Year-end is fast approaching, with the holidays just around the corner. While the market conditions may be front-and-center on the minds of many, individuals should not overlook year-end planning opportunities which may provide meaningful benefits.
Given the extent to which bonds and stocks have declined this year, tax loss harvesting can be a practical but meaningful planning opportunity for investors holding positions with unrealized losses in taxable accounts.
Realized losses can offset other realized gains; to the extent that realized losses exceed realized gains, net realized losses can offset up to $3,000 of ordinary income with any remainder resulting in a loss carryforward to be used in future years.
As an example, consider John and Jane Smith who currently have $8,000,000 of global equities in taxable accounts, for which the positions have a combined unrealized loss of $2,000,000. The Smiths sell the current positions and redeploy the $8 million of proceeds to equity index funds; in doing so, the Smiths have booked a $2,000,000 loss to offset current and/or future year realized gains, while their portfolio remains positioned to benefit from a subsequent market recovery.
Beware of the “wash sale rule” which states that a loss cannot be realized for tax purposes if a substantially identical position was bought within 30 days before or after the sale.
Analyze Mutual Fund Year-End Capital Gain Distributions
Mutual funds are required to pass along capital gains to fund shareholders. Regardless of whether the fund shareholder actually benefited from the fund’s sale of underlying securities, the shareholder will receive the capital gain distribution if the mutual fund is held as of the dividend record date.
Mutual fund families typically provide estimates for year-end dividend distributions over the course of October and November, with such distributions most commonly paid in December.
Capital gain distributions can be either short-term or long-term. Short-term capital gain dividends are treated as ordinary income and thus cannot be offset by realized losses; in contrast, long-term capital gain dividends are treated as capital gains and can be offset by realized losses.
It is important to review unrealized gains and losses across mutual fund holdings in taxable accounts and to compare those figures against capital gain distribution estimates to determine if selling a mutual fund position before the year-end distribution would produce a tax savings.
In addition, investors should be careful with late-year purchases of actively managed funds in taxable accounts. Investing in a fund just prior to its capital gain dividend record date could result in additional capital gains taxes. An investor might instead wait to invest in the given fund until after the dividend record date or could invest in an index ETF for the time being and swap from the ETF to the actively managed fund at a later date.
Manage Charitable Donations
Charitable donations represent one of the better planning tools which taxpayers can use to manage their overall tax picture.
In higher income years, it may make sense to give a greater amount to charity. This can be particularly true for individuals who are nearing retirement, where taxable income may fall several tax brackets after retirement. Conversely, in lower income years, it may make sense to pare back or delay charitable gifts.
For individuals who are charitably inclined but who now take the increased standard deduction ($13,850 for single; $27,700 for married filing jointly) rather than itemizing deductions, it could make sense to use a “bunching strategy” whereby a taxpayer gives multiple years’ worth of charitable gifts in a single tax year to itemize deductions in that year and then foregoes charitable gifts over the next several years while taking the standard deduction.
While some donors enjoy the convenience of making cash donations, one should not overlook the enhanced benefit of instead gifting long-term appreciated securities, as the charity receives the same economic benefit as a cash donation, while the taxpayer receives a tax deduction for the full market value of the gift and, importantly, avoids paying capital gains taxes on the gifted security.
Keep in mind that gifts of long-term appreciated securities to qualified public charities (including donor-advised funds) are limited to 30% of adjusted gross income (AGI) while similar gifts to a private foundation are limited to 20% of AGI. Charitable gifts in excess of the AGI limits result in a charitable carryforward which can be used over the next five years.
Satisfy Required Minimum Distributions using the IRA Charitable Rollover
The SECURE Act raised the beginning age for required minimum distributions (RMDs) to 72, from age 70½, previously; however, it did not adjust the age 70½ requirement for taxpayer eligibility to make a Qualified Charitable Distribution (QCD).
Under this provision, a taxpayer may gift up to $100,000 each year from an IRA to qualified 501(c)(3) charitable organizations (donor-advised funds, private foundations and supporting organizations are excluded). A qualified charitable distribution neither counts as an itemized deduction nor as taxable income, though it does count towards satisfying the RMD for that year.
This strategy may be beneficial for charitably inclined individuals who receive a greater tax benefit from the increased standard deduction rather than itemized deductions.
Consider a Roth Conversion
With global equities down sharply for the year and with income tax rates at historically favorable levels, the timing may be opportune for some individuals to execute a Roth conversion.
Individuals who believe their future tax rate might be higher than their current tax rate might consider converting a portion – or all – of existing Traditional IRA assets to a Roth IRA. Assuming the Traditional IRAs have no basis, the amount of the conversion is treated as taxable income; in exchange, the Roth IRA grows tax-free with qualified distributions also treated as tax-free.
Individuals with notable assets but with lower-than-usual income in 2023 might consider this strategy, as it allows the taxpayer to essentially pay a reduced rate on the conversion while taxable income is low.
This strategy can be particularly beneficial for individuals with a taxable estate, as the tax cost of the conversion effectively reduces the size of the estate, while the named beneficiaries one day receive a very tax-favorable asset, compared to inheriting a Traditional IRA. In some cases, high net worth individuals might consider pairing a Roth conversion with accelerated charitable giving, as the charitable deduction will help to offset the effective tax cost of the conversion.
Note that there are a number of factors (time horizon, overall net worth, tax bracket, etc.) to evaluate to determine whether a Roth conversion might ultimately be beneficial.
Have Questions? Our Team Can Help
Contact us to see how our team can help you start planning your finances for 2024. View five more tips in “Year-End Financial Planning Considerations: Part 2.”