As you hammer away at your income tax returns for 2019, it’s also a great time to think about how to improve your 2020 investment tax strategy. Here are a few straightforward pointers you can use now to help your investment portfolios when tax time rolls around again.
Determine the Most Suitable Account for Each Security
Tax-advantaged accounts like 401(k) plans and individual retirement accounts (IRAs) are fertile ground for many investments to grow tax-free until you retire. But these retirement accounts aren’t necessarily the best fit for all types of securities.
Municipal bonds (munis), for example, are typically most productive in taxable investment accounts. The federal government doesn’t tax interest paid by most munis, and state and local governments often don’t either. That means munis aren’t ideal for 401(k) accounts or IRAs because their primary advantage is wasted. Since the interest is already tax-exempt, there’s less benefit to holding municipal bonds in a tax-advantaged account.
Plus, munis tend to have a lower pre-tax yield than comparable taxable bonds, all other factors being equal. So if you’ve got munis sitting in your IRA or 401(k), you’re giving up yield for no additional tax advantage. In fact, your effective yield might be even lower because the “tax-free” muni income would eventually be taxable when you pull that money out during retirement.
For tax purposes, annuities can also be a headscratcher inside a traditional 401(k) or IRA. Despite often being complex, expensive and difficult to compare, annuities can offer tax-deferred accumulation. But so do 401(k) plans and IRAs. So holding an annuity within these types of tax-advantaged retirement plans can duplicate the same tax benefit. Plus, if you withdraw funds before retirement, you’d likely get hit not only with an IRS penalty, but also might pay a surrender charge from the annuity provider.
Optimize How You Realize Capital Gains
You realize a capital gain when you sell a security for a profit in a taxable account. No surprise here: the IRS wants to collect a tax on that profit. While no one likes paying more than they need to in taxes, capital gains are an aspect of the tax process where you can exert control and potentially extract some benefit.
Capital gains taxes are the culmination of a successful string of events. You’re paying tax because a security has appreciated in value, which is probably why you invested in the first place.
The IRS taxes capital gains at two levels: short-term (on securities held for 12 months or less) and long-term (held longer than 12 months). For most people, the IRS taxes short-term capital gains—and interest income—at the same rate as ordinary income. The IRS generally taxes long-term capital gains at a lower rate—around 15%-20% for most people. This preferential tax treatment can make long-term capital gains an efficient way of generating cash flow from your investments.
Maybe you’ve held a position for ages because it has a low cost basis—for example, employer stock purchased at a relatively low price. You may risk a lack of diversification if that position has grown to an outsized share of the overall portfolio. Consider selling some of that holding and help take initial steps to diversify your portfolio.
Strategizing what to sell and when can help you with both tax planning and investing. However, not all securities provide this kind of flexibility. While mutual funds have some benefits, they present a potentially frustrating case in which you may lose some control over how and when you realize capital gains.
Mutual funds can have unintended tax consequences when they’re held in taxable accounts. As with stocks, the IRS can tax profits earned from mutual funds. With a mutual fund in a taxable investment account, though, you’re on the hook for any capital gains the fund incurs as it trades throughout the year—regardless of when you buy and sell your shares in the fund. That means that you could end up owing capital gains taxes in a year when you didn’t sell any shares, or even when the overall fund incurs a loss. For taxable accounts, owning individual stocks or ETFs may offer more control and tax efficiency.
Use Investment Losses to Your Benefit
If you’re concerned about capital gains taxes, a strategy called tax-loss harvesting might offer some relief. This is when you sell securities that have declined in value so you can potentially reduce your tax bill by using those realized losses to offset realized gains, or even potentially offset regular income.
Many investors wait until December to lock in losses for the current year, but there are advantages to harvesting earlier. First, selling at the end of year—when many other investors are selling—may put additional downward pressure on the security price. If you start tax-loss harvesting in the spring or summer, you may be able to avoid some of the additional negative influence from other sellers.
Tax-loss harvesting earlier in the year also can give you the flexibility for additional selling later, if needed. One important note: The IRS’s wash-sale rule requires you to wait 30 days before you buy back a stock you’d sold for tax-loss purposes. The wash-sale rule is meant to prevent taxpayers from claiming artificial losses. So if you’re selling a security for tax-loss purposes, you’ll likely want to research a replacement security you could hold for 30 days that could provide similar exposure over that time to minimize the impact on your investment strategy.
Avoid the 50% Penalty
If you’re over age 72—or if you turned 70.5 on or before the end of 2019—the IRS may require you to withdraw a certain amount from qualified retirement plans like IRAs or 401(k)s. You calculate the amount, called a required minimum distribution (RMD) by dividing your previous December 31 balance by a life expectancy factor from an IRS table.
The IRS taxes RMDs from a traditional 401(k) or IRA at your marginal income tax rate. If you fail to take the full RMD from your retirement accounts, the IRS can penalize you up to 50% of the amount you didn’t withdraw.
So if you’re 74 years old and your traditional IRA balance was $500,000 on December 31, your RMD would be about $21,000.[i] If you didn’t take that distribution, you could owe the IRS about $10,500 in penalties.
A few other things to remember. First, RMDs don’t apply to Roth IRAs, but they do apply to Roth 401(k) accounts. Withdrawals from Roth 401(k) plans are tax free, but you’ll still pay the IRS penalty if you don’t take your RMD. Second, RMDs apply to each of your IRA or 401(k) plans. So if you have multiple IRA or 401(k) accounts, you need to calculate an RMD for each to avoid IRS penalties.
Lastly, you can use a single account to cover the total RMD amount across the same types of plans. That means you could use one IRA to cover RMDs for multiple IRAs, but not for the RMD on a 401(k) plan. Consult the IRS website (irs.gov) or your tax advisor for more details on how RMDs might affect you.
For most people, tax season isn’t particularly fun. But if you plan ahead and follow some of these tips, your investment portfolios may be working more to your benefit when tax time rolls around next year.
The contents of this article shouldn’t be construed as tax advice. Please consult your tax professional. Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Based on IRS “IRA Required Minimum Distribution Worksheet” https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf and new RMD age limits from Secure Act of 2019.
