If your financial adviser and certified public accountant (CPA) aren't already talking, this tax season would be a great time to introduce them. Most people understand the importance of having their money work for them, but few recognize the power of coordinating the advice they're receiving.
Here are six scenarios in which having your advisers working together can pay dividends for you:
Comparing Taxable vs. Tax-Free Investments
When building the fixed income allocation of your portfolio, your advisers should be considering three tax-related items:
Tax-equivalent yield: To effectively compare the yield on taxable and tax-exempt investments, you must calculate what is called the "tax-equivalent yield" or "after-tax yield." The calculation is not complex (you just take the tax-exempt yield and divide it by 1 minus your marginal tax rate), but most people don't know their marginal tax rate and need their CPAs to provide that information.
Alternative Minimum Tax (AMT): Your financial adviser needs to know if you are subject to paying the AMT because, if you are, interest from normally tax-exempt private activity bonds (bonds issued to fund stadiums, hospitals, housing projects and other qualified ventures) will be added back as a preference item and could be taxed at a rate of 28%.
Social Security "Stealth Tax:" Determining how much of your Social Security income is taxable is anything but straightforward. The Internal Revenue Service looks at "combined income," which includes your adjusted gross income, tax-exempt interest income and half of your Social Security benefits. If your combined income exceeds $34,000 as an individual, or $44,000 on a joint return, up to 85% of your Social Security benefits may be taxed. If you are on the cusp, your decisions about producing investment income could have a significant impact on the taxation of your Social Security benefits.
Real Estate: Owning vs. Renting
As first-time homebuyers prepare for the big purchase or retirees contemplate downsizing, the financial impact of owning versus renting must be considered. Mortgage interest and real estate taxes are tax deductible expenses (assuming you itemize); rent is not. How much are these deductions worth to you? The answer depends on your level of taxable income, your effective tax rate and whether you utilize the standard deduction or itemize. With your financial adviser and CPA working together, the taxable income generated within your investment portfolio can be managed to support your housing decisions.
Estate Planning: Projecting Estate Taxes & Strategies for Reducing Them
In 2016, the federal estate and gift tax exemption is $5.45 million per person or $10.9 million per married couple. That means you can leave up to that amount to your heirs and pay no federal estate or gift tax, if handled properly. The use of the combined exemption by the surviving spouse is not automatic and must be elected on the estate tax return of the first spouse to die (even if no estate taxes are due at that time).
Many advisers will utilize life insurance as a tool for covering estate taxes, but few take the time to do actual projections. In determining how much insurance you need, your adviser and CPA should work together to project the expected size of your estate, the potential federal estate tax liability and any anticipated state estate taxes. Remember, the value of policies that you own individually will be added to your gross estate. Consider using an irrevocable life insurance trust ("ILIT") to eliminate this issue.
Tax Loss Harvesting & When to Take Gains
Capital losses can be used to offset capital gains or up to $3,000 of ordinary income per year. If you have losses that exceed those amounts, you may carry forward the loss to use in future years. The amount you are carrying forward is listed on your tax return and can be used as a tax management tool. While you may not like the idea of realizing a loss on your investment, that capital loss may prove to be a valuable asset at tax time.
Similarly, there may be times when booking a gain makes sense. Losses do not pass to heirs when you die and should be used during your lifetime. Having your financial adviser and CPA coordinate these items is in your best interests.
Required Minimum Distributions (RMDs)
If you have money in an individual retirement account (IRA), savings incentive match plan (SIMPLE IRA), simplified employee pension (SEP) or 401(k), the IRS generally requires that you begin taking minimum distributions annually, starting with the year when you turn 70½. These required minimum distributions (RMDs) are calculated by taking your account balance as of December 31st of the previous year and dividing it by a distribution period from the IRS's uniform lifetime table. If you have multiple IRAs that have RMDs, you may take distributions from any or all of the accounts as long as the total distribution is taken in that calendar year. The penalty for failing to take your RMD is 50% of the distribution amount.
In the year when you turn 70½, there may be an opportunity for some strategic planning. If you turn 70 before July 1st, you have until April 1st of the following calendar year to take your first RMD, but all subsequent RMDs must be taken before the end of the calendar year. Depending on your expected income, it might be in your best interests to take your first distribution before the end of the calendar year (rather than waiting until April 1st) to avoid having to take two distributions in the following year.
One other possible strategy could be to convert your account to a Roth IRA. A Roth conversion would require that you pay taxes on the conversion amount (your adviser and CPA can plan to do this over a period of years to minimize the tax impact), but would make you exempt from having to take RMDs.
Maximizing Deductions of Investment Advisory Fees
If you itemize deductions on your Form 1040, you may be eligible to deduct your investment advisory fees as an investment expense (Line 23 on Schedule A). Keep in mind that these deductions provide tax savings only once they have exceeded 2% of your adjusted gross income and could be disallowed if you are subject to the AMT. This deduction does not apply to commissions or trading costs, only to advisory fees. The deduction is also only applicable to taxable accounts, not to retirement accounts. Many brokerage firms' 1099s do not list the advisory fees paid and if your CPA does not think to ask you, you could be leaving that deduction on the table.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor or lawyer.
Bryan Koslow, MBA, CFP®, CPA, PFS, CDFA™ is the President of Clarus Financial Inc. (opens in new tab), an Integrated Wealth Management firm with offices in NYC & NJ.
Bryan is the Founder & President of Clarus Financial Inc., an Integrated Wealth Management firm with offices in New York City and New Jersey.
Bryan is a Certified Public Accountant (CPA), Certified Financial Planner™ (CFP®), a Personal Financial Specialist (PFS), and a Certified Divorce Financial Analyst (CDFA™). He holds FINRA securities registrations Series 7, 63, 65, and has his New Jersey Life and Health Insurance license.
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