Let Year-End Planning Lower Your Tax Bill

by Cathy S. Butler, Morgan Stanley

By taking advantage of these strategies, you may be able to lessen your tax bite come April 15th.

With the passage of the American Taxpayer Relief Act of 2012, many Americans are facing higher tax rates, making tax planning more important than ever. And there’s no better time for tax planning than before year-end. That’s because there are a number of tax-smart strategies you can implement now that will reduce your tax bill come April 15th. Consider how the following strategies might help to lower your tax bill for 2014:

Put Losses to Work
If you expect to realize either short- or long-term capital gains, the IRS allows you to offset these gains with capital losses. Short-term gains (gains on assets held one year or less) are taxed at ordinary rates, which range from 10 to 39.6 percent, and can be offset with short-term losses. Long-term gains (gains on assets held longer than a year) are taxed at a top rate of 20 percent and can be reduced by long-term capital losses. To the extent that losses exceed gains, you can deduct up to $3,000 in capital losses against ordinary income on that year's tax return and carry forward any unused losses for future years.

Given these rules, there are several actions you might consider:

  • Avoid short-term gains when possible, as these are taxed at higher ordinary rates. Unless you have short-term losses to offset them, try holding the assets for at least one year. 
  • Take a good look at your portfolio before year-end and estimate your gains and losses. Some investments, such as mutual funds, incur trading gains or losses that are reported on Form 1099 and must be reported on your tax return. These are difficult to predict because they depend upon the fund's trading activity during the year and are not known until after year-end. But most capital gains and losses will be triggered by the sale of the asset, which you usually control. Are there some winners that have enjoyed a run and are ripe for selling? Are there losers you would be better off liquidating? The important point is to cover as much of the gains with losses as you can, thereby minimizing your capital gains tax. 
  • Remember that unused losses may be carried forward for use in future years, while gains must be taken in the year they are realized.

When evaluating whether or not to sell a given investment, keep in mind that a healthy unrealized gain does not necessarily mean an investment is ripe for selling. Remember that past performance is no indication of future results; it is expectations for future performance that count. Moreover, taxes should only be one consideration in any decision to sell or hold an investment.

IRAs: Contribute, Distribute or Convert
One simple way of reducing your taxes is to make tax-deductible contributions to a traditional IRA if you are eligible. Contributions are made on a pretax basis, so they reduce your taxable income. Contribution limits for the 2014 tax year—which may be made until April 15, 2015—are $5,500 per individual and $6,500 for those aged 50 or older. Note that deductibility phases out above certain income levels, depending upon your filing status and if you or your spouse are covered by an employer-sponsored retirement plan.

An important year-end consideration for older IRA holders is whether or not they have taken required minimum distributions. The IRS requires accountholders aged 70½ or older to withdraw specified amounts from their traditional IRA each year. These amounts vary depending on your age, increasing as you grow older. If you have not taken the required distributions in a given year, the IRS can impose a 50-percent tax on the shortfall, so make sure to take the requirement minimum distribution for the year by year-end.

Another consideration for traditional IRA holders is whether to convert to a Roth IRA. If you expect your tax rate to increase in the future—either because of rising earnings or a change in tax laws—converting to a Roth may make sense, especially if you are still a ways from retirement. You will have to pay taxes on any pretax contributions and earnings in your traditional IRA for the year you convert, but withdrawals from a Roth IRA are tax-free and penalty-free as long as you're at least 59½ and the converted account has been open at least five years. If you have a nondeductible traditional IRA (i.e., your contributions did not qualify for a tax deduction because your income was not within the parameters established by the IRS), investment earnings will be taxed but the amount of your contributions will not. The conversion will not trigger the 10-percent penalty for early withdrawals.

Work with your tax advisor to see what you can do now to reduce your tax bill in April. iBi

Cathy S Butler, CFP, CRPC is a financial advisor with the Butler/Luthy Group of Morgan Stanley. For more information, call (309) 671-2873 or visit www.morganstanleyfa.com/thebutlerluthygroup.