per year.

For distributions in February and March, we still have time to put those distributions back if you don’t need them. Be sure to also cancel any upcoming automatic distributions if you do not need them for 2020.

If you are in a low tax bracket this year, it may still make sense to take the distribution. Especially if you think you might be in a higher tax bracket in future years. An intriguing option this year is to do a Roth Conversion instead of the RMD. With no RMD, and stocks down in value, it seems like a ideal year to consider a Conversion. Once in the Roth, the money will grow tax-free, reducing your future RMDs from what is left in your Traditional IRA. We always prefer tax-free to tax-deferred.

Charitable Giving under the CARES Act

Congress also thought about how to help charities this year. Although RMDs are waived for 2020, you can still do Qualified Charitable Distributions (QCDs) from your IRA. And for everyone who does not itemize in 2020: You can take up to $300 as an above-the-line deduction for a charitable contribution.

Also part of the CARES Act: the 50% limit on cash contributions is suspended for 2020. This means you could donate up to 100% of your income for the year. This is a great opportunity to establish a Donor Advised Fund, if significant charitable giving is a goal.

Above the $300 amount, most people don’t have enough itemized deductions to get a tax benefit from their donations. Do a QCD. The QCD lets you make donations with pre-tax money. Of course, you could do zero charitable donations in 2020 and then resume in 2021 when the QCD will count towards your next RMD. But I’m sure your charities have great needs for 2020 and are hoping you don’t skip this year.

The Government was willing to forgo RMDs this year to help investors who are suffering large drops in their accounts. To have to sell now and take a distribution is painful. However, if you already took a distribution, you are not required to spend it. You can invest that money right back into a taxable account. In a taxable account, the future growth could receive long-term capital gains status versus ordinary income in an IRA. I’ll be reaching out to my clients this week to explain the 2020 CARES Act RMD rules. Feel free to email me if you’d like our help.

Tax Planning

Tax Planning – What are the Benefits?

Taxes are your biggest expense. Tax Planning can help. A typical middle class tax payer may be in the 22% or 24% tax bracket, but Federal Income Taxes are only one piece of their total tax burden. They also pay 7.65% in Social Security and Medicare Taxes. If they’re self-employed, double that to 15.3%. Most of my clients here in Dallas pay $6,000 to $20,000 a year in property taxes, more if they also have a vacation home. After getting to pay taxes on their earnings, they are taxed another 8.25% when they spend money, through sales tax. 

High earners may pay a Federal rate of 35% or 37%, plus a Medicare surtax of 0.9% on earned income and 3.8% on investment income. There’s also capital gains tax of 15% or 20%. Business owners get to pay Franchise Tax and Unemployment Insurance to the state. Add it all up and your total tax bill is probably a third or more of your gross income.

I’m happy to pay my fair share. But I’m not looking to leave Uncle Sam a tip on top of what I owe, so I want make sure I don’t overpay. I help people with their investments, prepare to retire someday, and to make sure they don’t get killed on taxes. It’s vitally important.

The tax code is complex and changes frequently. We have talked about how the Tax Cuts and Jobs Act changes how you should approach tax deductions. This past month, I’ve been talking and writing about the new SECURE Act passed in December.

It’s February and people are receiving their W-2s and 1099s and starting to put together their 2019 tax returns. I like to look at my client tax returns. We can often find ways to help you reduce your tax burden and keep more of your hard-earned money, completely legally.

Two sets of eyes are better than one.

I’m not a tax preparer, and I don’t mean to suggest that your tax preparer is making mistakes. While I have, of course, seen a couple of errors over the years, they are rare. However, I think there is a benefit to having a second set of eyes on your tax return. I may look at things from a different perspective than your CPA or accountant. As a Certified Financial Planner professional and Chartered Financial Analyst, I have extensive training on Tax Planning and have been doing this for over 15 years.

Tax preparers are great at looking at the previous year and calculating what you owe. What I sometimes find is that they don’t always share proactive advice to help you reduce taxes going forward. 

For example, this month, I met with an individual and looked over his 2018 tax return. He would have qualified for the Savers Tax Credit but did not contribute to an IRA. I told him “your CPA probably mentioned this, but last year, if you had contributed $2,000 to a Roth IRA, you would have received a $1,000 Federal Tax Credit”. Nope, he had never heard about this from his long-time preparer, and let’s just say he was displeased. While his tax return was “correct”, it could have been better.

When you become a client of Good Life Wealth Management, I will review your tax return and look for strategies which could potentially save you a significant amount of money. Such as?

5 Areas of Tax Planning

1. Charitable Giving Strategies. It has become more difficult to itemize your deductions and get a tax savings for your charitable giving. We identify the most effective approach for your situation. For example, donating appreciated securities or bunching deductions into one year. If you’re 70 1/2, you could make QCDs from an IRA. Or we could front-load a Donor Advised Fund to take a deduction while you are in a higher tax bracket before retirement. If you are planning to make significant donations, I can help your money go father and have a bigger impact.

2. Tax-advantaged accounts: which accounts are you eligible for and will enable the greatest contribution? No one can tell without looking at your tax return. Let’s maximize your pre-tax contributions to company retirement plans, IRAs, Health Savings Accounts, and FSAs. Often someone thinks they are doing everything possible and we find an additional savings avenue for them or their spouse.

3. Investment Tax Optimization. Do you have a lot of interest income reported on Schedule B? Why are those bonds not in your IRA or retirement account?  Are your investments creating short-term gains in a taxable account? Do you have REITs which don’t qualify for the qualified dividend rate? You could benefit from Asset Location Optimization. 

Showing a lot of Capital Gains Distributions on Schedule D? Many Mutual Funds had huge distributions in 2019. Let’s look at Exchange Traded Funds which have little or no tax distributions until you sell. There may be more tax-efficient investments for your taxable accounts. Are you systematically harvesting losses annually?

4. If you make too much for a Roth IRA, are you a good candidate for a Backdoor Roth IRA?

5. Tax-Efficient Retirement Income. What is the most effective way to structure your withdrawals from retirement accounts and taxable accounts? When should you start pensions or Social Security? How can you minimize taxes in retirement?

I could go on about tax-exempt municipal bonds, tax-free 529 college savings plans, the Medicare surtax, or reducing taxes to your heirs. It’s a long list because almost every aspect of financial planning has a tax component to it. 

Most Advisors Aren’t Doing Tax Planning

Even though taxes are your biggest expense, a lot of financial advisors aren’t offering genuine tax planning. For some, it’s just not in their skill set, they only do investments. For a lot of national firms, management prohibits their advisors from offering tax advice for compliance reasons. Other “advisors” specialize in tax schemes which are designed primarily to sell you an insurance product for a commission. I’m in favor of the right tool for the job, but if you only sell hammers, every problem looks like a nail. 

Tax Planning is making sure that all the parts of your financial life are as tax-efficient as possible. If you’d like a review of your 2018 return before you complete your 2019 taxes, give me a call. I get a better understanding of a client’s situation by reviewing their taxes and I really enjoy digging into a tax return. 

While I can’t guarantee that we can save you a bunch of money on your taxes, we do often have ideas or suggestions to discuss with your tax preparer. That way you can participate more than just dropping off a pile of receipts. If you do your taxes yourself, as many do today, you can ask me “Are there any additional ways to reduce my taxes?” Let’s find out.

SECURE Act Retirement Bill

Tax Savings under the SECURE Act

A few weeks ago, we gave an overview of key changes under the SECURE Act Retirement Bill. Today we are going to dive into a few questions that investors have been asking about the Act. Here’s how the SECURE Act can help you reduce your tax bill.

RMDs and QCDs

1. Required Minimum Distributions are pushed to age 72 from 70 1/2. If you turned 70 1/2 in 2019, even though you won’t reach 72 in 2020, you will still be responsible for taking RMDs. You will not get to skip a year. 

2. Although RMDs have been pushed to 72, the age for Qualified Charitable Distributions (QCDs) was unchanged at age 70 1/2. I’ve read some articles suggesting people under 72 not do QCDs now. Sure you could wait until after 72 to count a QCD towards your RMD. However, most donors I know want to support their favorite charities annually. So if you are 70 1/2 and want to make a $5,000 charitable donation this year, consider three scenarios:

  • You could make a cash donation. To be able to deduct your charitable donations, you have to have more than $12,400 (single) or $24,800 (married) in itemized deductions for 2020  It’s likely that a $5,000 donation nets you no tax benefit.
  • Or you could donate appreciated securities. If you had a $5,000 position with a $2,500 cost basis, donating those shares would save you $375 in long-term capital gains. (Most tax payers are in the 15% LT rate.)
  • With a QCD, it wouldn’t save you any taxes this year. But it would remove $5,000 from your IRA, saving you in future taxes. If you are in the 24% tax bracket, that would save $1,200 in future income taxes. That’s still the best choice of these three options.

529 Plans Can Pay Student Loans

3. Beneficiaries of a 529 College Savings Plan can now use their account to pay up to $10,000 in student loans. This will help those who have finished and have leftover funds. But also, there could be an advantage to deliberately taking $10,000 in Stafford Loans in the first or second year of college to receive deferment on the loan until after you’ve graduated. Then the funds can grow for four or so years while the student receives a loan which has no payments or interest accruing. Upon the end of the deferment period, you could use the 529 to pay off the loan in full. Additionally, owners of a 529 plan can also use the funds to pay $10,000 towards a sibling’s student loans, should the original beneficiary not need the funds.

Stretch IRA Eliminated in 2020

4. With the elimination of the Stretch IRA, we previously shared tax saving strategies for owners of larger IRAs. Here’s one additional approach for a married couple who both have IRAs and plan to leave them to their children. Assuming both spouses have more funds than they will need in their lifetime, consider making your children the primary beneficiaries of your IRAs. Otherwise, the traditional approach of leaving each IRA to the spouse will ultimately double up the tax burden on the children as well as increasing RMDs for the surviving spouse. Since all inherited IRAs must be distributed in 10 years or less, it may be more tax efficient for the children to receive two distributions spread out, rather than one combined inheritance from the second-to-pass parent. Contact me for an examination of your specific situation. 

Annuity for Retirement Income?

5. 401(k) plans can now offer annuities for retirees to create a guaranteed income stream. This sounds like a big deal, but you have always been able to do this once you roll over your 401(k) into an IRA. And it still might be better to buy an annuity in an IRA for a couple of reasons:

  • You could shop for the best annuity product for you. Otherwise, you are stuck with whatever the plan sponsors have decided to offer. It could be that another insurance company offers higher payout rates. Contact me for quotes if this is something you are considering.
  • Your State Insurance Guaranty Association probably only protects $250,000 in losses should an Insurance Company go bankrupt. Some of the biggest ones, including AIG, almost failed back in 2009. If I had $400,000 or $600,000 to invest in annuities, you bet I’m going to divide that between two or three companies to stay under the covered limits. (Read more on the Texas Guaranty Association.)

Changes in law are common and an important reason for having an on-going financial plan with a professional who is staying informed. If you have questions about how the SECURE Act Retirement Bill could be beneficial or detrimental to your situation, please contact me. Our first meeting is always free.

2019 Year-End Tax Planning

As 2019 draws to a close, we review our client files to consider if there are any steps we should take before December 31. Here are some important year end strategies we consider.

1. Tax Loss Harvesting

If an ETF, mutual fund, or stock is down, we can harvest that loss to offset any other gains we have realized during the year. Some mutual funds will distribute year end capital gains, so it is often helpful to have losses to offset those gains. If your losses exceed gains for the year, you can use $3,000 in losses to offset ordinary income. This is a great benefit because your ordinary income tax rate is often much higher than the typical (long-term) capital gains rate of 15%. Any additional losses are carried forward into future tax years.

We can immediately replace a sold position with another investment to maintain our target allocation. For example, if we sell a Vanguard Emerging Markets ETF, we could replace it with an iShares Emerging Markets ETF. This way we can realize a tax benefit while staying invested.

2019 has been a terrific year in the market, so there will be very few tax loss trades this year. That’s a good thing. Tax loss harvesting applies only to taxable accounts, and not to IRAs or retirement accounts. Conversely, when we rebalance portfolios and trim positions which have had the largest gains, we aim to realize those gains in IRAs, whenever possible.   

2. Income Tax withholding under the Tax Cuts and Jobs Act (TCJA)

For 2018, the TCJA lowered the withholding schedules for your federal income tax. Although many people paid lower total taxes for 2018, some were surprised to owe quite a bit in April 2019 when they completed their tax returns. Since your employer doesn’t estimate how much your spouse makes, or what deductions you may have, it is very easy to under-withhold for income taxes.

If you did end up owing taxes for 2018, the situation will likely be the same for 2019 if you have a similar amount of income. For W-2 employees, contact your payroll department to reduce your dependents. If you are already are at zero dependents, and are married, ask them to withhold at the single rate, or to add a set dollar amount to your payroll withholding.
If you are self-employed, you should do quarterly estimated payments. For more information on how to do this, as well as how to avoid underpayment penalties, see my article: What Are Quarterly Tax Payments? 

3. Bunch Itemized Deductions

After the TCJA, the number of tax payers who itemized their deductions fell from around 35% to 10%. If you anticipate having itemized deductions for 2019 (over $12,200 single, $24,400 married), you might want to accelerate any state/local taxes (subject to the $10,000 limit) or charitable contributions to be paid before December 31. Bunch your deductions into one year when possible to make that number as high as possible, and then take the standard deduction in alternate years.
Read more: 9 Ways to Reduce Taxes Without Itemizing

4. IRAs and the Required Minimum Distribution

If you are over age 70 1/2, you have to take a Required Minimum Distribution from your IRAs by December 31. Additionally, if you have an inherited IRA (also called Beneficiary IRA or Stretch IRA), you may also be required to take an RMD before the end of the year. When you have multiple retirement accounts, each RMD will be calculated separately, but it doesn’t matter which account you use for the distribution. As long as the total distribution for the year meets the total RMD amount, you can use any account for the withdrawal.

If you have not met your RMD and are planning charitable contributions before the end of the year, look into making a Qualified Charitable Distribution from your IRA. This offers a tax benefit without having to itemize your return, and the QCD can count towards your RMD.Read more: Qualified Charitable Distributions from Your IRA

How to Pay Zero Taxes on Interest, Dividends, and Capital Gains

How would you like to pay zero taxes on your investment income, including interest, dividends, and capital gains? The only downside is that you have to live in a beautiful warm beach town, where the high is usually 82 degrees and the low in the winter is around 65.

If this sounds appealing to you, you should learn more about the unique tax laws of Puerto Rico. As a US territory, any US citizen can relocate to Puerto Rico, and if you make that your home, you will be subject to Puerto Rico taxes and may no longer have to pay US Federal Income Taxes. You can still collect your Social Security, use Medicare, and retain your US citizenship. (But not vote for President or be represented in Congress!) 

Citizens of Puerto Rico generally do not have to pay US Federal Income Taxes, unless they are a Federal Employee, or have earned income from the mainland US. This means that if you move to PR, your PR-sourced income would be subject to PR tax laws. In 2012, PR passed Act 22, to encourage Individual Investors to relocate to PR. Here are a few highlights:

  • Once you establish as a “bona fide resident”, you will pay zero percent tax on interest and dividends going forward.
  • You will pay zero percent on capital gains that accrue after you establish residency.
  • For capital gains that occurred before you move to PR, that portion of the gain would be taxed at 10%, (reduced to 5% after you have been in PR for 10 years). So if you had enormous long-term capital gains and were facing US taxes of 20% plus the 3.8% medicare surtax, you could move to PR and sell those items later this year and pay only 10% rather than 23.8%.
  • The application for Act 22 benefits costs $750 and if approved, the certificate has a filing fee of $5,000. The program sunsets after 2036. This program is to attract high net worth individuals to Puerto Rico, those who have hundreds of thousands or millions in investment income and gains. If your goal is to retire on $1,500 a month from Social Security, you aren’t going to need these tax breaks.

To establish yourself as a “bona fide resident”, you would need to spend a majority of each calendar year in Puerto Rico, meaning at least 183 days. The IRS is cracking down on fraudulent PR residency, so be prepared to document this and retain proof of travel. Additionally, PR now also requires you to purchase a home in PR and to open a local bank account to prove residency. (Don’t worry, PR banks are covered by FDIC insurance just like mainland banks). Details here on the Act 22 Requirements.

Note that Social Security and distributions from a Traditional IRA or Pension are considered ordinary income and subject to Puerto Rico personal income taxes, which reach a 33% maximum at an even lower level than US Federal Income tax rates. So, Act 22 is a huge incentive if you have a lot of investment income or unrealized capital gains, but otherwise, PR is not offering much tax incentives if your retirement income is ordinary income. 

If you are a business owner, however, and want to relocate your eligible business to Puerto Rico, there are also great tax breaks under Act 20. These include: a 4% corporate tax rate, 100% exemption for five years on property taxes, and then a 90% exemption after 5 years. If your business is a pass-through entity, like an LLC, you may be eligible to pay only 4% taxes on your earnings. If you are in the US, you could be paying as much as 37% income tax on your LLC earnings. Some requirements for Act 20 include being based in PR, opening a local bank account, and hiring local employees.

For self-employed people in a service industry, PR is creating (new for 2019) very low tax rates based on your gross income, of just 6% on the first $100,000, and a maximum of 20% on the income over $500,000. Click here for a chart of the PR personal tax rates and the new Service Tax.
A comparison of Act 20 and Act 22 Benefits are available at  Puerto Rico Business Link

When most people talk about tax havens, they would have to renounce their US citizenship (and pay 23.8% in capital gains to leave), or they’re thinking of an illegal scheme of trying hide assets offshore. If you have really large investment tax liabilities or have a business that you could locate anywhere, take a look at Puerto Rico. Besides the tax benefits, you’ve got great weather, year round golfing, US stores like Home Depot, Starbucks, and Walgreens, and direct daily flights to most US hubs, including DFW, Houston, Miami, Atlanta, New York, and other cities. 

Puerto Rico is still looking to rebuild after the hurricane and it’s probably not the best place to be a middle class worker, but for a wealthy retiree, it might be worth a look. Christopher Columbus arrived in Puerto Rico in 1493 and the cities have Spanish architecture from the seventeenth century. I’ve never been to Puerto Rico, but would love to visit sometime in 2019 or 2020. If you’d care to join me for a research trip, let me know!

(Please consult your tax expert for details and to discuss your eligibility. This article should not be construed as individual tax advice.)

Roth Conversions Under the New Tax Law

Everybody loves free stuff, and investing, we love the tax-free growth offered by a Roth IRA. 2018 may be a good year to convert part of your Traditional IRA to Roth IRA, using a Roth Conversion. In a Roth Conversion, you move money from your Traditional IRA to a Roth IRA by paying income taxes on this amount. After it’s in the Roth, it grows tax-free.

Why do this in 2018? The new tax cuts this year have a sunset and will expire after 2025. While I’d love for Washington to extend these tax cuts, with our annual deficits exploding and total debt growing at an unprecedented rate, it seems unavoidable that we will have to raise taxes in the future. I have no idea when this might happen, but as the law stands today, the new tax rates will go back up in 2026.

That gives us a window of 8 years to do Roth conversions at a lower tax rate. In 2018, you may have a number of funds which are down, such as Value, or International stocks, or Emerging Markets. Perhaps you want to keep those positions as part of your diversified portfolio in the hope that they will recover in the future.

Having a combination of both lower tax rates for 2018 and some positions being down, means that converting your shares of a mutual fund or ETF will cost less today than it might in the future. You do not have to convert your entire Traditional IRA, you can choose how much you want to move to your Roth.

Who is a good candidate for a Roth Conversion?

1. You have enough cash available to pay the taxes this year on the amount you want to convert. If you are in the 22% tax bracket and want to convert $15,000, that will cost you $3,300 in additional taxes. That’s painful, but it saves your from having to pay taxes later, when the account has perhaps grown to $30,000 or $45,000. Think of a conversion as the opportunity to pre-pay your taxes today rather than defer for later.

2. You will be in the same or higher tax bracket in retirement. Consider what income level you will have in retirement. If you are planning to work after age 70 1/2 or have a lot of passive income that will continue, it is entirely possible you will stay in the same tax bracket. If you are going to be in a lower tax bracket, you would probably be better off not doing the conversion and waiting to take withdrawals after you are retired.

3. You don’t want or need to take Required Minimum Distributions and/or you plan to leave your IRA to your kids who are in the same or higher tax bracket as you. In other words, if you don’t even need your IRA for retirement income, doing a Roth Conversion will allow this account will grow tax-free. There are no RMDs for a Roth IRA. A Roth passes tax-free to your heirs.

One exception: if you plan to leave your IRA to a charity, do NOT do a Roth Conversion. A charity would not pay any taxes on receiving your Traditional IRA, so you are wasting your money if you do a conversion and then leave the Roth to a charity.

The smartest way to do a Roth Conversion is to make sure you stay within your current tax bracket. If you are in the 24% bracket and have another $13,000 that you could earn without going into the next bracket, then make sure your conversion stays under this amount. That’s why we want to talk about conversions in 2018, so you can use the 8 year window of lower taxes to make smaller conversions.

2018 Marginal Tax Brackets (this is based on your taxable income, in other words, after your standard or itemized deductions.)

Single Married filing Jointly
10% $0-$9,525 $0-$19,050
12% $9,526-$38,700 $19,501-$77,400
22% $38,701-$82,500 $77,401-$165,000
24% $82,501-$157,500 $165,001-$315,000
32% $157,501-$200,000 $315,001-$400,000
35% $200,001-$500,000 $400,001-$600,000
37% $500,001 or more $600,001 or more

On top of these taxes, remember that there is an additional 3.8% Medicare Surtax on investment income over $200,000 single, or $250,000 married. While the conversion is treated as ordinary income, not investment income, a conversion could cause other investment income to become subject to the 3.8% tax if the conversion pushes your total income above the $200,000 or $250,000 thresholds.

You used to be able to undo a Roth Conversion if you changed your mind, or if the fund went down. This was called a Recharacterization. This is no longer allowed as of 2018 under the new tax law. Now, when you make a Roth Conversion, it is permanent. So make sure you do your homework first!

Thinking about a Conversion? Want to reduce your future taxes and give yourself a pool of tax-free funds? Let’s look at your anticipated tax liability under the new tax brackets and see what makes sense your your situation. Email or call for a free consultation.

Specified Service Professions and the QBI Deduction

This year, there is a new 20% tax deduction for self-employed individuals and pass through entities, commonly called the QBI (Qualified Business Income) deduction, officially IRC Section 199A. While most people who file schedule C will be eligible for this deduction, high earners – those making over $157,500 single or $315,000 married – will see this deduction phased out to zero, if they are in a Specified Service Trade or Business (SSTB).

See: FAQs: New 20% Pass-Through Tax Deduction

Professions that are considered an SSTB include health, law, accounting, athletics, performing arts, and any company whose principal asset is the skill or reputation of one or more of its employees. That’s pretty broad.

Some business owners may have income that is from an SSTB and other income which is not. For example, consider an eye doctor who has a business manufacturing glasses. If she performs an eye exam, clearly she is working in an SSTB as a health professional. If she is manufacturing glasses, that might be a different industry.

This possibility of splitting up income into different streams has occupied many accountants this year, to enable business owners to qualify for the QBI deduction for their non-SSTB income. Since this is a brand new deduction for 2018, this is uncharted territory for taxpayers and financial professionals.

In August, the IRS posted new rules which will greatly limit your ability to carve off income away from an SSTB. Here are some of the details:

  • If an entity has revenue of under $25 million, and received 10% or more of its revenue from an SSTB, then the entire entity is considered an SSTB. If their revenue is over $25 million, the threshold is 5%
  • An endorsement (by a performing artist, for example), or use of your name, likeness, signature, trademark, voice, etc., shall not be considered a separate profession. If you are in an SSTB, an endorsement shall also be considered part of the SSTB.
  • 80/50 rule. If a company shares 50% or more ownership with an SSTB, and receives at least 80% of its revenue from that SSTB, it will be considered part of the SSTB. So, if our eye doctor who makes glasses only makes glasses for her own practice, then it will be considered part of her SSTB. If the manufacturing business has at least 21% in revenue from other buyers, then it could be considered a separate entity and qualify for the QBI deduction.

Business owners in the top tax bracket of 37% for 2018 (making over $500,000 single or $600,000 married), might be considering forming a C-corporation if they are running into issues with the SSTB. While a C-Corp is not eligible for the QBI deduction, the federal income tax rate for a C-Corp has been lowered to a flat 21% this year.

Of course, the challenge with a C-Corp is the potential for double taxation: the company pays 21% tax on its earnings, and then the dividend paid to the owner may be taxed again from 15% to 23.8% (including the 3.8% Medicare surtax on Net Investment Income.)

Still, there may be some benefits to a C-corp versus a pass-through entity, including the ability to retain profits, being able to deduct state and local taxes without the $10,000 cap, or the ability to deduct charitable donations without itemizing.

If you have questions about the QBI Deduction, the Specified Service Business definition, or other self-employment tax issues, we can help you understand the new rules. We want to help you keep as much of your money as possible, but you can’t wait until next April and then hope you can do something about 2018.

The New 2018 Kiddie Tax

Last year’s Tax Cuts and Jobs Act (TCJA) significantly changed the way your dependent children are taxed. Previously, they used to be taxed at their parent’s tax rate, but starting this year, their income could be taxed at the egregious “Trust and Estate” rate of 37% with as little as $12,501 in taxable income. With higher deductions, other children will pay less tax in 2018. Both changes give rise to additional planning strategies that parents will want to know before potentially getting a nasty surprise next April when they file their next tax return.

First, let’s define dependent child for IRS purposes. A dependent child includes any child under 18, an 18 year old who does not provide more than 50% of their own support from earned income, or a full-time student who is under age 24 and also does not not provide more than 50% of their own support from earned income. A child’s age for the tax year is the age they are on December 31.

There are different tax methodologies for earned income (wages, salary, tips, etc.) versus unearned income (interest, dividends, capital gains, etc.) under the Kiddie Tax.

First, some good news, for Earned Income, the standard deduction has been increased to $12,000 for 2018, which greatly increases the amount of income a child can earn income tax-free. Of course, they will still be subject to payroll taxes (Social Security and Medicare) on these earnings.

Strategy 1. For Self-Employed Parents: did you know that when you hire your dependent children, you do not have to pay or withhold payroll taxes (Social Security and Medicare) on their income. If you hire them, and have legitimate work for them to do, you could shift $12,000 from your high tax rate to their 0% tax rate. If they open a Traditional IRA and contribute $5,500, they could earn $17,500 tax-free. Just be aware that the IRS scrutinizes these arrangements, so be prepared to demonstrate that the work was done and the pay was “reasonable”. (Paying your kids $500 an hour to mow the lawn might be considered excessive.)

For Unearned Income, the Kiddie Tax is more complicated. The standard deduction for unearned income is only $1,050 (or their earned income plus $350 up to the $12,000 maximum). Above this amount, the next $2,100 is taxed at the child’s rate, and then any unearned income above this level is now taxed at the Trust and Estates rate. If a child has a significant UTMA, inherited IRA, or other investment account, this is where their taxes could soar in 2018, especially if they used to be taxed at their parent’s rate, say, of 22%. If their parents were in the highest tax bracket, there would be no change, but for middle class kids with investment income, they now could be taxed at a much higher rate than their parents!

Here are the 2018 Trust and Estates Tax Marginal Rates, which now apply to the Kiddie Tax:
10% on income from $0 to $2,550
24% from $2,551 to $9,150
35% from $9,151 to $12,500
37% over $12,501

Long-Term Capital Gains and Qualified Dividends will be taxed at:
0% if from $0 to $2,600
15% if from $2,601 to $12,700
20% if over $12,701

2. Children with under $1,050 in income do not need to file a tax return.

3. The first $4,700 in long-term capital gains are at the 0% rate (a $2,100 deduction followed by $2,600 at the zero rate). This is an opportunity to gift appreciated shares to a child and then they will not owe any tax on the first $4,700 in capital gains. If you are planning to support your kids and set up a fund for them, or pay for college, why should you pay these taxes if they can be avoided? We can establish a program to make use of this annual 0% exclusion.

4. If a child’s investment income is subject to the Kiddie Tax, and the portfolio is going to be used for college education, a 529 Plan can offer tax-free growth and withdrawals for qualified higher educational expenses. In these cases, 529 Plans have just become more valuable for their tax savings.

5. For some college aged kids, it may be better for the parents to stop listing them as a dependent if eligible. In the past, parents received a personal exemption for each child ($4,050 in 2017), but this was eliminated by the TCJA. It was replaced with an expanded child tax credit of $2,000 in 2018. However, the tax credit only applies to children under 17. Unless you are able to claim a college tax credit, it is possible you are not getting any tax benefits for your college kids over 17. In this case, not claiming them as a dependent, and having your child file their own tax return, may allow them to receive the full standard deduction, save them from the Kiddie Tax, and may even allow them to qualify for the college credit. You would need to verify with your tax professional that your child did in fact have enough earned income to be considered independent.

College financial aid doesn’t exactly follow the IRS guidelines for dependency, and they don’t even ask if a parent lists a child as a dependent or not. Instead, the Free Application for Federal Student Aid (FAFSA), has its own form, Am I Dependent or Independent?, which looks at factors including age, degree program, military service, and marital status.

If you’ve got questions on how to best address the Kiddie Tax for your family, let’s talk.

9 Ways to Manage Capital Gains

Investors want to rebalance or reduce their exposure to stocks without creating a large tax bill. We specialize in tax-efficient portfolio management and can help you minimize the taxes you will pay. Here are 9 ways to manage your investment taxes more effectively:

1. Use ETFs instead of Mutual Funds. ETFs typically have very little, and often zero, capital gains distributions. Actively managed mutual funds are presently sitting on very large embedded gains, which will be distributed on to shareholders as the managers trade those positions. Using ETFs gives you better control of when you choose to realize gains.

2. Donate appreciated securities to charity instead of cash. If you are already planning to give money to a charity, instead donate shares of a stock or fund which has appreciated. The charity will get the same amount of money and they will pay no capital gains on the sale. You will still get the same tax deduction (if you exceed the now higher standard deduction) plus you will avoid paying capital gains. Use the cash you were planning to donate to replenish your investment account. Same donation, lower taxes.

Consider funding a Donor Advised Fund and contributing enough for several years of charitable giving. If you give to a large number of charities, it may be easier to make one transfer of securities each year to the Donor Advised Fund, and then give to the charities from the Fund.

3. Give appreciated securities to kids in the zero percent capital gains bracket. Some taxpayers in the lower brackets actually pay a 0% capital gains rate. If your grown children are no longer dependents, and would qualify, they may be able to receive the shares and sell them tax-free. Just be sure to stay under the $15,000 annual gift tax exclusion per person. For 2018, the zero percent capital gains rate will apply to single taxpayers under $38,600 in income and married couples under $77,200.

4. Harvest losses annually. Those losses give you the opportunity to offset gains and rebalance your portfolio. Any unused losses will carry forward to future years without expiration. And you can also use $3,000 a year of losses to offset your ordinary income, which means that instead of just saving 15-20% in taxes you could be saving 37% or more.

5. Develop a Capital Gains Budget. It’s not all or nothing – you don’t have to sell 100% of a position. We can trim a little each year and stay within an annual capital gains target. We also can sell specific lots, meaning we can reduce a position and choose to sell shares with the highest or lowest cost basis.

6. Wait a year for long-term treatment. We try to avoid creating gains under 12 months. The long-term rate is 15% or 20%, but short-term gains are taxed as ordinary income.

7. Use your IRA. If you have a well diversified IRA, we can often rebalance in that account and not create a taxable event. While many investors put taxable bonds in IRAs and leave the equities in a taxable account, for taxpayers in a high bracket, you may prefer to buy tax-free municipal bonds in the taxable account and keep equities in the IRA.

8. Stop Reinvesting Distributions. If your position in a stock or fund has grown, don’t make it larger through reinvestment of dividends and distributions! Reinvesting takes away your choice of how to rebalance your portfolio with the cash flow you receive. However, please make sure you are doing something with your distributions in a timely manner and not letting them accumulate in cash.

9. Just take the Gains already! Don’t let a gain disappear because you don’t want to pay 15% in taxes. If you have a big winner, especially with an individual stock or a speculative investment like bitcoin, take your gains and move on. If we become too obsessed with taxes we run the risk of letting our investment returns suffer.

While most people are thinking about their 2017 taxes right now, reacting to what has already passed, we suggest looking ahead to 2018 and being proactive about managing your futuretax liabilities. Taxes can be a significant drag on performance. If you’re investing in a taxable account, we can give you peace of mind that you have a plan not only for financial security, but also to manage your capital gains as efficiently as possible.