Kitces | Nerd's Eye View - Taxes

Is Capital Loss Harvesting Overvalued?

nospam@example.com (Michael Kitces) — Wed, 01 May 2013 06:01:00 -0500

Capital loss harvesting has long been a staple of investment tax strategy - so much that the Internal Revenue Code has special "wash sale" rules to ensure that the technique is not overly abused. Fortunately, though, the wash sale rules can be navigated effectively, allowing taxpayers some means to take advantage of available tax losses.

However, while tax loss harvesting remains a viable strategy, it is often greatly overvalued, as the true benefit is not the tax savings from harvesting a loss but merely the benefit of deferring those gains. In the meantime, the strategy has a non-trivial exposure to several risks, including the potential for the alternative investment held during the 30-day wash rule period underperforming the original investment, the possibility of negative tax arbitrage if the investment rebounds in the near term, and the danger that harvesting losses too effectively over time will drive the client's future capital gains into a higher tax bracket! In addition, the fact remains that capital loss harvesting produces no benefits for clients who are eligible for 0% capital gains tax rates, and in fact potentially harms them; in such scenarios, clients should actually be harvesting gains, not losses!

Ultimately, this doesn't mean that harvesting capital losses is a bad strategy, but it is a strategy where the risks must be carefully considered, as they can easily outweigh the relatively modest benefits!

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Harvesting Losses Or Harvesting Gains - Planning Around Four Long-Term Capital Gains Tax Rates

nospam@example.com (Michael Kitces) — Wed, 03 Apr 2013 06:04:00 -0500

Traditional tax planning for portfolios has been relatively straightforward - given that the same maximum capital gains tax rate applied regardless of whether someone had $100,000 or $1,000,000 of income, the dominant strategy was simply to defer capital gains as long as possible, and harvest capital losses to further maximize the benefit.

In today's world, however, the introduction of both a new top 20% long-term capital gains tax rate, and a 3.8% Medicare surtax on portfolio income, makes the picture far more complicated. Instead of just having two long-term capital gains tax brackets that reach a cap at $72,500 of income (for married couples), there are now four capital gains tax brackets, that extend as high as $450,000 before the top rate is reached!

The end result of this graduated four-tax-rate structure is that now it's no longer best to just defer capital gains indefinitely, which - just like accumulating a huge IRA - could eventually drive the client's tax rates higher as income is ultimately recognized in the future! Instead, tax planning for portfolios becomes more proactive, where some years it's still best to harvest capital losses, but in other years it's better to harvest the gains, instead!

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The Taxation Of Social Security Benefits As A Marginal Tax Rate Increase?

nospam@example.com (Michael Kitces) — Wed, 27 Mar 2013 06:07:00 -0500

Social Security benefits first became partially taxable in 1983, and the rule was expanded in 1993 to its current form. As the rules stand now, rising income can subject 50% or even 85% of Social Security benefits to taxation, until a maximum of 85% of all Social Security benefits are included in income for tax purposes.

The reason the taxability of Social Security matters is not just that it raises a client's tax burden in the aggregate, but that it can boost a client's marginal tax rate far above the tax bracket alone; those in the 15% tax bracket may actually face marginal rates of 22.5% to 27.75%, and those in the 25% tax bracket can see marginal tax rates spike as high as 46.25%!

Fortunately, this rate eventually reaches a cap - when the maximum amount of Social Security benefits are being taxed - and the client's tax rate returns to normal. Nonetheless, while clients are going through the income levels where Social Security phases in - which can begin with as little as $25,000 of income for individuals - tax rates rise high enough that more proactive tax planning, from Roth conversions to the use of annuities and asset location strategies, becomes crucial to manage a client's overall tax exposure!

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Income Thresholds For Medicare Part B And Part D Premiums - An Indirect Marginal Tax?

nospam@example.com (Michael Kitces) — Wed, 20 Mar 2013 06:04:00 -0500

Since 2007, higher-income individuals and couples have been required to pay an additional income-related monthly adjustment amount (IRMAA) on their Medicare Part B premiums; a similar rule took effect in 2011 for Medicare Part D premiums. The ultimate impact can potentially be significant; although only a small number are affected, those at the highest income levels will see their Medicare Part B premiums rise from a base of $99.90/month up to $319.70/month, and Part D premiums will cost an extra $66.40/month in addition to the base rate of the plan itself.

Although the higher premium amounts are a cost, because they're determined based on income and may change from year to year, they effectively equate to an "indirect tax" in the form of a higher burden on higher income levels. In turn, this means that the income thresholds for Medicare Part B and D premiums should itself be treated as a "tax bracket" that can be planned and managed around, as a form of proactive income tax planning. Strategies that might create income, or defer income resulting in a greater concentration down the road, must be evaluated for not only their outright tax consequences, but their indirect tax consequences in the form of higher Medicare premiums!

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Will The New 3.8% Medicare Surtax Reinvigorate Non-Deductible IRA Contributions?

nospam@example.com (Michael Kitces) — Wed, 13 Mar 2013 06:02:00 -0500

The non-deductible IRA has long been a financial planning tool, albeit one that has become far less popular in recent years, given the tax preferences for both qualified dividends and long-term capital gains. However, with the new 3.8% Medicare surtax on net investment income that took effect in 2013, a new incentive has emerged: even with ordinary income treatment, the non-deductible IRA provides a way to permanently avoid the surtax, which would otherwise apply to interest, dividends, and capital gains, as well as income from other tax-deferred vehicles like deferred annuities. The strategy is especially appealing to those who are in the peak income years of their career, where a Roth conversion is unappealing due to the high current tax bracket (and other IRAs that will be aggregated), tax deferral is valuable, and a permanent avoidance of the 3.8% Medicare tax provides yet another added value... especially if the account will hold fixed income investments that were going to be taxed at ordinary income rates anyway. Fortunately, the strategy is available regardless of how high income rises (and in fact, is best at high income levels), and while the value of the strategy is limited by the IRA contribution limit of $5,500 in 2013, several years of compounded efforts can still potentially produce a significant tax savings in the future!

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Understanding Marginal Tax Rate Vs Effective Tax Rate And When To Use Each

nospam@example.com (Michael Kitces) — Wed, 30 Jan 2013 07:03:00 -0600

Effective financial planning for clients often has tax-related consequences, which in turn requires a good understanding of not only the tax laws themselves, but also the client's tax rates. Unfortunately, though, significant confusion abounds regarding what tax rates should be used when analyzing various problems. Is it the client's tax bracket? Or a marginal tax rate? Or an effective tax rate? When should each be used? The key is that in the end, marginal tax rates should be used to compare strategies, and effective tax rates should be used to compare people.

Accordingly, if you want to know who commits a larger portion of their total income to their tax obligations, use an effective tax rate. But if you want to know whether to do that Roth conversion/IRA withdrawal/annuity investment/sale for a capital gain or loss/etc., the marginal tax rate is what should be used. In point of fact, this actually means that the marginal tax rate is really the only rate that should be used for financial planning scenarios!

The caveat, however, is that in practice determining a client's marginal tax rate requires more than just looking at his/her tax bracket... so be certainly to calculate the marginal tax rate correctly, too!

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Special 2012 Lookback Rules To Make A Qualified Charitable Distribution (QCD) From An IRA In 2013

nospam@example.com (Michael Kitces) — Wed, 09 Jan 2013 06:30:00 -0600

Amongst the various "extenders" included in the American Taxpayer Relief Act of 2012 (ATRA) was the reinstatement of rules allowing an individual to make a "Qualified Charitable Distribution" (QCD) from an IRA to a charity with favorable tax consequences, assuming the individual has reached the minimum 70 1/2 age, stays within the $100,000 dollar limit, and meets other requirements regarding the distribution and the receiving charity. Unfortunately, though, bringing back QCDs retroactively for 2012 was of limited use when the law wasn't even passed until the first week of 2013 and the 2012 tax year was already closed!

To accommodate, Congress included two special lookback rules under ATRA - the first allows QCDs done in January of 2013 to be treated as a 2012 QCD, and the second allows December 2012 IRA distributions to be recharacterized as a QCD if a comparable amount of cash is donated to a charity after the IRA distribution but before the end of January, 2013. While these two rules are nice to have, though, the reality is that neither may be very useful, except for a few unique situations, such as those who already plan to max out their QCDs up to the $100,000 limit for 2013 and are looking to donate more. In addition, most clients will still benefit more by contributing appreciated securities to a charity, than by donating cash (with or without the QCD treatment). Nonetheless, the new rules do open up some useful planning scenarios for some client situations, and with only a few weeks available to take advantage of the rules, the time window is short to decide whether or not to take advantage of the two new special 2012 lookback rules for QCDs!

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Financial Planning Implications of HR8 - the Taxpayer Relief Act of 2012

nospam@example.com (Michael Kitces) — Tue, 01 Jan 2013 11:50:00 -0600

The last-minute fiscal cliff compromise - H.R. 8, which will also be known as the American Taxpayer Relief Act of 2012 (or "ATRA") - extends the majority of tax cuts that were scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. However, the legislation also introduces a number of changes as well - including a new top tax bracket of 39.6%, and an increase in the top long-term capital gains and qualified dividend rate to 20%. And some old rules that had lapsed and were scheduled to come back have in fact returned, such as the Pease limitation (phaseout of itemized deductions) and the Personal Exemption Phaseout (PEP). In addition, a new rule will allow 401(k) participants to complete intra-plan Roth conversions.

For planning purposes, though, the good news is that not only was the fiscal cliff largely "averted" with last minute legislation, but the changes under ATRA are permanent. On the other hand, making some rules permanent - such as not only the current gift and estate tax exemption, but also the portability of a deceased spouse's unused exemption - will change income and estate tax planning going forward.

In this article, we take a first look at the details of the H.R. 8 fiscal cliff legislation and some of its financial planning implications.

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What’s The Real Value Of Deferring Capital Gains? Less Than Most People Think…

nospam@example.com (Michael Kitces) — Wed, 26 Dec 2012 07:02:00 -0600

With the looming specter of not only the fiscal cliff with rising capital gains tax rates, but also the onset of the new 3.8% Medicare tax on net investment income in 2013, many investors have been looking to harvest capital gains before the end of the year.

The strategy is somewhat controversial, inasmuch as most taxpayers (and their accountants) have long since trained themselves to avoid ever paying taxes sooner than they absolutely have to, maximizing the value of tax deferral according to the basic principles of the time value of money. Nonetheless, the math of the situation with rising tax rates is quite straightforward, and in such environments it can require significant appreciation in a short period of time to make deferral worthwhile.

But perhaps at a more basic level, the debates about whether or not to harvest capital gains have revealed an even more problematic point of confusion: we may be grossly overvaluing the actual benefit of deferring capital gains in the first place, and the unwillingness to harvest capital gains may be part of a broader tendency to allow the tax tail to wag the dog far more than it should.

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IRS Issues Guidance For New 3.8% Medicare Tax On Net Investment Income

nospam@example.com (Michael Kitces) — Wed, 19 Dec 2012 06:01:00 -0600

In early December, the IRS and Treasury issued a series of Proposed Regulations for the two new Medicare taxes scheduled to begin on January 1, 2013 - the 3.8% Medicare tax on unearned income (generally, a 3.8% surtax on net investment income), and the 0.9% Medicare tax on earned income (i.e., wages and self-employment income), applied to "high income" individuals above certain thresholds. Although the new rules are still proposed and may ultimately be amended or changed, the Treasury and IRS nonetheless indicated that they can be relied upon by taxpayers. However, given the limited time to cultivate these regulations - including addressing potential loopholes - the rules did indicate that taxpayers should not try to read between the lines to find loopholes in the proposed regulations, and that the IRS will closely review transactions that manipulate net investment income to eliminate Medicare tax exposure.

While there were no huge surprises in the guidance, it does provide important clarification on a wide range of issues that planners and their clients must contend with heading into 2013, including how the Medicare tax rules interact with other parts of the tax code, and serves as a reminder to complete any last minute capital gains harvesting that high-income clients may wish to engage in before 2013 begins (including a special opportunity for Charitable Remainder Trusts!)!

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IRS Rules For Paying Investment Fees From Taxable And Retirement Accounts

nospam@example.com (Michael Kitces) — Wed, 14 Nov 2012 06:01:00 -0600

Given the costs associated with investment advice, clients often want to maximize any available tax benefits to help mitigate the cost. Fortunately, the IRS does allow a tax deduction for certain investment-related expenses, and while the treatment isn't ideal - a miscellaneous itemized deduction subject to the 2%-of-AGI floor, and an AMT adjustment - something is better than nothing. In fact, the IRS even allows investment advisory fees to be deducted when paid on behalf of retirement accounts like IRAs and 401(k) plans. Alternatively, the IRS also allows investment advisory fees to be paid directly from a retirement account - which effectively allows the fee to be paid with 100% pre-tax dollars. However, an important caveat is that while retirement accounts can cover their own fees, paying any other fees from such accounts can trigger highly adverse results, including taxable distributions, early withdrawal fees, and even a prohibited transaction disqualification of the entire retirement accounts! In the end, the power of tax deferral means that most clients will probably simply pay fees from taxable accounts and claim whatever tax deduction they can, but clients with shorter time horizons - including and especially retirees - should consider paying fees directly from their IRAs and other retirement accounts... but be certain those fees are only for the associated retirement accounts!
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IRS Crackdown On IRAs Threatens To Catch Financial Planners In The Crossfire

nospam@example.com (Michael Kitces) — Thu, 19 Jul 2012 06:09:00 -0500

As the so-called "fiscal cliff" looms, and the debate continues about whether to solve the country's fiscal woes with tax increases and/or spending cuts, a third option to help the situation is also emerging: do a better job collecting the taxes already due under the laws as they're written now. In the latest such shift, the word is out that the IRS is becoming less and less lenient regarding IRA mistakes, given the significant potential penalties involved - for instance, failing to take a required minimum distribution results in a penalty that is a whopping 50% of the RMD itself, and the penalty for an improper IRA contribution is 6%, per year, potentially accumulating for years on end. And there is potential that the IRS' efforts could extend further, leading to a crackdown on perceived abusive IRA strategies. As a result, clients should be more cautious than ever to comply properly with all IRA rules, including the timely distribution of RMDs, and proper compliance with all IRA contribution and rollover limits, and be wary of aggressive IRA strategies. From the planner's perspective, it's more important than ever to not only help clients comply properly with the rules, but to be cautious about giving accurate IRA advice, or run the risk that if the client ends out with IRS penalties, that the advisor - or his/her E&O insurance - may end out sharing in the high penalty cost to fix the mistake.
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The End Of Qualified Dividends For Small Business Owners

nospam@example.com (Michael Kitces) — Wed, 11 Jul 2012 06:02:00 -0500

With the looming "fiscal cliff" at the end of 2012, a wide range of tax increases are scheduled to occur at the start of 2013. One of the most dramatic is the treatment of dividends, which will nearly triple from a current maximum rate of 15% to a top rate of 43.4% (or higher when accounting for high-income phaseouts). In the case of small business owners with closely-held C corporations, this presents a unique planning opportunity, because the client can actually control the timing of dividends, choosing to extract cash and profits from the business by the end of 2012 instead of waiting for 2013 and beyond. And given the magnitude of the scheduled tax increase, it may well make sense to do so. While some clients may at least adopt a wait-and-see approach until the election and potential end-of-year tax legislation, the reality is that it's prudent to at least begin planning now - because getting this "wrong" for a business with $1,000,000 of accumulated profits could cost the client a whopping $284,000 in lost taxes!
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Does Your Portfolio Have The Right Default Cost Basis Method?

nospam@example.com (Michael Kitces) — Tue, 19 Jun 2012 06:04:00 -0500

Although the tax laws have technically always required that, when investments are sold, the specific lots and their associated cost basis are identified to determine the amount of any gains or losses, in practice most clients have simply chosen after the fact - when the tax return is prepared - which shares were sold, selecting the lots that produce the most optimal tax result. However, under new laws coming into effect, brokers and custodians will begin to automatically report transactions - including which lots were sold, the cost basis, the amount of gain/loss, and the date of acquisition and character of the loss - directly to the IRS, with sales locked in at the time the transaction settles. As a result, clients and their advisors must make proactive decisions regarding a proper method of accounting for portfolios, or run the risk that the "wrong" lots will be sold, with no way to remedy the situation after the fact! And while the IRS does provide a default method of accounting that will apply, in reality most clients will find the default a sub-optimal solution. Which means the burden really shifts to clients and their advisors to put the optimal method in place... which first requires making the right decision about whether it's better to harvest gains or losses in the first place, depending on the client's situation!
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Forget Harvesting Losses! It's Time To Harvest Gains!

nospam@example.com (Michael Kitces) — Wed, 14 Mar 2012 08:12:00 -0500

Prior to the implementation of the so-called "second Bush tax cut" - the Jobs Growth and Tax Relief Reconciliation Act of 2003 - the long-term capital gains tax rate was 20%, which was reduced to 10% for those in the lowest tax bracket. With the 2003 tax legislation, the maximum long-term capital gains rate was reduced to 15%, with a tax rate of 5% for the bottom two tax brackets, and in 2008 the latter rate was reduced to 0%. Those 15% / 0% long-term capital gains rates remain in effect today, and are scheduled under the Tax Relief Act of 2010 to continue until the end of 2012. After that point, the current laws expire, and the long-term capital gains rate reverts to its prior 20% / 10% rates... with the addition of another 3.8% for high income clients under the new Medicare unearned income tax! Not only does the scheduled increase in long-term capital gains rates represent a rising potential tax burden for clients in the future, but it also creates a surprisingly counter-intuitive but beneficial tax planning strategy - instead of the traditional approach of harvesting capital losses, in 2012 it's time to harvest long-term capital gains!
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