Although Tax Day is in the books for 2023, the tax conversation isn’t done. What are you doing for your clients to put them in a better tax situation this year and into the future? Being a tax-smart advisor isn't just about reducing the tax drag on your clients’ taxable accounts, it’s about aligning their total investment plan for a more optimal outcome. Consider the following tax planning tips.
Are your clients taking advantage of these tax-advantaged accounts to grow their retirement assets? Traditional individual retirement accounts allow investors to contribute pretax dollars, which lowers their current year tax liabilities, and the assets grow tax-free. While the annual contribution limit is not large, these accounts are a good complement to other components of an investor’s total savings and investment picture.
For 2022, the IRA contribution limit was $6,000, and individuals over the age of 50 could also make catch-up contributions of $1,000. For 2023, those contribution limits have increased to $7,000 for individuals under age 50 and $7,500 for those over 50.
Encourage your clients to make IRA contributions as soon as possible, either as a single contribution or automatic contributions.
For 2023, the 401k contribution limits have increased from $20,500 to $22,500. In addition, most employers will contribute to an individual’s 401(k) plan in the form of a match. You wouldn’t ignore a $100 bill sitting on a sidewalk, so make sure your clients don’t miss the potential of thousands of dollars in “free” money. It might be worthwhile to look at the elections your clients have made with their employers and ensure they are taking full advantage of the 401(k) plan and maximizing their pretax retirement savings.
Regarding catch-up contributions for clients who are 50 or older, the limit in 2023 is an additional $7,500. This allows an eligible individual, who perhaps didn’t give enough thought to retirement earlier in their career, to save up to $30,000 a year in pretax dollars for retirement in 2023.
Work with clients who have room for additional contribution in their 401(k): They will benefit from immediate tax savings by lowering their taxable income and from the growth of their portfolios not being taxed until they start taking distributions. This is a clever way to build a tax-deferred nest egg and for you to introduce your clients to the double-barreled benefit of reducing the tax drag on their portfolios. Then, look at moving their nonqualified accounts to tax-managed investing solutions, so those funds can also aim to reap these benefits.
Even with 2022 in the books, it’s not too late to take advantage of tax-loss harvesting. While harvested losses can't be used to offset 2022 tax liabilities, they can be used for the 2023 calendar year.
Take advantage of this opportunity while it still exists. The current tax-loss harvesting opportunity isn't going to last forever or maybe even much longer. With U.S. large-cap stocks down 19.1% in 2022 (S&P 500), U.S. small-cap stocks down 20.4% (Russell 2000 Index) and international stocks down 14.5% (MSCI EAFE Net Index), there is some but not much runway before those valuable harvestable tax assets evaporate. International markets have already started a moderately strong recovery in early 2023, so don’t hesitate if tax management is something you want to take advantage of for your clients.
Unlike 2022, the U.S. equity market usually ends the year higher; over the last 104 years, the S&P 500 Index has reflected a positive annual return 73% of the time.
It’s easy to take for granted the distributions of interest, dividends and capital gains of the prior year — or any year in most cases. The tax cost from these distributions can be sizable. The cost impact comes from the size of the overall distributions and the actual tax classification of these distributions.
Let’s start with size, especially since 2022 was a down market year. The average U.S. equity fund distributed 7% of its net asset value in capital gains. The kicker, though, is that both dividends and interest income increased in 2022. Dividend yields increased on average by 0.5%, according to Bloomberg, and taxable bond interest increased a whopping 3.2%. As you can see from the table below, this resulted in a pretty hefty overall 2022 tax bill for the average investor.
The second thing to consider is the tax classifications of the distributions. Only long-term capital gains and qualified dividends receive preferential investment tax treatment. Short-term gains, nonqualified dividends and taxable bond interest are taxed at the ordinary income tax rate. This results in higher than expected and higher than necessary tax bills.
Get a head start on helping your clients position their portfolios for a better after-tax outcome. What better time than when paying taxes is fresh on their mind? If you run a 1099 analysis with their tax figures, you'll have a good picture of their tax cost. Why not use this information now to steer your clients’ portfolios into a more optimal tax-managed direction?
Start by thinking about the loss harvesting potential if that has not happened yet (or using accumulated losses if loss harvesting was done). The tax liability of making a switch is often less than perceived. In addition, doing it now has the immediate benefit of lowering the expected distribution rate of the individual investor’s portfolio for this tax year.
Tax-managed accounts allow investors to save for retirement by providing advantages such as long-term tax deferrals or tax-free growth with tax-free withdrawals. It is important to consider tax-management techniques that help assets grow while limiting the impact of taxes and ultimately increasing the probability of the investor reaching their goals.
Rob Kuharic is director of tax managed solutions at Russell Investments.
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