2017 Year End Tax Strategies

| December 11, 2017
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While we wait on the House and the Senate to settle on a finalized tax bill, there are still several strategies that will not be affected by the outcome. However, all of the outlined strategies are recommended only on a case-by-case basis. Please consult your advisor or tax preparer before proceeding.

December 31st Deadline

Maximize Your 401(k)- Pre-Tax and After-Tax (Not Roth)

Generally, there is one broad takeaway from the proposals being reported, which is that income tax rates will be falling across the board in 2018. For most who are debating between making pre-tax contributions or Roth, it does appear that your tax rate will be higher in 2017.

Remember how this works: If you are in the 33% federal bracket and 5% state bracket (Massachusetts) today, contributing pre-tax defers your tax bill to when you take this money out for retirement. If you are a modest retiree who moves to an income tax free state (Florida), this could mean lowering your tax bill from 38% to 15% (or 12% under the new House plan).

Generally, Roth contributions are only recommended for someone who expects their income tax bracket to rise substantially over time- such as for a young worker or for someone who is currently in a low bracket due to being out of the workforce (see Roth Conversions below).

One little known fact: any American is allowed to contribute $54,000 to their 401(k) if their employer permits after-tax contributions ($60,000 if over the age of 50). If you have already made your $18,000 pre-tax contributions, ask if your employer allows "after-tax contributions" and "in-plan Roth conversions." While you won't receive an income tax deduction in 2017, you will be able to park away more of your assets within a retirement account that will not be subject to capital gains taxes. If you have already been making after-tax contributions throughout the year, be sure to make that in-plan Roth conversion before December 31st to ensure you have tax-free growth moving forward.

Offset Investment Gains With Losses (Tax Loss Harvesting)

In a year like 2017, almost all of your investments will have gains. If these are in a taxable account (non-retirement), they will be subject to capital gains taxes once you sell them. However, if you had a diversified portfolio in a taxable account, you are certain to have at least a couple of investments that went down.

As part of our service for managing your investments, we are looking at your bond funds, alternative investment funds, and individual stocks such as General Electric, Exxon Mobil, Walgreens or AT&T that had a bad year. If you have a loss in there and we aren't committed to that investment, we will be harvesting the loss for you.

Here's how it works: let's say your taxable account has $20,000 in gains and $5,000 in losses. By selling off the investment with a loss and a portion of an investment with a gain (up to $5,000 in gain), you will be left with $15,000 in unrealized gains. 

We then invest the proceeds into a similar, but not "substantially identical" investment to avoid the wash sale rules. While this is a bit of a grey area, there are easy ways to get around it. For example, if we were selling an ETF that tracked the S&P 500 from Charles Schwab, we could not pick up an ETF from Vanguard that also tracked the S&P 500. However, we could instead pick one that tracked the Russell 1000. There would be some overlap, but enough of a difference to avoid the wash sale rule. After 31 days, we can always go back to the original investment.

If you have a situation where you would not like us to take a loss, or would like to discuss your situation in more detail, please do not hesitate to reach out.

Avoid Large Capital Gains Distributions

Another part of our December tax analysis revolves around distributions that mutual funds make this month. Most tax planning is within our control- if we have an investment that has done well, but we don't want to pay the taxes on that yet, we don't have to sell that investment. However, mutual funds with excess profits make distributions each December that will be taxable to you if you hold the investment. In a year like 2017 where stocks have gone up, these distributions can be massive- up to 13% of the fund's value.

If we were planning on selling the investment anyway due to a rebalance or we no longer like the fundamentals of the investment, we will pull the trigger on selling this investment now, as distributions are typically made in December. For further reading on this topic, please see this U.S. News article. To find out if your mutual funds have a large distribution planned, visit CapGainsValet.com. 

Convert IRA's and 401(k)'s to a Roth IRA In Low Income Years

Most people earning over $50,000 and/or are over the age of 30 (my own rules of thumb) should be making pre-tax contributions and preserving their pre-tax assets in their 401(k)'s and IRAs. However, with those who have fluctuating incomes, a Roth conversion in a low income year could save you a significant amount on taxes.

There are many reasons that your income could have been lower in 2017 than it normally would be: you went back to school, you left the workforce for an extended period of time, or your profession calls for lower earning years before rising substantially, such as with a medical resident, paralegal, or new business owner. 

Let's say you are married and will end up with $50,000 of income in 2017, putting you in the 15% tax bracket. You anticipate reaching $250,000 of income within 5 years, reaching the 33% tax bracket. Expecting to save diligently for retirement, you anticipate withdrawing your retirement assets at a rate of $100,000 per year at the 25% bracket. 

By converting an IRA to a Roth IRA now, you are raising your hand to the government and saying "I'm willing to pay taxes on this today, at my 15% bracket, to let it grow tax-free for the rest of my life." While tax rates can shift over 30 years of your working life, you are locking in a fairly low rate of 15%. 

Keep in mind a few things here. First, you likely won't convert the entire IRA into a Roth- only enough to "fill up the bucket" of your income tax bracket. In this case, your 15% bracket would jump to 25% once your income went over $75,900. Thus, as a $50,000 earner, you would only want to convert $25,899. Second, since a conversion means paying taxes, be sure you have enough cash on hand to pay that next April.

For those that have retired in their 60's with significant IRA assets and have yet to be subject to Required Minimum Distributions (RMDs), the partial Roth conversions can also be a way to ensure your exposure to an RMD does not bump you up in brackets down the road. Please talk to your advisor about this strategy.

Spend Down Your Flexible Spending Account (FSA)

These pre-tax accounts offered by employers are "use it or lose it" accounts. If you have been putting off certain medical expenses or doctor visits and still have a balance, now is the time to empty this account! While some employers allow you to carry $500 into 2018, some do not.

Defer Income to 2018

Income is taxed in the year it is received. If your tax bracket could fall under the House or Senate tax proposals, you may benefit from deferring income to January. Employees may have a tough time doing this, especially in a large corporation. However, if your small business employer is paying you a bonus, it could be worth the conversation.

If you are self-employed or do freelance or consulting work, you could delay billings until late December to ensure you won't receive payment until next year. Of course, if you anticipate your income rising substantially next year, that could push you up in brackets and prove counterproductive. 

Required Minimum Distributions OR Qualified Charitable Distributions

Once you reach age 70.5, you must make a distribution from pre-tax retirement assets (IRA, 401(k), 403(b), 457, etc.) by April 1st following the year you reach age 70.5. Thereafter, all distributions are required by December 31st. 

As an example, if you have $1,000,000 in retirement assets, you may be required to take out $50,000 whether you need it or not. Failure to do so would trigger a 50% penalty on the amount of the required withdrawal- in this case, $25,000! Be sure to check with your advisor on what amount your RMD is and whether or not it has been distributed.

If you do not need the funds and have charitable aspirations, consider making a qualified charitable distribution. This involves making a direct transfer of funds from your IRA to a qualified charity. In addition to the benefits of giving to charity, a QCD excludes the amount donated from taxable income. This might keep your taxable income low enough to reduce the impact you would have otherwise had on certain tax credits and deductions, including Social Security and Medicare. The maximum QCD allowed is $100,000.

Pay 2018 Taxes In 2017

Currently, taxpayers who itemize can deduct the amount they pay in state and local taxes (such as property and income taxes) from their federal tax return. For income taxes, the deduction keeps income from being taxed twice- once at the state level and again at the federal level.

However, both the Senate and House bills eliminate these deductions, with the exception of a state and local property tax deduction capped at $10,000. Thus, you may want to consider paying 2018 1st quarter property taxes in 2017.

Likewise, you may also want to pay your state income taxes this year. If you are anticipating having a balance due from your state income tax return, pay that now. But be aware as to whether paying those taxes in 2017 will trigger the alternative minimum tax (or AMT) which is a separate system for the treatment of income and deductions. If you will end up losing that deduction because of the AMT, you should just pay the tax bill next year. Please check with your tax preparer if you are uncertain. 

April 17th Deadline

Contribute to a Health Savings Account

With more Americans choosing high deductible health plans (HDHPs) in order to lower their monthly bill and control their medical expenses, health savings accounts (HSAs) have skyrocketed in popularity. To help with large out of pocket expenses, HSAs were created to provide a tax-advantaged way to save for medical emergencies.

Health savings accounts essentially act like an IRA. As long as you have a HDHP, defined as having a deductible of at least $1,300 for single filers and $2,600 for families, you may contribute $3,400 to the account as a single filer, $6,750. This shows up as a deduction on your tax return, lowering your income that is subject to tax.

After you have opened an HSA, you will save all receipts for your qualified medical expenses. If you incur $1,000 of expenses, you are permitted to withdraw $1,000, but you don't have to. In fact, you could let that money accumulate just like you would with an IRA. Unlike a flexible spending account. a health savings account does not need to be used every year- it continues to accumulate. 

Like an IRA, the investments within an HSA will grow tax-deferred. Unlike an IRA which allows retirement withdrawals at age 59.5, HSA's cannot be tapped until age 65. That could be a small price to pay for advancing your retirement savings and lowering your taxes.

Complete a "Backdoor Roth IRA Contribution"

Another way of accelerating your retirement savings is by adding to the Roth IRA, which grows tax free. For those making over $133,000 single or $196,000 married, you cannot directly contribute to a Roth IRA. This means that you cannot enjoy all of the benefits of a Roth IRA (such as withdrawing contributions at anytime tax-free, or using earnings for certain exceptions such as a first time home purchase).

However, for those high earners, they are permitted to contribute via the backdoor. This happens by contributing $5,500 to an IRA and immediately converting it to a Roth IRA. We discussed Roth conversions earlier- in this case, since the IRA contribution is not deductible for a high earner, they do not owe taxes on the contribution.

This works best for those who do not have assets already in an IRA. Due to a "pro-rata" rule, if you have money in an IRA already, you will end up owing taxes on the conversion. However, if all of your assets currently sit in a 401(k) or Roth IRA, this is a great way to add to the retirement savings bucket.

While we hope all of these strategies prove useful, we would remind you not to "let the tax tail wag the dog." Please consult with your advisor about your overall financial picture before rushing to a tax strategy that may prove counterproductive. 

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