“It doesn’t matter how much you make, but how much you keep.” Over time, taxes can be a significant drag on returns, especially for those who are in the higher tax brackets. Today, many families are also hit with the 3.8% Medicare surtax on investment income. If you are in the top tax bracket, you could be paying as much as 43.4% (39.6% plus the 3.8% Medicare surtax) for interest income or short-term capital gains.
For several years, taxpayers have had an opportunity to make Qualified Charitable Distributions, or QCDs, from their IRA. This was originally offered for just one year and then subsequently was renewed each December, an uncertainty which made it difficult and frustrating for planners like myself to advise clients. Luckily, this year Congress made the QCD permanent. Here is what it is, who it may benefit, and how to use it.
A QCD is a better way to give money to charity by allowing IRA owners to fulfill their Required Minimum Distribution with a charitable donation. To do a QCD, you must be over age 70 1/2 at the time of the distribution, and have the distribution made payable directly to the charity.
If you are over 70 1/2, you must take out a Required Minimum Distribution from your IRA each year, and this distribution is reported as taxable income. When you make a qualified charitable contribution, you can deduct that amount from your taxes, through an itemized deduction. The QCD takes those two steps – an IRA distribution and a charitable contribution – and combines them into one transaction which can fulfill your RMD requirement while not adding to your Adjusted Gross Income (AGI) for the year.
The maximum amount of a QCD is $100,000 per person. A married couple can do $100,000 each, but cannot combine or share these amounts. For most IRA owners, they will likely keep their QCD under the amount of their RMD. However, it is possible to donate more than your RMD, up to the $100,000 limit. So if your goal is to leave your IRA to charity, you can now transfer $100,000 to that charity, tax-free, every year.
The confusing thing about the QCD is that for some taxpayers, there may be no additional tax benefit. That is to say, taking their RMD and then making a deductible charitable contribution may lower their taxes by exactly the same amount as doing a QCD. Who will benefit from a QCD, then? Here are five situations where doing a QCD would produce lower taxes than taking your RMD and making a separate charitable contribution:
1) To deduct a charitable contribution, you have to itemize your deductions. If you take the standard deduction (or would take the standard deduction without charitable giving), you would benefit from doing a QCD instead. That’s because under the QCD, the transaction is never reported on your AGI. Then you can take your standard deduction ($6,300 single, or $12,600 married, for 2016) and not have to itemize.
2) If you have a high income and your itemized deductions are reduced or phased out under the Pease Restrictions, you would benefit from doing a QCD. The Pease Restriction reduces your deductions by 3% for every $1 of income over $259,400 single, or $311,300 married (2016), up to a maximum reduction of 80% of your itemized deductions.
3) If you are subject to the Alternative Minimum Tax (AMT). The AMT frequently hits those who have high itemized deductions. With the QCD, we move the charitable contributions from being an itemized deduction to a direct reduction of your AGI.
4) If you are subject to the 3.8% Medicare Surtax on investment income. While IRA distributions are not part of Net Investment Income, they are part of your AGI, which can push other income above the $200,000 threshold ($250,000, married) subject to this tax.
5) If your premiums for Medicare Parts B and D are increased due to your income, a QCD can reduce your AGI.
You can make a QCD from a SEP or SIMPLE IRA, provided you are no longer making contributions to the account. You can also make a QCD from a Roth IRA, but since this money could be withdrawn tax-free, it would be preferable to make the QCD from a Traditional IRA. 401(k), 403(b), and other employer sponsored plans are not eligible for the QCD. If you want to do the QCD, you would need to rollover the account to an IRA first.
Charitable giving is close to our heart here at Good Life Wealth Management. We believe that true wealth is having the ability to fearlessly help others and to use our blessings to make the world a better place. If that’s your goal too, we can help you do this in the most efficient manner possible.
I received a tremendous response from readers about last week’s article comparing 15 and 30 year mortgages (read it here). A number of readers astutely asked how the mortgage interest tax deduction would impact the decision of choosing between the 15 and 30 year note. Here is your answer!
For our example, we are looking at buying a $250,000 home, putting 20% down and assuming a mortgage of $200,000. At today’s interest rates, we’d be choosing between a 15 year mortgage at 3.00% or a 30-year at 3.75%. Here are the monthly payments, not including insurance or property taxes.
|15 Year Mortgage @ 3.00%||30 Year Mortgage @ 3.75%|
|payment $1381.16||payment $926.23|
|difference = $454.93|
Over the full term of the mortgages, you will pay the following amounts of principal and interest:
|15 Year Mortgage @ 3.00%||30 Year Mortgage @ 3.75%|
|principal $200,000.00||principal $200,000.00|
|interest $48,609.39||interest $133,443.23|
|total payments $248,609.39||total payments $333,443.23|
You will pay a significantly higher amount of interest over the life of a 30 year mortgage. The interest payment of $133,443.23 increases your total payments by 67% over the amount you have borrowed. And that’s at today’s rock bottom mortgage rates! I should point out that above 5.325%, the interest portion on a 30 year mortgage exceeds the original principal. In other words, the interest would double your cost from $200,000 to $400,000.
You can deduct the mortgage interest expense from your taxes, but the amount of the benefit you will receive depends on your marginal federal income tax rate. Here is the value of the tax benefit for six tax brackets.
|15 Year Mortgage @ 3.00%||30 Year Mortgage @ 3.75%|
|interest $48,609.39||interest $133,443.23|
|15%: $7,291.41||15%: $20,016.48|
|25%: $12,152.35||25%: $33,360.81|
|28%: $13,610.63||28%: $37,364.10|
|33%: $16,041.10||33%: $44,036.27|
|35%: $17,013.29||35%: $46,705.13|
|39.6% $19.249.32||39.6%: $52,843.52|
Obviously, the 30 year mortgage provides much higher tax deductions, although they are spread over twice as long as the 15 year mortgage. If we subtract the tax savings from the total payments of the mortgage, we end up with the following costs per tax bracket.
|15 Year Mortgage @ 3.00%||30 Year Mortgage @ 3.75%|
|15%: $241,317.98||15%: $313,426.75|
|25%: $236,457.04||25%: $300,082.42|
|28%: $234,998.76||28%: $296,079.13|
|33%: $232,568.29||33%: $289,406.96|
|35%: $231,596.10||35%: $286,738.10|
|39.6%: $229,360.07||39.6%: $280,599.71|
It should not be a surprise that even though the 30-year mortgage provides higher tax deductions, that it is still more expensive than a 15-year mortgage, even when we consider it on an after-tax basis.
For most Americans, the actual tax benefit they will receive is much, much less than described above. That’s because in order to deduct mortgage interest, taxpayers have to itemize their tax return and forgo the standard deduction. As a reminder, itemized deductions also include state and local taxes, casualty, theft, and gambling losses, health expenses over 10% of AGI, and charitable contributions.
For 2015, the standard deduction is $6,300 for single taxpayers and $12,600 for married couples filing jointly. So, if you are a married couple and your itemized deductions total $13,000, you’re actually only receiving $400 more in deductions than if you had no mortgage at all and claimed the standard deduction. And of course, if your itemized deductions fall below $12,600, you would take the standard deduction and you would not be getting any tax savings from the mortgage whatsoever.
While the mortgage interest deduction is very popular with the public, economists dislike the policy because it is a regressive tax benefit. It largely helps those with a big mortgage and a high income. For many middle class taxpayers, the tax benefits of mortgage interest is a red herring. With our example of 3.75% on a $200,000 mortgage, even in the first year, the interest is only $7,437. That’s well under the standard deduction of $12,600 for a married couple, and the interest expense will drop in each subsequent year.
Compare that to someone who takes out a $1 million mortgage: their first year interest deduction would be $37,186 on a 30 year note. Simply looking at the amount of the mortgage interest will not determine how much tax savings you will actually reap, without looking at your other deductions, and comparing these amounts to the standard deduction.
Even if you are one of those high earners with a substantial mortgage, you have another problem: your itemized deductions can be reduced under the so-called “Pease limitations”. These limitations were reintroduced in 2013. For 2015, itemized deductions are phased out for tax payers making over $258,250 (single) or $309,900 (married).
Bottom line: If your mortgage is modest, your interest deduction may not be more than your standard deduction. And if you are a high earner, you are likely to have your deductions reduced. All of which means that the tax benefit of real estate is being highly overvalued by most calculations. There is a substantial floor and ceiling on the mortgage interest deduction and it provides no benefit for taxpayers who are below or above those thresholds.
Ceiling: Pease limits on tax payers making over $258,250 (single) or $309,900 (married).
Middle: receive a tax benefit between these two levels.
Floor: no benefit on deductions below the standard deduction of $6,300 (single) or $12,600 (married).
For several years, there has been a proposal in Washington to eliminate the Stretch IRA, also known as the “Inherited IRA” or “Beneficiary IRA”. Currently, when your beneficiary inherits your IRA, they can keep the account tax-deferred by leaving the assets in a Stretch IRA. While they have to take Required Minimum Distributions, using a Stretch IRA keeps distributions small and taxes low, as well as encourages beneficiaries to use the money gradually rather than spend their inheritance immediately.
Congress is looking for new ways to reduce the budget deficit, and according to IRA expert Ed Slott, it is increasingly probable that the Stretch IRA will be eliminated in the near future. Forcing beneficiaries to withdraw their inherited IRAs will raise billions in tax revenue, while allowing politicians to say that they haven’t raised tax rates.
If the Stretch IRA is repealed, beneficiaries will have to withdraw all of an inherited IRA – and pay taxes on the distributions – within five years. For many retirees, their retirement accounts are their largest assets. Many have accumulated a significant sum, often $1 million or more. If your beneficiary receives a $1 million IRA in one year, regardless of whether they spend the money or invest it, they could owe up to $396,000 in income tax. Even spreading the withdrawal over five years ($200,000 a year) will push any tax payer into a high tax bracket where the IRS will collect 28%, 33%, or more from your IRA.
If you aren’t touching your IRAs because you have other sources of retirement income, such as a pension, Social Security, or other investments, you may have been thinking that you would leave the IRA to your heirs and not take any withdrawals. It’s a very generous plan, but if the Stretch IRA is repealed, a significant amount of your IRA is going to end up in the pockets of the IRS.
What can you do to minimize the taxes and maximize the amount your heirs will receive? Here are three ways to accomplish this:
1) Buy life insurance. Use your IRA money to fund a permanent life insurance policy, such as a level premium Universal Life policy. Life insurance death benefits are received income tax-free. Purchase a $1 million policy for your beneficiaries and they will receive all $1 million tax-free.
For example, a healthy 65-year old male can purchase a $1 million Universal Life policy for as little as $17,218 per year. That is a sizable premium, but not a bad deal to guarantee your heirs a $1 million payout, tax-free. While funding those premiums from your IRA does create taxes, the taxes paid will be lower if you take small withdrawals over a period of many years rather than leaving your heirs in a position of having to take the entire distribution over 5 years (or 1 year if they don’t do the distribution correctly).
If you don’t need the income from your RMDs, using those distributions to fund a life insurance policy may have a significant benefit for your heirs.
2) Leave to Charity. There is a way to pay no tax on your IRA on death and that is to leave the account to a charity. 501(c)(3) non-profit organizations will not have to pay any income tax when they are named as the beneficiary of your IRA or retirement accounts. If you were planning to leave something to charity, make sure that bequest is from your IRA and not from a regular account.
Scenario 1: You leave a $1 million taxable account to charity and a $1 million IRA to your daughter. The charity receives $1 million, but your daughter will owe taxes up to $396,000 on the IRA, leaving her with as little as $604,000.
Scenario 2: You leave the $1 million taxable account to your daughter and the $1 million IRA to the charity. The charity receives $1 million, your daughter receives $1 million (and a step-up in cost basis), and the IRS gets zip. Much better!
3) Spread out your IRA. If you leave $1 million to one beneficiary, they will have to pay tax on the entire amount. If you leave the IRA to 10 beneficiaries (perhaps grandchildren, nieces, nephews, etc.), the tax due will be much less on $100,000 for 10 tax payers than on $1 million received by one person.
Please note that spouses can roll their deceased spouse’s IRA into their own IRA and treat it as their own. If the Stretch IRA is repealed, this may not be a problem for leaving an IRA to your spouse. However, if your spouse consolidates both of your IRAs into one account, the tax problem for the subsequent heirs will have become even more significant.
The one good thing about IRAs is that you can change your beneficiaries at any time without having to re-do your Will and other documents in your Estate Plan. It is very important to remember that your IRA beneficiary designations override any instructions in your Will, so it is vital to have your beneficiary designations correct and up-to-date.
Not sure where to begin with your Estate Plan? We can help you find the right solution for your family, using our Good Life Wealth planning process. Interested in finding out more about life insurance? I’m an independent agent and can help you choose the best insurance policy for your goals. Call me with your questions, reducing taxes is my passion!
We talk about Individual Retirement Accounts (IRAs) regularly, yet even for long-time investors, there are often some gaps in understanding all your options. This means that many investors are missing chances to save money on taxes, which is the primary advantage of IRAs versus regular “taxable” accounts.
Here’s a primer on the six types of IRAs you might encounter. For each type of IRA, I’m including an interesting fact on each, which you may be something you haven’t heard before! All numbers are for 2015; call me if you have questions on 2014 eligibility.
1) Traditional IRA. This is the original IRA, yet has the most complicated rules. Anyone can contribute to a Traditional IRA. Contributions grow tax-deferred and then you are taxed on any gains when the money is withdrawn.
The confusing part of the Traditional IRA is whether or not you can deduct the contribution from your income taxes. If you are in the 25% tax bracket, a $5,500 contribution will reduce your taxes by $1,375. Anyone can contribute, but not everyone can deduct their contribution. Here are the rules for three scenarios:
a) If you are not eligible for an employer sponsored retirement plan (and your spouse is also not eligible for one), then you (and your spouse) can deduct your IRA contributions.
b) If you are covered by an employer sponsored retirement plan, you can deduct your contribution if your Modified Adjusted Gross Income (MAGI) is below $61,000 (single), or below $98,000 (married, filing jointly).
c) If your spouse is covered by an employer sponsored plan, but you are not, you can deduct your contribution if your joint MAGI is below $183,000.
I suggest avoiding non-deductible contributions to a Traditional IRA as the deduction is the main benefit. If you’re eligible for a Roth IRA, never make a non-deductible contribution to a Traditional IRA. Non-deductible contributions create a cost basis for your IRAs, which you will have to track for the rest of your life. It’s a headache you don’t need.
Spouses can contribute to an IRA based on joint income, even if they do not have an income of their own. You cannot contribute to a Traditional IRA in the year you reach age 70 1/2. At that point, you must start Required Minimum Distributions. A premature withdrawal, before age 59 1/2, is subject to a 10% penalty, in addition to any income taxes due.
Interesting Fact: A Rollover IRA is a Traditional IRA. You can roll a 401(k) or other employer sponsored plan to a Traditional IRA or a Rollover IRA; they receive the same treatment. 401(k) plans are governed by Federal ERISA rules, whereas IRAs are protected under state creditor laws. If you want to remain under the Federal Regulations, you should designate the account as a “Rollover IRA” and not commingle with a Traditional IRA. I consider this step unnecessary. In Texas, we have robust protection for IRAs, so you are not at risk by consolidating accounts into one Traditional IRA.
2) Roth IRA. In a Roth IRA, you contribute after-tax dollars, so there is no upfront tax deduction. Your account grows tax-free, and there is no tax due on withdrawals in retirement. The Five Year Rule” requires you to have had a Roth open for at least 5 years before you can take tax-free withdrawals in retirement. So, if you open a Roth at age 58, you would not be able to access tax-free withdrawals until age 63.
Not everyone is eligible to contribute to a Roth IRA. To be eligible for a full contribution, your MAGI must be below $116,000 (single), or $183,000 (married).
Interesting Fact: There are no RMDs on Roth IRAs and no age limits. Even after age 70 1/2, you can contribute to a Roth IRA (provided you have earned income) or convert a Traditional IRA to a Roth.
3) “Back Door” Roth IRA. This is not a separate type of account, but rather a funding strategy. If you make too much to contribute to a Roth IRA, you can fund a Non-Deductible Traditional IRA, then immediately convert the account to a Roth. You pay taxes on any gains, but since there were no gains, your tax due is zero. Very important: the conversion is only tax-free if you do not have any existing Traditional IRAs.
Both Traditional and Roth IRAs are subject to a combined contribution limit of $5,500, or $6,500 if age 50 or older.
Interesting Fact: Thinking of rolling your old 401(k) to an IRA? Don’t do it if you might want to do a Back Door Roth in the future. Rolling to an IRA will eliminate your ability to do a tax-free Roth conversion. Instead, leave your old 401(k) where it is, or roll it into your new 401(k).
4) Stretch IRA, also called an Inherited IRA or a Beneficiary IRA. If you are named as the beneficiary of an IRA, the inherited account is taxable to you. If you take the money out in the first year, it will all be taxable income. With a Stretch IRA, you can keep the inherited IRA tax-deferred, and only take Required Minimum Distributions each year. Note that Stretch IRA RMDs are based on the original owner’s age, so you cannot use a regular RMD calculator to determine the amount you must withdraw.
Interesting Fact: a spouse who inherits an IRA from their deceased spouse does not have to do a Stretch IRA. Instead, he or she can roll the IRA into their own account and treat it as their own. This is especially beneficial if the surviving spouse is younger than the decedent.
5) SEP-IRA. SEP stands for Simplified Employee Pension. A SEP is an employer sponsored plan where the employer makes a contribution of up to 25% of the employee’s compensation, with a contribution cap of $53,000. Since it is an employer plan, you cannot discriminate and must make the same contribution percentage for all employees. As a result, pretty much the only people who use a SEP are those with no employees. The SEP is most popular with people who are self-employed, sole proprietors, or who are paid as an Independent Contractor via 1099 rather than as an Employee via W-2.
Let’s say you have a regular job and also do some freelancing as an Independent Contractor. You can contribute to the 401(k) through your employer AND contribute to the SEP for your 1099 work. You can also do a SEP in addition to a Traditional or Roth IRA.
Interesting Fact: The SEP is the only IRA which you can fund after April 15. If you file a tax extension, you have until you file your taxes to fund your SEP. We can accept 2014 SEP contributions all the way up to October 15, 2015.
6) SIMPLE IRA is the Savings Incentive Match Plan for Employees. It’s like a 401(k), but just for small businesses with fewer than 100 employees. Employees who choose to participate will have money withheld from their paycheck and invested in their own account. The employer matches the contribution, up to 3% of the employee’s salary. This is a great option for small businesses because the costs are low and the administration and reporting requirements are easy. The 2015 contribution limit is $12,500, or $15,500 if over age 50.
Interesting Fact: Traditional and SEP IRAs have a 10% penalty for premature distributions prior age 59 1/2. For a SIMPLE IRA, if you withdraw funds within two years of opening the account, the penalty is 25%. Contributions made by both the employee and employer are immediately vested, so the high penalty is to discourage employees from raiding their SIMPLE accounts to spend the employer match.
IRAs are a very important tool for wealth accumulation, yet a lot of investors miss chances to participate and maximize their benefits. Since the contribution limits are low, it can be tough to make up for lost years. Your best bet: meet with me, bring your tax return and your investment statements and we can discuss your options.
For new investors, taxes are often an afterthought. Chances are good that your initial investments were in an IRA or 401(k) account that is tax deferred. If you had a “taxable” account, the gains and dividends were likely small and had a negligible impact on your income taxes. Over time, as your portfolio grows and you have more assets outside of your retirement accounts, taxes become a bigger and bigger problem. Eventually, you may find yourself paying $10,000 a year or more in taxes on your interest, dividends, and capital gains.
A high level of portfolio income may be a good problem to have, but taxes can become a real drag on the performance of your portfolio and eat up cash flow that you could use for better purposes. Luckily, there are a number of ways to reduce the taxes generated from your investment portfolio and we make this a special focus of our process at Good Life Wealth Management. We will discuss six of the ways that we work with each of our clients to create a portfolio that is tax optimized for their personal situation.
1) Maximize contributions to tax-favored accounts. While the 401(k) is the obvious starting place, investors may miss other opportunities for investing in a tax advantaged account. Since these have annual contribution limits, every year you don’t participate is a lost opportunity you cannot get back later. In addition to your 401(k) account, you may be eligible to contribute to a:
- Roth or Traditional IRA;
- SEP-IRA if you have self-employment or 1099 income;
- “Back-door” Roth IRA;
- Health Savings Account (HSA).
Also, don’t forget that investors over age 50 are eligible for a catch-up contribution to their retirement accounts. For 2014, the catch-up provision increases your maximum 401(k) contribution from $17,500 to $23,000.
2) Use tax-efficient vehicles. Actively managed mutual funds create capital gains distributions as managers buy and sell securities. These capital gains are taxable to fund shareholders, even if you just bought the fund one day before the distribution occurs. These distributions are irrelevant in a retirement account, but can be sizable when the fund is held in a taxable account.
To reduce these capital gains distributions, we use Exchange Traded Funds (ETFs) as a core component of our equity holdings. ETFs typically use passive strategies which are low-turnover and they may be able to avoid capital gains distributions altogether. It used to be difficult to estimate the after-tax returns of mutual funds, but thankfully, Morningstar now has a tool to evaluate both pre-tax and after-tax returns. Go to Morningstar.com to get a quote on your mutual fund, then click on the “Tax” tab to compare any ETF or fund to your fund. I find that even when a fund and ETF have similar pre-tax returns, the ETF often has a clear advantage when we compare after-tax returns.
One last factor to consider: many mutual funds had loss carry-forwards from 2008 and 2009. So you may not have seen a lot of capital gains distributions in the 2010-2012 time period. By 2013, however, most funds had used up their losses and resumed distributing gains, some of which were substantial.
3) Avoid Short-Term Capital Gains. Short-term gains, from positions held less than one year, are taxed as ordinary income, whereas long-term gains receive a lower tax rate of 15% (or 20% if you are in the top bracket). We try to avoid creating short-term capital gains whenever possible, and for this reason, we rebalance only once per year. We do our rebalancing on a client-by-client basis to avoid realizing short-term gains.
4) Harvest Losses Annually. From time to time, a category will have a down year. We will selectively harvest those losses and replace the position with a different ETF or mutual fund in the same category. The losses may be used to offset any gains harvested that year. Additionally, with any unused losses, you may offset $3,000 of ordinary income, and the rest will carry forward to future years.
A benefit of using the loss against other income is the tax arbitrage of the difference between capital gains and ordinary income. For example, if you pay 33% ordinary tax and 15% capital gains, using a $3,000 long-term capital loss to offset $3,000 of ordinary income is a $540 benefit ($3,000 X (.33-.15)).
5) Consider Municipal Bonds. We calculate the tax-equivalent rates of return on tax-free municipal bonds versus taxable bonds (i.e. corporate bonds, treasuries, etc.) for your income tax bracket. With the new 3.8% Medicare tax on families making over $250,000, tax-free munis are now even more attractive for investors with mid to high incomes.
6) Asset Location. This is a key step. Not to be confused with Asset Allocation, Asset Location refers to placing investments that generate interest or ordinary income into tax-deferred accounts and placing investments that do not have taxable distributions into taxable accounts. For example, we would place high yield bonds or REITs into an IRA, and place equity ETFs and municipal bonds into taxable accounts. This means that each account does not have identical holdings, so performance will vary from account to account. However, we are concerned about the performance of the entire portfolio and reducing the taxes due on your annual return.
If these six steps seem like a lot of work to reduce taxes, that may be, but for us it is second-nature to look for opportunities to help clients keep more of their hard-earned dollars. The actual benefits of our portfolio tax optimization process will vary based on your individual situation and can be difficult to predict. However, a 2010 study by Parametric Portfolio Associates calculates that a tax-managed portfolio process can improve net performance by an average of 1.25% per year.
Tax management is a valuable part of our process. And even if, today, your portfolio doesn’t generate significant taxes, I’d encourage you to think ahead. Prepare for having a large portfolio, and take the steps now to create a tax-efficient investment process.