Investors are conditioned to think about tax-planning at year-end. During the last quarter of the year, many advisory firms publish tax-related articles, literature and checklists. Financial advisers may begin to contact their high-net-worth clients or respond to accountants questions about realized capital gains around then.
While the reminders are important, they are reactionary. Tax strategies consistent with objectives should be a proactive year-round activity. If not, advisers may miss opportunities and investors may fall short of their goals.
Let's discuss how to implement a few action items for working effectively with clients on tax issues and helping them to reach their objectives.
Action Item #1: Actively Manage Retirement Contributions
High-net-worth investors may pay tax at the marginal rate of 36%, or perhaps at the highest rate, 39.6%. Contributions to 401(k) or 403(b) plans are limited to $18,000 in 2015. The problem is that many investors only think about the maximum contribution at year-end — when it's too late.
Most plans have not only maximum dollar-amount limits but also a limit on the percentage of each paycheck that can be contributed. If clients wait until the fourth quarter to increase their percentage, they may not hit the maximum of $18,000. At the highest marginal rate, an $18,000 contribution saves more than $7,000 in federal taxes, and more could be saved in state tax as well. And remember, participants age 50 and over can contribute an additional $6,000 for added tax savings of $2,000-plus.
Trying to hit the limits of $18,000 or $24,000 by making significant year-end increases in contributions may cause cash flow issues as well.
A strategy to help clients manage their cash flow is to encourage them to increase the contribution percentage earlier in the year when they have maxed out the Federal Insurance Contributions Act (FICA) contribution limit.
In 2015, the FICA tax of 6.2% can only be withheld on compensation up to $118,500. Once that income limit has been reached, the 6.2% goes back into the taxpayer's take-home pay. We all know what happens to that extra income once it hits the checking account.
Advisers should encourage clients to plan ahead and increase their retirement contribution instead, ensuring that they receive the maximum tax benefits allowed — and potentially an employer's matching contribution to a company-sponsored defined contribution plan.
Action Item #2: Actively Manage Capital Gains and Losses Year Round
For a mutual fund investor, it is difficult to estimate what gains various funds may distribute at year-end. Advisers and accountants scramble to advise investors on how to offset the gains declared at the end of the year. However, the management of a portfolio should not be left till then.
Gains and losses should be harvested during the year as advisers make prudent investment and asset-allocation decisions. If an investment is sold at a loss, then those losses are on the books — not only for the current year, but also carried over to future tax years.
Too many times investments — stocks, bonds or mutual funds — are sold at year-end to cover gains either from mutual-fund distributions or managed portfolios. It may not be the time to sell, but advisers often develop strategies to avoid wash-sale rules by selling stocks with losses and buying back the same investment either 30 days before (doubling up the position) or after the sale (out of the market position). This strategy could cost investors fees or increase investment risk.
The better strategy is to utilize the losses that are on the books from investment decisions that were made proactively, not based on tax savings.
Action Item #3: Simple Techniques to Actively Reduce the Size of Your Estate
For many high-net-worth individuals, it is difficult to determine the tipping point at which to move from the asset accumulation phase to a strategy to reduce the size of the taxable estate. If clients' goals are not clear or if advisers do not review them adequately, fear will cause inaction and the taxable estate will continue to grow.
Generally, you could argue that this is not a bad thing, but remember, estate taxes at death could be as high as 40% of the estate's fair-market value. Without getting into more complicated estate-planning techniques, simple annual planning makes sense.
First, advise clients to use the annual gift limit, which is $14,000 per donee in 2015. This is basically the “free money” that they can give to their family and friends without taxation issues. The limit is per donee, which means if the goal is to benefit 10 individuals, $140,000 annually could be removed from the estate.
Second, be aware of other limitless gifts, such as paying direct medical expenses for individuals, giving direct gifts to institutions for education expenses or providing charitable donations. These gifts cause no additional gift tax and will effectively reduce the size of the estate subject to the 40% tax at death.
Tax planning is not only a year-end activity; it should be an integrated component of each client's overall financial plan. A clear focus on the stated goals and objectives will lead to the discipline that is necessary to make timely and more effective decisions.
Joyce Schnur is vice president overseeing the financial services business at the Kaplan School of Professional and Continuing Education. She is also a contributing author to the CFP Board of Standards' "Financial Planning Competency Handbook, 2nd Edition" (Wiley, 2015).