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Andy Friedman’s 8 Tips to Cut Taxes for Clients Before Congress Acts

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Andy Friedman of The Washington Update has cast an experienced gimlet eye on all things Washington, from the presidential race (Andy Friedman: Indie Voters Crucial to Clinching Presidency; Trump Could Trip Up) to the Department of Labor’s fiduciary rulemaking (How to Kill DOL’s Fiduciary Rule: Andy Friedman) as reported on ThinkAdvisor.

In a recent white paper, Friedman — a former tax lawyer — writes about the federal tax situation, particularly for higher-income taxpayers, and argues that while the current Congress — and potentially future Congresses — might not increase tax rates, tax reform efforts (often called “loophole closing” ) could mean that investors will pay more in taxes.

Taxes paid by high income investors are likely to rise as Congress over time eliminates favorable tax treatment of more items to pay for additional spending,” he writes.

Friedman argues that investors and their advisors should “take advantage of the current tax treatment of endangered items while it remains available.” Following are his eight tips to minimize taxes now:

Shield Investment Earnings From Taxes

1.  Shield Investment Earnings From Taxes

To maximize the after-tax returns of investing, Friedman suggests using municipal bonds, master limited partnerships (MLPs) and real estate investment trusts (REITs), which provides investment income free in all or part from federal income tax. As an example, he cites a municipal bond paying 3% interest that produces a tax-equivalent yield of 4.6% for a taxpayer in the 35% tax bracket.

This is one tax loophole that Friedman believes won’t be closed by Congress, “although there can be no guarantee when predicting the whims of Congress.”

Consider Investments Providing Long-Term Capital Gains

2.  Consider Investments Providing Long-Term Capital Gains

Since the federal tax rate on capital gains and qualifying dividendsis about 45% lower than the tax rate on ordinary income,” Friedman suggests investors consider investments producing qualified dividend income, and do so long enough “to produce long-term capital gains” when they’re sold.

Harvest Tax Losses Now and Buy and Hold

3.  Harvest Tax Losses Now and Buy and Hold
Friedman counsels investors to take advantage of the tax deferral provided by buy-and-hold investment strategies, again to take advantage of the lower taxes on longer-term capital gains and also to harvest tax losses “throughout the year to shelter gains that are recognized.” 

Pay Attention to the Basis of Holdings Before Selling

4.  Pay Attention to the Basis of Holdings Before Selling

Friedman says that when investors are selling part of their holdings, “it pays to identify the particular lot that is being sold” so that assets with the highest basis are sold first.

Use Professional Managers to Maximize After-Tax Returns

5.  Use Professional Managers to Maximize After-Tax Returns

 Friedman suggests that, especially in a rising tax environment, investors hire investment managers who employ strategies that maximize after-tax returns by “balancing investment and tax considerations – buy and hold, harvesting losses, tax lot selling.”

Professional managers who keep their portfolio’s holdings turnover in check, who buy stocks producing qualifying dividends and who are in the habit of “selectively using tax-advantaged hedging techniques as an alternative to taxable sales” will all pay off for taxpayers, he writes.

Take Advantage of Tax Deferral

6.  Take Advantage of Tax Deferral

Friedman argues that while fund managers who seek to maximize returns can be rewarding to investors, doing so without an eye to the tax consequences of those high returns can be, well, taxing. Instead he counsels that investors should holdtax inefficient investments in tax-deferral vehicles,” and start by mazimizing their contributions to their IRA and 401(k) accounts.

Even if Congress “might see fit to impose a cap on the total assets an individual can hold in retirement accounts, as the president has proposed,” Friedman says the amounts in those accounts “likely would be grandfathered.” He also suggests that higher-income taxpayers consider using a deferred annuity to provide “additional tax-deferred compounding on retirement savings,” and life insurance, since the death benefits are usually free of capital gains and income taxes. “If the life policy is held inside an irrevocable life insurance trust (ILIT), proceeds are also free from estate and gift taxes.”

Donate Appreciated Investments to Charity

7.  Donate Appreciated Investments to Charity

Friedman reminds advisors and their clients that donating appreciated assets to a recognized charity produces a dual tax benefit:  “a deduction equal to the full value of the asset contributed … without recognition of gain on the asset appreciation.”

Don’t limit yourself to thinking such donations can only be made at “irregular” intervals. One example: “instead of making weekly or monthly payments to a church or other religious institution, an investor can pay a year’s worth of contributions with appreciated assets.”

Use Your IRA for Philanthropy Purposes

8.  Use Your IRA for Philanthropy 

The budget legislation passed by Congress last December (see 14 Tax Changes in PATH Bill End Uncertainty for Many Planners) made permanent an on-again, off-again provision that allows taxpayers 70 ½ and older to make up to $100,000 in tax-free charitable donations directly from their IRAs. At the same time, Friedman says, the donation “counts toward satisfying the individual’s required minimum distribution [RMD] obligation.” So Friedman suggests that qualified taxpayers are “well advised to use IRA funds to make their first charitable contributions, before using nonqualified money.”

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