With the year end upon us, savvy investors will once again be reviewing the tax efficiency of their retirement and investment portfolios. For many, the tax pain caused by the recent changes under the American Taxpayer Relief Act (ATRA) is still fresh in their mind.
ATRA not only increased the top income tax rates but also reduced the value of certain tax expenditures such as itemized deductions and personal exemptions for some taxpayers. But for many, the biggest tax increase was on their investment income.
ATRA increased the top tax rates for long-term capital gains and qualified dividends from 15 percent to 20 percent. In addition, many are now subject to the 3.8 percent Medicare surtax introduced as part of the Patient Protection and Affordable Care Act (PPACA) in 2013. This is an additional tax on certain investment income for those that make over $200,000 single filer and $250,000 for joint filers.
As a result of this surtax and the increased top tax rate for capital gains, there are now four different tax rates for long-term capital gains and qualified dividends depending on the taxpayer's income. For those in the bottom two income tax brackets, there is no tax on long-term gains and qualified dividends.
For those in the 25 percent tax bracket, the tax is 15 percent. For those that are subject to the 3.8 percent surtax, the tax increases to 18.8 percent. Those in the highest tax bracket will be subject to a 23.8 percent long-term capital gain and qualified dividend tax. It's getting more complicated.
Although ATRA affected the wealthiest taxpayers the most, as it was designed to do, the biggest tax hike actually happens at the $37,450 level for a single filer and $74,900 for a married couple filing jointly.
This is where a taxpayer goes from a 15 percent to 25 percent tax bracket. That is a 66 percent increase. For those taxpayers, tax bracket management, tax timing and tax efficient investing can be powerful tools in reducing taxes. Furthermore, by keeping in the 15 percent tax bracket, their long-term capital gains and qualified dividends will be tax free.
Strategies to reduce income taxes
There are strategies available to all clients in all tax brackets that may help them manage their taxes, control the timing of their taxes, keep them in a lower tax bracket and reduce their actual tax liability. The following are a few to consider as the year end approaches.
1. Reduce income:
A simple way to reduce taxes is to reduce the income subject to tax. Taxpayers should consider maximizing contributions to 401(k) plans, IRAs, Spousal IRAs for non-working spouses and catch up contributions into those accounts for individuals 50 and over.
An increasingly popular way to reduce income is by contributing to a Health Savings Account (HSA). Those that enroll in a high deductible health insurance plan (a plan with a minimum deductible of $1,300 for single and $2,600 for a family), can make contributions into an HSA up to $3,350 for a single and $6,650 for a family. Think of it as a "health IRA." The contributions are tax deductible regardless of income, grow tax deferred and can be withdrawn tax-free to pay for qualified medical expenses.
Also, it is portable, meaning when you change jobs you can take it with you. Furthermore, HSAs are not a 'use it or lose it' account. The taxpayer can pay for out-of-pocket medical expenses with money out of their pocket, allowing the HSA to continue grow tax deferred. When the taxpayer retires, tax free distributions from HSAs can be used to pay for out-of-pocket Medicare expenses such as premiums (other than premiums for Medigap insurance), deductibles and co-pays.
2. Maximize deductions:
Clients should work with their tax preparers now to make sure they do not overlook any valuable deductions. Further-more, they may want to consider accelerating deductions by paying real estate taxes and 2016 mortgage payments in 2015. Of course, don't ignore how this may affect possible exposure to the Alternate Minimum Tax (AMT).
3. Tax loss harvesting:
Taxpayers may want to consider whether it makes sense to dump some of their poor performing investments, and recognize a loss to offset a gain from other investments. Capital losses can fully offset capital gains to $3,000 of ordinary income.
But don't be tempted to immediately (within 30 days) repurchase the sold investment. The "Wash Sale Rule" will apply and the loss will not be recognized.
4. Conduct a portfolio review:
Many people don't think about how taxes could affect their long-term investment and retirement goals. The taxes an investor pays annually on capital gains, dividends and interest could significantly erode a portfolio's return in the future.
Morningstar measures the tax cost ratio of most mutual funds, and while some funds will have a low tax cost ratio, other funds can have ratios as high as 3 percent or more each year. This means that a mutual fund with a 2 percent tax ratio will surrender 2 percent of its returns to taxes each year.
