November 23, 2013 - Year-End Tax-Saving Strategies for Your Investment Portfolio - by Morningstar Investment Research
With the stock market up nearly 30% so far in 2013 and up 18% on an annualized basis during the past five years, it would be hard to blame investors for feeling some trepidation about the upcoming tax-filing season. Funds could distribute taxable capital gains between now and year-end, and offsetting tax-loss candidates tend to be few and far between in most portfolios. Moreover, the 2013 tax year brings with it a new income tax bracket that's higher than all others, a 20% capital gains rate, and a new Medicare surtax for the highest-income earners.
Against that backdrop, several Morningstar.com readers said they were getting busy to keep their tax bills down--not just for 2013 but in future years, as well. In response to my query about year-end tax strategies, which I posted in the Portfolio Design/Management section of Morningstar.com's Discuss forums, readers said they were honing their taxable portfolios for greater tax efficiency, converting traditional IRAs to Roth, and strategizing about deductions in an effort to stay in the lowest possible tax bracket. To read about some of the most popular tax-management strategies or share your own plan, click here.
'I Couldn't Imagine the Problem That Many of Us Now Confront'
Of the recently strong market conditions, posters were unequivocal: It's getting harder to limit taxable capital gains because it's difficult to find losing positions to offset them.
That's a high-class problem to have, noted EFHutton: "Coming out of the 2000-02 bear market, I couldn't imagine the problem that many of us now confront; namely the 'problem' of too much investment success and a tax issue. Not surprisingly many funds have had success in the wake of the 2008-09 bear market and have substantial taxable distributions planned for December. It is a trap of sorts. To get out, one incurs substantial tax cost."
A handful of posters said they still have unused tax losses that they could use to offset their winners. Yogibearbull wrote, "I still have loss-carryovers [that I booked aggressively with tax-swaps in 2008-09], so my taxable accounts are essentially tax-free for a while. But this may end soon."
Bnorthrop's tax-loss carryforwards are also ebbing away. "Alas, this will be the year that I use up my tax-loss carryforward from 2008-09. The only investment I plan to sell for a small additional tax loss is a high-yield municipal-bond fund that I calculate will help shield a bit of ordinary income. I plan to exchange it for a short-term muni fund."
For Mickeg, tax-loss carryforwards helped offset gains during much of the current bull market--until this year. "During the market meltdown from 2007 through early 2009, I was selling funds to harvest short-term capital losses before they became long-term losses," this poster wrote. "I was buying similar but sufficiently different types of funds to avoid the wash-sales rule. Thus, I accumulated a lot of short-term capital loss carryforwards. Tax years 2009 through 2013 I have been using up my short-term capital loss carryforwards, which has allowed me to buy and sell without being concerned about whether a gain was a short or long-term gain. But, I have run out of short-term capital loss carryforwards this year."
'I Need to Keep My Income Low'
The fact that tax-loss carryforwards have dwindled has prompted several investors to make sure their taxable accounts are as tax-efficient as they can be.
For Dragonpat, that means getting mutual funds out of her taxable accounts and instead concentrating on more tax-efficient assets. "In 2012, I moved the last of my mutual funds to my Roths," this veteran poster wrote. "My taxable account consists only of exchange-traded funds and individual stocks because then I only pay taxes on dividends and not on year-end capital gains distributions from mutual funds."
Also convinced of the merits of indexing for tax efficiency is Alpha28, particularly now that qualifying for Affordable Care Act subsidies is a consideration. "I am retired and under 65. I need to keep my income low enough to get Affordable Care Act subsidy. I will be selling some active mutual funds and putting the money in index funds. This will lower the amount of taxes since index funds do less buying and selling than index funds and have much lower capital gains distributions. I'm also selling some bonds I have in my taxable account and buying some bonds for my tax-deferred account."
Artsdoc is also focusing on the asset-location question. "I sold out emerging markets in my taxable account (dividends are greater than 3% and only about 65% are qualified dividends) and bought them in a tax-sheltered account (the foreign tax credit doesn't make up for the taxes I would have had to pay)."
'The Best Amount to Convert Each Year'
Several readers said that they're busily converting traditional IRA assets to Roth with an eye toward limiting taxable income in retirement. As they do so, respondents say they're trying to make sure the conversions don't bump them into a higher tax bracket.
Tomas47 has been converting IRA assets to Roth to reduce required minimum distributions, which are inherently taxable. "I have been trying to balance minimization of current taxes against the pain I'll feel in five years when required minimum distributions kick in. Net, I convert enough traditional IRA to Roth IRA to stay in the 28% bracket and avoid the alternative minimum tax."
Darwinian hasn't been converting IRA assets to Roth but has been making annual Roth contributions using monies in taxable accounts. The net result? "My only unsheltered assets now are short-term muni bonds and bank accounts."
Carefully mulling the tax effects of conversions is Rule72, who wrote, "I created a spreadsheet when I retired five years ago that helps me determine the best amount to convert each year to minimize taxes long term for the wife and I and the kids. This spreadsheet needs to be updated to reflect the latest in income, deductions, and tax law changes if any."
For BobE315, Intuit's (NASDAQ:INTU) TurboTax product has helped him figure out the amount of traditional IRA assets he and his spouse can convert to Roth without bumping themselves into a higher tax bracket. "We determined the amount of the Roth conversion by entering in our 2013 state and property taxes and charitable contributions as well as an initial Roth conversion amount into TurboTax and then tweaking numbers as needed."
'Tis the Time of Year to Give'
Other posters noted that they were taking care to maximize the value of their deductions.
Making charitable contributions was a frequently cited maneuver. BMWLover wrote, "'Tis the time of the year to give, and we'll be making donations of appreciated securities to our favorite charities. In that way we do not pay the capital gains and we get the charitable gift deduction!"
Tomas47 is using a donor-advised fund to obtain the same dual tax benefit. "My only tweaking opportunities will then be to make additional charitable contributions to my donor advised fund with low cost basis stock."
Beanclub is gifting highly appreciated securities to a child: Although this investor won't be able to obtain a tax deduction on the gift, as with a charitable contribution, the maneuver gets some highly appreciated securities out of the portfolio while aligning with the child's goals. "I've just gifted [my newly graduated daughter] some MasterCard (NYSE:MA) shares I purchased at IPO and asked her to sell them in December to take advantage of her reduced capital gains rate. She'll use the proceeds for spring tuition and to fully fund her Roth IRA. I'll gift her more MasterCard shares in 2014 to pay tuition, fund her IRA, and hike her 401(k) to hit her employer match. It's nice to have the tax regulations work in our favor for a change, and I'm fortunate to be in a position to take advantage."
Several posters said they've gotten savvy about "bunching" deductions--taking itemized deductions in certain years while claiming the standard deduction in others.
Texasboy wrote, "Last year in retirement we had started the every-other-year of doubling up on donations/taxes/medical expenses so we could increase total deductions."
Also using a "bunching" strategy is DouglasJohnson, who explained, "We paid our 2012 property taxes in January this year and will pay 2013's in December. We're busy making our charity contributions for next year by Dec. 31. Next year, we'll take the standard deduction."
TJBTJB notes that seniors can deduct their medical expenses that exceed 7.5% of adjusted gross income, whereas a higher threshold pertains to filers under age 65--until 2016, at least. "The Internal Revenue Service offers an extension of the 7.5% of medical expense exclusion for seniors while moving to 10% for others. We piled up some elective, allowable expenses to take advantage of this."