Year-End Tax Planning Tips and Tools

Whether you’re saving, investing, spending, bequeathing, or receiving wealth, there’s scarcely a move you can make without considering how taxes might influence the outcome. As 2021 draws to a close, let’s consider year-end moves that may help you maximize tax-efficiency and minimize your tax bill.

Watch for Fund Distributions

Even as we’ve continued to weather the pandemic storm, our forward-looking, global markets have been delivering relatively strong returns year-to-date for many foreign and U.S. stock funds. That’s good news, but it also means mutual funds’ capital gain distributions may be on the high side this year. Capital gain distributions typically occur in mid-December, based on the fund’s underlying year-to-date trading activities through October. For funds in your tax-sheltered accounts, the distributions aren’t taxable in the year incurred, but they are for funds held in your taxable accounts.

Taxable distributions aside, staying put to earn all potential market returns is the more important determinant in our buy-and-hold approach. With that said, in your taxable accounts only, if you don’t have compelling reasons to buy into a fund just before its distribution date, you may want to wait until afterward. On the flip side, if you are planning to sell a fund anyway - or you were planning to donate a highly appreciated fund to charity - doing so prior to its distribution date might spare you some taxable gains. 

Consider Tax Loss or Gain Harvesting

Having an investment plan facilitates your or your advisor’s ability to identity and make best use of tax-loss and tax-gain harvesting opportunities when appropriate. 

How Does Tax-Loss Harvesting Work?

Tax-loss harvesting typically involves:

1. Selling all or part of a position in your portfolio when it is worth less than you paid for it. 
2. Reinvesting the proceeds in a similar (not “substantially identical”) position. 
3. Optionally returning the proceeds to the original position after at least 31 days have passed (to avoid the IRS “wash-sale rule”). 

You can then use any realized capital losses to offset current or future capital gains, without significantly altering your portfolio mix. If there are capital losses beyond those used to offset gains, up to $3,000 may also be used to offset ordinary income each year, with any additional losses available to carry forward indefinitely.

It’s worth noting that tax-loss harvesting typically lowers a harvested holding’s cost basis. So contrary to popular belief, you’re usually postponing rather than eliminating taxable gains. Why bother? More time gives you more control over when, how, or even if you’ll realize the gains. For example, you could wait until tax rates are more favorable, or reduce embedded gains over time through gifting, charitable giving, or estate planning tactics.  

Why Harvest Capital Gains?

Along with relatively strong year-to-date market performance, many Americans are also benefiting from historically lower capital gain and income tax rates that may or may not last. Taxpayers often view each tax season in isolation, seeking to minimize taxes owed that year. We prefer to view tax planning as a way to reduce your lifetime tax bill. Of course, we can’t know what your future taxes will be. But it can sometimes make good, big-picture sense to intentionally generate taxable income in years when tax rates seem favorable. Basically, you’re sacrificing a tax return battle or two, hoping to win the tax-planning “war.”

Tax-gain harvesting involves selling appreciated holdings to deliberately generate taxable income. Why would you do that? Remember, your goal is to minimize lifetime taxes paid. So you may wish to generate taxable gains in years when your capital gains tax rate may be lower, or in limited instances, even 0%. For example, if you are self-employed and have a year with particularly low income, or if you are in early retirement and are not yet required to take RMDs (required minimum distributions) from your retirement accounts, you may be subject to lower capital gains rates.

Consider a Roth Conversion

A Roth conversion involves choosing to pay taxes today (hopefully at lower rates) in order to avoid paying taxes tomorrow.

A Roth conversion refers to the act of converting a traditional IRA account into a Roth IRA account. A traditional IRA account is created using pre-tax dollars, meaning the distributions you take from a traditional IRA account are taxed at ordinary income tax rates. A Roth IRA is created using after-tax dollars, meaning the distributions you take from a Roth IRA account in retirement are tax-free.  

One of the main reasons to choose a Roth conversion is for the advantage of tax-free withdrawals in retirement. With that in mind, you’ll want to take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds. If you believe you’ll be in a lower tax bracket come retirement, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of interrupted or lowered income (lost a job, missed out on a bonus, etc.), you may be in a lower tax bracket now than you would when entering retirement. If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation. This strategy is best executed with the assistance of an experienced financial advisor or tax professional.

Another reason to consider a Roth conversion is to ease the tax burden on your heirs. With the passage of the 2020 SECURE Act, the stretch IRA was eliminated - most non-spouse beneficiaries of inherited IRAs must now withdraw all funds from an inherited IRA within 10 years of the date of death of the original owner. This may lead to higher tax bills as distributions may no longer be "stretched" indefinitely, potentially bumping heirs into higher tax brackets in the years that they withdraw the IRA funds.

If you're looking at a Roth conversion through the lens of tax planning for your heirs, you'll need to assess whether you’d rather prioritize reducing your own lifetime taxes or those of your heirs, and proceed accordingly.¹

Seize the Day On Your Charitable Giving

Unlike many other pandemic-inspired tax breaks, several charitable-giving incentives still apply for 2021, but may not moving forward. This includes the ability for single/joint filers to deduct up to $300/$600 in cash contributions to qualified charities, even if they’re taking the standard deduction on their tax return. If you’re so inclined, you also can still donate up to 100% of your AGI to qualified charities in 2021.

Consult your wealth advisor to evaluate whether one or more of the gifting strategies below may be beneficial to your unique situation:

Saving for Giving (DAFs)

The Donor-Advised Fund (DAF) is among the simplest, but still relatively effective tools for pursuing tax breaks for your charitable giving. Instead of giving smaller amounts annually, you can establish a DAF, and fund it with a larger, lump-sum contribution in one year. You then recommend DAF distributions to your charities of choice over future years. Combined with other itemized deductions, you might be able to take a sizeable tax write-off the year you contribute to your DAF - beyond the currently higher standard deduction. There also are many other resources for higher-end planned giving. For these, you’d typically collaborate with a team of tax, legal, and financial professionals to pursue your tax-efficient philanthropic interests.

Qualified Charitable Distributions (QCDs)

Many people are aware that they may make charitable contributions throughout the year, then deduct the total on the Schedule A of the tax return. For those who must make Required Minimum Distributions (RMDs), Qualified Charitable Distributions (QCDs) up to $100,000 per year may be used to satisfy all or a portion of their RMD, providing a unique tax-planning opportunity. Making donations directly from the IRA may offer several key tax advantages over the traditional route: if a gift is made directly from your IRA, it is considered a qualified distribution and counts toward your RMD, but is NOT included in your gross income. The QCD is a particularly effective strategy in years that you take the standard deduction, as it allows you gets the same tax benefit of a charitable gift while still taking the higher, post-Tax Cuts and Jobs Act standard deduction. Some custodians (including Schwab), allow IRA account holders to order checks for their IRA, allowing them to make QCDs throughout the year with no additional paperwork - see our article Get A Checkbook For Your IRA for details.

Gifting Highly Appreciated Shares

If you’re going to be donating anyway, consider doing so with highly appreciated securities like stocks, stock funds, property, or similar holdings that are worth considerably more than when you acquired them. If you sell a highly appreciated holding outside of a tax-sheltered account such as an IRA, you’ll pay capital gains taxes on the difference between its cost and its sale price, less expenses. If you instead donate it “in kind” to a non-profit organization (i.e. without selling it first), you triple its tax-wise potential: 

1. The holding’s full market value on the date of donation is available to you as a charitable deduction in the year you donate it (subject to a cap based on your Adjusted Gross Income).
2. You avoid capital gains tax on the unrealized gain. 
3. The charity is free to keep or sell the holding, also without incurring taxable gains, maximizing your gift.

As you approach year-end, you may consider two additional planning opportunities to maximize investment growth while reducing current tax bills:

Saving for Healthcare (HSAs)

If you're considering a new health insurance plan for the upcoming year, you may wish to look into an HSA. The Healthcare Savings Account (HSA) offers a rare, triple-tax-free treatment to help families save for current or future healthcare costs. You contribute to your HSA with pre-tax dollars; HSA investments then grow tax-free; and you can spend the money tax-free on qualified healthcare costs. That’s a good deal. Plus, you can invest unspent HSA dollars, and still spend them tax-free years later, as long as it’s on qualified healthcare costs. At age 65, you can even use HSA funds as you would Traditional IRA funds – at 65 and beyond, you may withdraw funds for non-qualified expenses without a tax penalty (though these withdrawals would be subject to ordinary income tax). However, there are some catches. Most notably, HSAs are only available as a complement to a high-deductible healthcare plan, to help cover higher expected out-of-pocket expenses. 

Saving for Education (529 Plans)

529 plans are among the most familiar tools for catching a tax break on educational costs. You fund your 529 plan(s) with after-tax dollars. Those dollars can then grow tax-free, and the beneficiary (usually, your kids or grandkids) can spend them tax-free on qualified educational expenses. Many states offer tax breaks on 529 contributions. You may also consider “superfunding” 529 plans, making up to five years-worth of contributions in a single year, spreading the gift over five years for tax purposes, thereby not exceeding the annual exclusion. Be sure to consult a qualified tax advisor to determine whether front-loading makes sense for you, and to ensure proper reporting.

1. Note that Roth conversion is currently under review as part of the Build Back Better Act; stay tuned for information on future limits to this planning strategy.

This content is developed from sources believed to be providing accurate information as of the date of publication, and is intended for informational purposes only. Please consult your financial professionals for specific information regarding your individual situation. Past performance does not guarantee future results. All investing involves risk, including risk of loss.