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Mid-year tax planning adjustments for your clients

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Tax season is barely over and the last thing you may want to revisit is your (or your client’s) tax position.

But with the year more than half over, it might be prudent to consider making adjustments to manage tax liability for 2015 and beyond.

Adjust your withholding/estimated tax payments

Compare your income now with what you anticipated when you set up your 2015 tax withholding or estimated tax payments. Is the income what you expected? More? Less? If more, do you need to increase your withholding or your estimated payments to ensure you’re not under withheld and subject to penalties

Remember, there’s a withholding safe harbor that allows you to pay either 100 percent of your prior year tax liability or 90 percent of your current year liability to avoid penalties. For those who make more than $150,000, the safe harbor is met when you pay 110 percent of your prior year tax liability or 90 percent of your current-year liability. 

Note also that if you are making estimated payments, the third payment is due Sept. 15 and the final payment is due Jan. 15, 2016. Assuming your income for the year is evenly distributed, you should make four equal estimated tax payments.

If your income is not evenly distributed over the year, then making estimated tax payments is more complex. The tax system is a pay-as-you-go regime and you cannot backload your estimated taxes. Failure to make estimated payments mirroring the timing of your income will result in an IRS penalty and interest charges, notwithstanding that you have had the appropriate amount withheld for the full year. 

If you find you’ve withheld less than you should have for the first two quarters of 2015, and if you or your spouse has wage income as an employee, consider paying more tax by adjusting your withholding. Because any tax paid through employer withholding will be treated as paid evenly throughout the year, you may decrease any under withholding for prior periods.

If you are under-withheld and neither your spouse nor you works for an employer, then pay the under-withheld portion as soon as possible. Each day you are under withheld adds to IRS-imposed penalties and interest.

Make or adjust IRA and retirement plan contributions 

Review your IRA and retirement plan contributions and consider if you want to modify the amount. 

If your employer matches your contribution, you may want to time your contributions for each pay period to not lose the match. If you front load your contributions and max them out, and if your employer matches each contribution, you’ll lose the match for the part of the year you’re not making contributions.

Ideally, you’ll want to fully fund both your IRA and retirement plan. This goes the same for your clients.

Manage increasing mutual fund capital gain distributions 

If you invest in a mutual fund outside an IRA or retirement plan, you’re probably aware the fund periodically distributes taxable capital gains. Even though you haven’t sold a share of your investment, you must pay tax on capital gains triggered by the underlying purchases and sales of investments within the fund. With the duration of the bull market, capital gains distributions are growing in many mutual funds. Many investors have been surprised by the increase in taxes owed on the same investment. 

The capital gains tax triggered by internal trading in a mutual fund is different than the tax that you pay when you sell shares. For one thing, you control when you sell shares but the fund manager controls what the fund trades. Also, when you sell shares, you have the proceeds to pay your tax liability. The capital gain “distribution” you receive from a mutual fund is somewhat of a misnomer; you do not actually receive funds and you must pay the tax liability from your other assets (or sell some of the fund, possibly triggering more tax liability).

The other component is that the effective capital gains rate has been increased twice over the last several years. Assuming you are not in the lowest two tax brackets that qualify for the zero percent rate, you will pay 15 percent if you make $200,000 or less, 18.8 percent if you are single and make more than $200,000 ($250,000 if you are married) but are not in the highest tax bracket, and 23.8 percent if you are in the highest tax bracket.  

The combination of the larger mutual fund capital gain distributions and the applicable increased tax rate has necessitated increasing estimated tax payments and, for retirees living on fixed income, has reduced after-tax funds. It has also prompted action to minimize such capital gain distributions going forward.

How can you reduce tax liability associated with mutual fund capital gain distributions? 

One strategy is to maximize tax-favored assets, like traditional and Roth IRAs, because they are not affected by capital gain distributions. You can do so by selling your taxable mutual fund and making an after-tax IRA or Roth IRA contribution with the proceeds.

If your income precludes you from making the Roth IRA contribution directly, you can make a traditional IRA contribution then convert that IRA to a Roth IRA. Of course, the sale of your mutual fund can trigger gain recognition that needs to be considered. 

A second strategy is to transfer traditional IRA assets to a Roth IRA and pay any tax liability by selling your taxable mutual funds. In effect, you’ll be eliminating some or all the asset  generating the troublesome capital gains distribution, and replacing it with an asset  generating no income tax liability, not subject to mandatory distributions at age 70 ½, and not counting as a trigger for the 3.8 percent investment tax. 

A third strategy is to change the taxable investments you hold. You can reduce or eliminate future capital gain distributions by selling the fund and replacing it with a “tax-efficient” mutual fund designed to minimize internal trading. For example, an indexed mutual fund that tracks the S&P 500 should not generate the same taxable capital gain distributions.

There are also actively managed mutual funds where the manager specifically considers the level of internal trading. Another possibility is purchasing stocks directly. Direct stock investments do not cause capital gain distributions.

All of these strategies may necessitate selling some of your mutual fund investment and triggering capital gains, based on the difference between your purchase price and the sales proceeds. To minimize this, try to sell a fund at a loss or with little gain. Also, the Roth IRA conversion will trigger ordinary income on the gain in the converted value.

However, while the tax drag on the Roth conversion might be the greatest, this approach also offers the most potential tax savings over the longer term.

See also:

4 keys to Roth conversions

The dangerous lie Dave Ramsey tells about cash value life insurance

Higher contributions, better balances among 403(b) plans