As the 2020 year comes to an end in the coming weeks, tax planning is that last thing that many of us want to think about. Especially, given how turbulent the year has been with the coronavirus pandemic, civil unrest, and an election year. We also witnessed an impressive stock market resurgence after it cratered in March. Then, the impressive production of the covid-19 vaccines that will be available globally at record speeds. Can’t tax planning wait until next year?
Tax planning is something that should be top of mind for any successful business owner or entrepreneur. Tax planning doesn’t have to be complicated. If you think about it, with the right finesse, the tax fee you are accessed could be controlled by you versus the alternative of being reactionary on the day you prepare your taxes. Given that there will be a new presidential administration, tax laws in the next four years could change drastically. The Biden tax proposal could potentially impact everything from individual tax rates, capital gains, corporate tax rate and estate & gift taxes to name a few. I put together 5 specific strategies that most people could consider to help optimize growth and be more tax efficient.
Asset Location
The first tax planning strategy that I will mention, is, in my opinion, the most important. Furthermore, I hope that it then sets up an understanding how it applies to the other strategies that I mention. Asset location is significantly important and the first strategy to keep in mind. Most certainly, this may not be a familiar concept, especially since you normally hear about asset allocation or diversification. The application of asset location should take into account what you hold, how long you plan to hold and how the profits will be treated. Are you holding real estate and how will the cost basis be treated in the future if no step-up in basis? Is the asset a qualified (tax-deferred account) or non-qualified account and subject to ordinary rates? These are just a few of the considerations when thinking about your potential profits and how to better control what tax you might have to pay.
Roth IRA Conversion
Roth IRA conversion and contributions could be great opportunities where there could be zero to lower tax brackets now and into the next few years. Doing a conversion now when tax rates are lower could be more advantageous. If tax rates increase, doing a Roth IRA conversion just isn’t that sexxy because the conversion would be more expensive. In terms of contributions, the concept is the same, funding your future retirement with more money and paying less tax with the same amount of money. Now, that's very appealing! One other note on Roth IRA conversions, The Tax Cuts and Jobs Act from 2017 eliminated recharacterizations of Roth IRA conversions starting in 2018, which means that conversions are now permanent. Lastly, on this point, remember that the goal is intended to pay the least amount of taxes on your assets, and that Roth IRA distributions in retirement will be zero.
Net Unrealized Appreciation
Net Unrealized Appreciation (NUA), for those that have highly appreciated company stock, could allow for tax savings when utilizing long-term capital gains versus claiming ordinary income tax rates on those shares. This obviously doesn’t apply to everyone, and certain rules apply. For example, someone who worked for a major corporation and received company stock. In order for this strategy to make since, a few conditions would need to be triggered such as:
1- 59 1/2 years of age and still employed
2- Separation from service - Furloughed or you told them to take this job and shove it
3- Death - Your beneficiaries could benefit
4- Disability
Options and considerations for a NUA. The company stock that is a net unrealized appreciation must be withdrawn as part of a lump-sum distribution. The stock can be withdrawn in-kind and transferred to a non-qualified brokerage account. Any remaining plan funds must be paid out, rolled over or converted to a Roth IRA. When managed properly, the NUE can be subject to future long-term capital gains rather than ordinary income tax. A few benefit now are to lock in today's low tax rates and reduce limitations on how funds can be used or when. Additionally, this helps with not having worry about RMD's in retirement or problems to heirs.
Coronavirus Related Distributions
Retirement account coronavirus related distributions (CRD’s) (Only 2020 so far, could change?), which was part of the CARES ACT. Individuals that were affected by Covid-19 can take a distribution from their retirement account(s) and receive an exemption from the 10% early distribution penalty. The tax relief also allows the option to spread the tax owed on the CRD’s evenly over a three year period. Keep in mind that most plan administrators withhold 10-20 percent as a safety measure to pay for the tax you might owe. Eligibility could be met by either you or your spouse and/or dependent(s) being diagnosed with Covid. Also, other eligibility situations could be met if you have experienced adverse financial consequences, such as being furloughed, being quarantined, unable to find childcare, to name a few situations. The max amount, if you qualify, is $100,000. Pulling income from your retirement account should be a last resort, but it is very understandable for those that need it.
Tax-Efficient Investment Management
The final strategy deals with tax efficient investment management. Have you ever used tax losses to reduce the amount of tax you pay, whether on income or capital gains? Another question to ask yourself is, could vehicles that distribute capital gains each year be better suited for tax-deferred accounts or tax-exempt? When it comes to tax efficient investment management, the concept is broad but can be simplified when understanding what your financial goals are. As an example, two aspects of tax efficient management deal with tax-loss harvesting and placement.
Tax-loss harvesting is not an easy philosophy to understand, simply because of the notion of saying you have lost money on an investment. However, it can become a powerful tool in a forward-looking, tax aware approach if used effectively to reduce capital gains or shield a small amount of ordinary income.
In terms of placement or the location of the investments, where investments are held should be part of your tax plan. There are three main considerations when determining optimal asset location.
1- Tax-Exempt Roth IRA
2- Tax-Deferred Account, such as Traditional IRA or 401(k) (qualified)
3- Fully Taxable Brokerage Account (non-qualified)
In fully taxable accounts, there could be triggers that create capital gains or losses. Each has potential benefits, but capital gains may create an unnecessary or unwanted taxable event. Events such as rebalancing, interest and dividends paid by a stock company, mutual fund or ETF.
The application of a tax efficient strategy can be tailored to you in terms of what point of life you are in. Are you just getting started on your wealth building strategy, or achieving a level of success and earning great income or in a conversation state and planning on generating income?
I hope that these ideas can help you start thinking about tax planning in a different light that helps you more effectively manage what you pay in taxes and build wealth. Additionally, these are just a few of the many options available that can help you build wealth more effectively. Should you need help and looking to see if you could be positioned in a more favorable financial situation, book a quick complimentary consultation.