Thoughts on Tax Planning


Thoughts on Tax Planning


In the final days of 2012 (and early hours of 2013) Congress and the President put in place a comprehensive tax law – the American Taxpayer Relief Act. The specifics of this law were covered in a previous email, the content of which can be found here.


We’ve spent many hours digesting the consequences of the new law, and with April 15th less than a month away, it seems appropriate to examine some strategies for tax management under this new tax regime.


Let me begin by stating that the new law makes tax planning incredibly complex and is a decided move backwards in whatever efficiencies had been gained in previous versions of tax reform. There are now multiple tax rates on multiple income sources, each with different thresholds, brackets and phase-outs.


While each new (and old) tax seemingly stands on its own, there is significant interplay between all these various taxes, rates, and brackets. This reinforces the need for proactive tax planning to maximize the efficiency of investments, estate planning, and charitable decisions going forward. While each family’s situation is unique, listed below are some strategies worth considering.


Less Income = Less Tax


To reduce exposure to new and higher taxes, the most bang-for-the-buck will come (somewhat obviously) from lowering your gross adjusted income. Not only will minimizing income keep you out of the higher brackets, it may help you avoid the stealthy add-ons like the 3.8% tax on investment income, the 0.9% Medicare tax, and the phase-outs of deductions, all of which begin to affect tax payers (to varying degrees) once incomes rise above $250,000 for married couples and $200,000 for singles. While lower income might not sound like fun at first, there are several strategies to consider that may align with other longer-term goals.


Defer Income


The benefits of income deferral are stronger than ever, so maximizing retirement savings is an obvious choice. Non-qualified deferred compensation programs, if available, should be considered as well. Business owners who can control compensation and dividend distributions can spread them out over multiple years. Eliminating RMDs through ROTH conversions or charitable gifts may also be options to consider (see below).


Smooth Out Lumpy Income


If you are having a big pay day – from the sale of a business, vesting of restricted stock, or large capital gains – you may want to explore ways to spread that income over multiple years. Techniques could include charitable remainder trusts, installment sales, and non-qualified deferred compensation.


Don’t Take Deductions for Granted


As mentioned above, actually reducing income will get a better result than relying on deductions to minimize taxes. Deductions won’t eliminate the potentially higher tax rates on investment income and deductions phase out gradually for very high income earners.


Invest with Taxes in Mind


The old saying – don’t let the tail wag the dog – is applicable to taxes and investments. One should never manage investments myopically focused on taxes. However, there are many opportunities to minimize taxes when implementing an investment strategy and they should certainly not be ignored. Some practices we use on a case by case basis:


Proactive use of tax-deferred accounts: Tax deferral is almost always your friend when trying to grow an investment portfolio. In addition to traditional retirement accounts, there are low-cost annuities and variable life insurance policies that can shelter investment income from current taxes. For the right situation, this can be a wonderful solution.


Asset location strategies: Where you own your assets can be as important as what assets you own. The least tax-efficient assets should be allocated to the most tax-advantaged accounts, and likewise, the most tax-efficient assets should be held in taxable accounts.


Tax-efficient investments: It is hard for active managers to beat the market and harder still when taxes are taken into account. This is one reason we rely heavily on passively managed mutual funds. They pay out little if any capital gains distributions while delivering market returns with great consistency.


Strategic ROTH Conversions


There are many good reasons to consider converting a traditional IRA to a ROTH, but there are also many variables to consider.  Each conversion opportunity needs to be examined in the context of other family goals. Going forward, however, tax management will play a bigger role in potential conversions for the following reasons.


With new, higher top tax rates, the benefit of a ROTH conversion (if done in years when taxable income is lower) can be considerable. Investors can even do a series of partial conversions year after year – all designed to fill up lower brackets, while making sure that the conversion doesn’t accidentally trigger the Net Investment Income (NII) tax.


ROTH conversions also have a special re-characterization option - the ability to call “do over” and convert all or some of the ROTH back to a traditional IRA. This was a well-intentioned provision aimed at protecting taxpayers who lost money in market corrections, but it can be especially useful in managing tax brackets. A tax payer can never be sure of the ideal amount to convert in a given year until the return is being prepared after the fact. The re-characterization option allows a tax payer to go back and fine-tune taxable income any time up till the due date for the return.


A ROTH conversion can eliminate or reduce your need to take required minimum distribution (RMDs) in the future. While RMDs are not themselves subject to Net Investment Income  tax, they can push your adjusted gross income high enough to subject  other investment income to the additional 3.8% tax.


Trust Traps


Trusts can be especially impacted by the new law because the highest rates – 39.6% on interest and dividends, 3.8% NII, and 20% capital gains rates - kick in after just $11,950 of income. This again makes tax efficient investing a priority. It also may warrant making distributions to beneficiaries who would pay taxes at lower rates than the trust itself. Of course these decisions need to be made within the confines of the terms of the trust, but should be considered none the less.




We have always believed there is great value in the coordination of investments, charitable giving, estate, and tax planning. This new, complex tax landscape increases that value even further.

Posted by Jay Healy at 2:56 PM
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