While the The Coronavirus Aid, Relief, and Economic Security Act (aka the CARES Act) did postpone the deadline for tax filing from April 15th to July 15th, those taxes will soon become due. For those that may be feeling the pinch from Uncle Sam, we will share 4 strategies you can start implementing now to fine-tune your taxes for 2020 and beyond.
Suspend Required Minimum Distributions (RMD) for 2020
One form of relief for retirees that was part of the CARES Act allowed retirees to skip their RMD for this year. For those that have inherited retirement accounts or surpassed the magic age to start taking mandatory distributions from retirement accounts after they turn 72, we are recommending that they suspend their 2020 distributions if they are able to. These mandated distributions increase taxable income and can result in increased taxes on Social Security income and have the potential to increase Medicare Part B premiums.
Because the CARES Act wasn't passed until March 27th, it is possible that some may have already taken their RMD for 2020. If this is the case and the RMD was not from an inherited IRA, these funds can still be replaced as a tax-free rollover if done so by August 31, 2020.
Increase your tax-free income
Those approaching and in retirement typically hold a substantial portion of their assets in interest bearing investments like money markets, certificates of deposit or bonds. Because most interest income is taxed at ordinary income rates which can reach as high 40.8% (including 3.8% Medicare Tax on investment income) this can greatly erode the after-tax return of these types of investments. Fortunately, most tax-free municipal bonds pay interest that is exempt from Federal Taxes. For investors that own municipals bonds issued by governments in the state they reside or any U.S. Territory, they are also exempt from state income taxes. As you will see below, this can be very powerful to enhance after-tax returns.
As an example, a hypothetical Tennessee investor, John E. Major who has $500,000 in a taxable bond portfolio paying 3% interest is earning $15,000/year in taxable interest. Let's assume he is in the 37% tax bracket, subject to the 3.8% Medicare Tax and 2% State Income Tax (Halls Tax on interest and dividends) for a marginal tax rate of 42.8% In this example he would be paying $6420/year ($15,000 × 42.8%) in Federal Taxes for an after-tax return of $8,580/year on his investment.
Now let's assume the same John E. Major had instead used the $500,000 to purchase a portfolio of Tennessee Municipal Bonds of similar quality paying 3% in tax-exempt interest. The same portfolio would generate $15,000 per year in tax-free income. A taxable bond portfolio would have to yield 5.20% (3% / (1-tax rate)) to generate the same after-tax income as the municipal bond portfolio.
When reviewing a potential client's portfolio, I am regularly amazed at how many are not reaping the benefits of tax-free income. Oftentimes, this is because they are working with a broker who may not be trained and knowledgeable on the impact of the client's unique tax situation.
Pay attention to where your investments are located
As we just reviewed, not all investment income is taxed equally. Interest bearing investments and those that pay non-qualified dividends like preferred stock, as well as short-term capital gains are taxed as ordinary income. Conversely, qualified dividends and long-term capital gains are taxed at lower rates. This is just another reason we believe it pays to be a long-term investor.
Holding bonds, preferred stock and higher turnover investments inside tax-deferred accounts like IRA's, 401k's and annuities may be preferable. Owning lower turnover investments that produce qualified dividends and long-term capital gains in taxable brokerage accounts may also be to your advantage.
Let's imagine another investor, Lisa Petty that has a million dollar portfolio that consists of two accounts: $500,000 in Lisa's IRA and $500,000 in her individual brokerage account. Let's assume that based upon Lisa's appetite for risk she would like to maintain a balanced portfolio with 50% in Stock and 50% in bonds. Rather than maintaining the 50/50 allocation individually in both her IRA and her brokerage account Lisa may want to consider owning all of the bonds in her IRA and all of the stock in her brokerage account. By looking at the big picture of her entire portfolio, Lisa may be able to reduce her taxation and increase her overall growth potential over time.
Source: Fidelity Investments
Utilize Tax-Loss Harvesting
In a properly diversified portfolio, you should expect some investments to be doing better than others. While it can be disappointing to see a loss in some portfolio investments, it can create an opportunity to offset some gains in your taxable investment portfolio. This is a strategy we employed in early April, shortly after the S&P 500 index's recent bottom on March 23rd.
If you realize some capital gains in a portfolio by selling some investments that are up while also selling some investments that are down for a capital loss, your gains may be offset up to the amount in losses. This can enable you to avoid some taxes on your gains by rebalancing in a tax-efficient manner. This would not be beneficial in retirement and other tax-deferred or tax-free accounts like IRA's, 401k's and Roth IRA's.
It is important to note, once you sell an investment for a loss you cannot repurchase the same investment within 30 days or you will have completed a wash-sale. If you transact a wash-sale, your loss will be disallowed and it will result in the cost basis of the new purchase being increased by the amount of the disallowed loss. You can avoid the wash-sale rule by instead purchasing a similar but not identical investment after realizing the loss or waiting at least 31 days before repurchasing. One example of how you may avoid the wash-sale rule is selling a stock for a loss and purchasing an exchange traded fund that tracks the same industry sector. For example, selling AT&T stock and purchasing an exchange traded fund that tracks the telecom sector.
You don't have to be an expert to understand that minimizing the impact of taxes and unnecessary expenses can lead to better outcomes in your financial strategy. The tax code is designed to be complicated and a lack of understanding can lead to you and your family keeping less of your hard earned wealth. It has never been more important to work with a financial planner that is knowledgeable on tax considerations who will take the time to understand the "Big Picture" of your finances. We are here when you are ready to start the conversation.
Nerdwallet, Yahoo Finance