Using Tax-Efficient Strategies to Retain More of Your Wealth

October 11, 2017

As we move closer to year-end, we start to focus on what we can do to minimize our clients’ taxable income. Marginal tax rates have risen sharply over the past three decades from a 28% marginal federal tax rate in the late 1980s to a 44.6% top marginal rate in 2017 (52.6% for California residents). As a result, tax planning has become an even more important part of how we assist clients in building and preserving wealth.

As of October 2017, certain tax proposals that might impact 2018 tax law for individuals include the following:

  • Reduce the top marginal tax bracket from 39.6% to 35%
  • Reduce the maximum rate on small businesses conducted as sole proprietorships, partnerships, and S corporations from 39.6% to 25% (20% for C corporations)
  • Repeal the Alternative Minimum Tax (AMT)
  • Eliminate all itemized deductions except for charitable deductions and mortgage interest (this would mean that state income taxes and property taxes would no longer be deductible).
  • Repeal the estate tax

In light of these potential tax changes, we wanted to highlight the following tax planning techniques to consider, noting as always, each taxpayer’s tax situation is different, so we strongly recommend you talk to your tax advisor before making any planning moves:

Defer business net income from 2017 to 2018. Current tax proposals suggest federal tax rates on business income (possibly including business income from partnerships and limited liability companies) could drop to as low as 20%–25% in 2018. This could provide an opportunity to defer business revenues and accelerate expenses into 2018 when tax rates will likely be lower.

Consider prepaying property taxes and state income taxes. If you can deduct your property tax or state income tax payments (some people cannot due to AMT restrictions), consider prepaying or even overpaying these taxes in 2017. At a minimum, you will receive a federal tax deduction a year early and if state and local tax deductions are eliminated in 2018, you may receive a deduction in 2017 that you would not be able to receive in 2018. Also, there is a chance that itemized deductions could be capped in 2018 (an old Trump proposal that could be revived) so locking in the deduction seems prudent.

If you are considering making large charitable donations over the next few years, consider making them this year. If tax rates drop in 2018 from 39.6% to 35%, you would receive a larger tax benefit for your contribution in 2017 versus in 2018. Additionally, there is a chance that an itemized deduction cap proposed by Trump during the election cycle could resurface, so taking deductions in 2017 when the deductibility is known is wise.

If you are considering large wealth transfers in 2017, consult with your attorney about possibly delaying them to 2018. The tax proposals on the table include eliminating the estate tax in 2018, so delaying large wealth transfers could be prudent.

If you are retired or retiring soon, consider retirement locations with low or no state income tax rates. States with no state income tax include: Nevada, Texas, Florida, Washington, South Dakota, Alaska, and Wyoming. Current proposals call for the elimination of the deduction for state income taxes starting in 2018. A California couple with $1 million of income and an 11% average income tax rate would pay $110,000 in state income taxes. If their marginal federal tax rate is around 40%, under current law the federal government subsidizes their state income tax to the tune of $44,000 ($110,000 tax deduction x 40% tax rate). If state income taxes are no longer tax deductible, it could make it materially more expensive to live in a high-income tax state.

There is still a lot of uncertainty about the proposed 2018 tax changes as House and Senate committees start the process of putting tax proposals into actual bills, so it is hard to predict what the outcome might be. However, lower tax rates in 2018 and a more generous estate tax exclusion are possibilities, and even if a bill does not pass in 2017, there is a chance a bill will pass in 2018 with tax changes retroactive to January 1, 2018. While the uncertainty makes it difficult to plan, some techniques (such as those outlined above) will likely make sense even without a change in tax law.

Year-End Tax Planning

While a tax rate cut may be in limbo, it does not appear likely a tax rate increase would occur in 2018, so certain traditional year-end planning techniques seem relatively safe to implement. Here are some tax planning techniques you may wish to consider regardless of potential tax law changes:

  • Maximize the use of tax-deductible retirement plan contributions. The 401(k) annual contribution limit is now $18,000. If you are age 50 or older you can contribute another $6,000 for a total of $24,000. Some defined contribution plans allow for total contributions in excess of $50,000. If you have consulting or board of directors’ income, you may be eligible to set up a self-employed retirement plan to shelter some of this income. (Some changes to retirement plan incentives are being considered for 2018 but few details currently exist.)
  • Make annual or one-time gifts to family members. To remove investment income from your portfolio, consider making annual gifts to your children, grandchildren, or other heirs up to the $14,000 ($28,000 per couple) annual exclusion amount. If you have the financial means, consider transferring money in excess of the annual exclusion amount. Gifts in excess of the annual exclusion amount count toward an individual’s gift tax exclusion amount of $5,490,000 (in 2017). This exclusion applies at the donor level and any gifts excluded due to the lifetime gift tax exclusion are counted against a donor’s estate tax transfer exclusion at death. Gifts not only reduce your estate’s value, but can also reduce your family’s income tax liability by shifting assets and the related income generated to family members who may be in a lower tax bracket.

Note: A portion of the investment income for children under the age of 25 may be taxed at their parents’ marginal tax rate, so consider sheltering gifts that will be used to pay for college expenses in a College Savings Plan (AKA “529 Plan”). Income earned inside a college savings plan is exempt from income tax if used to pay qualified educational expenses. (Tax proposals include some mention of additional incentives for college savings for 2018, but few details have been provided.)

  • Gift appreciated securities held for more than one year directly to charities or to a charitable donor-advised fund. Donors receive two types of tax benefits for gifting appreciated securities to a charity: First, they receive a federal tax benefit for the donation. For example, a donor in the 45% tax bracket making a $10,000 gift would receive a tax benefit of $4,500 ($10,000 x 45%) for the fair market value of the gift. Second, tax on the built-in appreciation is eliminated. If you donated shares worth $10,000 that you purchased for $1,000 and you were in a 33% long-term capital gains tax bracket, you would eliminate the capital gains tax on $9,000 of appreciation ($10,000 value less $1,000 purchase price), saving $3,000 ($9,000 x 33%). If you have long-term investments (i.e., investments held for more than one year) with built-in gains (your purchase price is lower than the current market price) in your portfolio, consider donating them to fund your charitable contributions instead of making cash gifts. (No proposed changes for charitable gift deductions in 2018.)
  • Consider a Roth-IRA or Roth-401(k) conversion. Converting an IRA to a Roth-IRA, or a 401(k) to a Roth 401(k), can be an effective technique to minimize long-term taxes on investment earnings. Though an upfront tax is due on conversions, none of the future income earned inside a Roth vehicle is subject to income tax. A Roth can therefore provide you and your family with decades of tax-free compounded earnings. A conversion is particularly effective if you can execute it in a low-income-tax-rate year. If you will be in a lower tax bracket in 2018, consider delaying a conversion to next year.

Tax Efficiency in our Client Portfolios

In addition to working with our clients’ tax advisors to implement saving strategies, we regularly look for opportunities to maximize clients’ after-tax returns and build their long-term wealth. We utilize these techniques in our client portfolios and you may wish to consider using some of them with the money you manage for yourself and your family:

  • Hold investment assets for more than a year before selling them so that the long-term capital gains rate will apply. There is still a significant tax benefit for holding assets for longer than one year, as the top federal long-term capital gains rate is 19.6 percentage points lower than the top short-term capital gains rate (25% versus 44.6%). Though, keep in mind, taxes should not outweigh other investment considerations; deciding whether to extend your holding period should include assessing any potential risk or return tradeoffs that result.
  • Place the interest-earning portion of your portfolio in tax-deferred accounts. With the top marginal tax rate being assessed on interest-bearing assets, current tax law favors holding these assets (taxable bonds, REITs, etc.) in tax-deferred accounts (like IRAs, 401(k) plans, 403(b) plans, etc.) where the income can be sheltered from tax until it is distributed.
  • Avoid selling investments with large built-in gains, unless the sale is justified by a higher expected return from an alternative investment, or is necessary to maintain portfolio asset allocation objectives.
  • Sell securities (or individual lots of a security, if you purchased the investment over time) that have the largest tax losses (or least taxable gain) when raising cash in the portfolio.
  • At year-end, sell positions with built-in losses to offset realized gains. Proceeds can be placed in a comparable investment. For example, if you sell a bond fund to take a loss, you could invest the proceeds in a comparable bond fund to keep your portfolio in balance.
  • Consider holding tax-exempt bonds in lieu of taxable bonds for a portion of your bond portfolio. Holding some taxable bonds can still be a prudent source of diversification, especially if they can be held in a tax-deferred account such as an IRA.

Final Thoughts

We welcome the opportunity to discuss these topics with you. As with all tax planning, every person’s tax situation is different. We suggest consulting with your tax advisor before implementing any of these tax planning techniques.

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