Mutual Funds: Handle With Care at Year End

Mutual Funds: Handle With Care at Year End

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As we approach the end of 2018, it’s a good idea to review the mutual fund holdings in your taxable accounts and take steps to avoid potential tax traps. Here are some tips.

Avoid surprise capital gains

Unlike with stocks, you can’t avoid capital gains on mutual funds simply by holding on to the shares. Near the end of the year, funds typically distribute all or most of their net realized capital gains to investors. If you hold mutual funds in taxable accounts, these gains will be taxable to you regardless of whether you receive them in cash or reinvest them in the fund.

For each fund, find out how large these distributions will be and get a breakdown of long-term vs. short-term gains. If the tax impact will be significant, consider strategies to offset the gain. For example, you could sell other investments at a loss.

Buyer beware

Avoid buying into a mutual fund shortly before it distributes capital gains and dividends for the year. There’s a common misconception that investing in a mutual fund just before the ex-dividend date (the date by which you must own shares to qualify for a distribution) is like getting free money.

In reality, the value of your shares is immediately reduced by the amount of the distribution. So you’ll owe taxes on the gain without actually making a profit.

Seller beware

If you plan to sell mutual fund shares that have appreciated in value, consider waiting until just after year end so you can defer the gain until 2019 — unless you expect to be subject to a higher rate next year. In that scenario, you’d likely be better off recognizing the gain and paying the tax this year.

When you do sell shares, keep in mind that, if you bought them over time, each block will have a different holding period and cost basis. To reduce your tax liability, it’s possible to select shares for sale that have higher cost bases and longer holding periods, thereby minimizing your gain (or maximizing your loss) and avoiding higher-taxed short-term gains.

Think beyond just taxes

Investment decisions shouldn’t be driven by tax considerations alone. For example, you need to keep in mind your overall financial goals and your risk tolerance.

But taxes are still an important factor to consider. Contact us to discuss these and other year-end strategies for minimizing the tax impact of your mutual fund holdings.

Time For NQDC Plan Deferral Elections

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If you’re an executive or other key employee, your employer may offer you a nonqualified deferred compensation (NQDC) plan. As the name suggests, NQDC plans pay employees in the future for services currently performed. The plans allow deferral of the income tax associated with the compensation.

But to receive this attractive tax treatment, NQDC plans must meet many requirements. One is that employees must make the deferral election before the year they perform the services for which the compensation is earned. So, if you wish to defer part of your 2019 compensation, you generally must make the election by the end of 2018.

NQDC plans vs. qualified plans

NQDC plans differ from qualified plans, such as 401(k)s, in that:

  • NQDC plans can favor highly compensated employees,
  • Although your income tax liability can be deferred, your employer can’t deduct the NQDC until you recognize it as income, and
  • Any NQDC plan funding isn’t protected from your employer’s creditors.

While some rules are looser for NQDC plans, there are also many rules that apply to them that don’t apply to qualified plans.

2 more NQDC rules

In addition to the requirement that deferral elections be made before the start of the year, there are two other important NQDC rules to be aware of:

1. Distributions. Benefits must be paid on a specified date, according to a fixed payment schedule or after the occurrence of a specified event — such as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.

2. Elections to make certain changes. The timing of benefits can be delayed but not accelerated. Elections to change the timing or form of a payment must be made at least 12 months in advance. Also, new payment dates must be at least five years after the date the payment would otherwise have been made.

Be aware that the penalties for noncompliance with NQDC rules can be severe: You can be taxed on plan benefits at the time of vesting, and a 20% penalty and interest charges also may apply. So if you’re receiving NQDC, check with your employer to make sure it’s addressing any compliance issues.

No deferral of employment tax

Another important NQDC tax issue is that employment taxes are generally due when services are performed or when there’s no longer a substantial risk of forfeiture, whichever is later. This is true even though the compensation isn’t actually paid or recognized for income tax purposes until later years.

So your employer may withhold your portion of the tax from your salary or ask you to write a check for the liability. Or your employer might pay your portion, in which case you’ll have additional taxable income.

Next steps

Questions about NQDC — or other executive comp, such as incentive stock options or restricted stock? Contact us. We can answer them and help you determine what, if any, steps you need to take before year end to defer taxes and avoid interest and penalties.

Donate Appreciated Stock for Twice the Tax Benefits

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A tried-and-true year end tax strategy is to make charitable donations. As long as you itemize and your gift qualifies, you can claim a charitable deduction. But did you know that you can enjoy an additional tax benefit if you donate long-term appreciated stock instead of cash?

2 benefits from 1 gift

Appreciated publicly traded stock you’ve held more than one year is long-term capital gains property. If you donate it to a qualified charity, you may be able to enjoy two tax benefits:

  1. If you itemize deductions, you can claim a charitable deduction equal to the stock’s fair market value, and
  2. You can avoid the capital gains tax you’d pay if you sold the stock.

Donating appreciated stock can be especially beneficial to taxpayers facing the 3.8% net investment income tax (NIIT) or the top 20% long-term capital gains rate this year.

Stock vs. cash

Let’s say you donate $10,000 of stock that you paid $3,000 for, your ordinary-income tax rate is 37% and your long-term capital gains rate is 20%. Let’s also say you itemize deductions.

If you sold the stock, you’d pay $1,400 in tax on the $7,000 gain. If you were also subject to the 3.8% NIIT, you’d pay another $266 in NIIT.

By instead donating the stock to charity, you save $5,366 in federal tax ($1,666 in capital gains tax and NIIT plus $3,700 from the $10,000 income tax deduction). If you donated $10,000 in cash, your federal tax savings would be only $3,700.

Watch your step

First, remember that the Tax Cuts and Jobs Act nearly doubled the standard deduction, to $12,000 for singles and married couples filing separately, $18,000 for heads of households, and $24,000 for married couples filing jointly. The charitable deduction will provide a tax benefit only if your total itemized deductions exceed your standard deduction. Because the standard deduction is so much higher, even if you’ve itemized deductions in the past, you might not benefit from doing so for 2018.

Second, beware that donations of long-term capital gains property are subject to tighter deduction limits — 30% of your adjusted gross income for gifts to public charities, 20% for gifts to nonoperating private foundations (compared to 60% and 30%, respectively, for cash donations).

Finally, don’t donate stock that’s worth less than your basis. Instead, sell the stock so you can deduct the loss and then donate the cash proceeds to charity.

Minimizing tax and maximizing deductions

For charitably inclined taxpayers who own appreciated stock and who’ll have enough itemized deductions to benefit from itemizing on their 2018 tax returns, donating the stock to charity can be an excellent year-end tax planning strategy. This is especially true if the stock is highly appreciated and you’d like to sell it but are worried about the tax liability. Please contact us with any questions you have about minimizing capital gains tax or maximizing charitable deductions.

Could “Bunching” Medical Expenses into 2018 Save You Tax?

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Some of your medical expenses may be tax deductible, but only if you itemize deductions and have enough expenses to exceed the applicable floor for deductibility. With proper planning, you may be able to time controllable medical expenses to your tax advantage. The Tax Cuts and Jobs Act (TCJA) could make bunching such expenses into 2018 beneficial for some taxpayers. At the same time, certain taxpayers who’ve benefited from the deduction in previous years might no longer benefit because of the TCJA’s increase to the standard deduction.

The changes

Various limits apply to most tax deductions, and one type of limit is a “floor,” which means expenses are deductible only to the extent that they exceed that floor (typically a specific percentage of your income). One example is the medical expense deduction.

Because it can be difficult to exceed the floor, a common strategy is to “bunch” deductible medical expenses into a particular year where possible. The TCJA reduced the floor for the medical expense deduction for 2017 and 2018 from 10% to 7.5%. So, it might be beneficial to bunch deductible medical expenses into 2018.

Medical expenses that aren’t reimbursable by insurance or paid through a tax-advantaged account (such as a Health Savings Account or Flexible Spending Account) may be deductible.

However, if your total itemized deductions won’t exceed your standard deduction, bunching medical expenses into 2018 won’t save tax. The TCJA nearly doubled the standard deduction. For 2018, it’s $12,000 for singles and married couples filing separately, $18,000 for heads of households, and $24,000 for married couples filing jointly.

If your total itemized deductions for 2018 will exceed your standard deduction, bunching nonurgent medical procedures and other controllable expenses into 2018 may allow you to exceed the applicable floor and benefit from the medical expense deduction. Controllable expenses might include prescription drugs, eyeglasses and contact lenses, hearing aids, dental work, and elective surgery.

Planning for uncertainty

Keep in mind that legislation could be signed into law that extends the 7.5% threshold for 2019 and even beyond. For help determining whether you could benefit from bunching medical expenses into 2018, please contact us.

Consider All The Tax Consequences Before Making Gifts to Loved Ones

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Many people choose to pass assets to the next generation during life, whether to reduce the size of their taxable estate, to help out family members or simply to see their loved ones enjoy the gifts. If you’re considering lifetime gifts, be aware that which assets you give can produce substantially different tax consequences.

Multiple types of taxes

Federal gift and estate taxes generally apply at a rate of 40% to transfers in excess of your available gift and estate tax exemption. Under the Tax Cuts and Jobs Act, the exemption has approximately doubled through 2025. For 2018, it’s $11.18 million (twice that for married couples with proper estate planning strategies in place).

Even if your estate isn’t large enough for gift and estate taxes to currently be a concern, there are income tax consequences to consider. Plus, the gift and estate tax exemption is scheduled to drop back to an inflation-adjusted $5 million in 2026.

Minimizing estate tax

If your estate is large enough that estate tax is a concern, consider gifting property with the greatest future appreciation potential. You’ll remove that future appreciation from your taxable estate.

If estate tax isn’t a concern, your family may be better off tax-wise if you hold on to the property and let it appreciate in your hands. At your death, the property’s value for income tax purposes will be “stepped up” to fair market value. This means that, if your heirs sell the property, they won’t have to pay any income tax on the appreciation that occurred during your life.

Even if estate tax is a concern, you should compare the potential estate tax savings from gifting the property now to the potential income tax savings for your heirs if you hold on to the property.

Minimizing your beneficiary’s income tax

You can save income tax for your heirs by gifting property that hasn’t appreciated significantly while you’ve owned it. The beneficiary can sell the property at a minimal income tax cost.

On the other hand, hold on to property that has already appreciated significantly so that your heirs can enjoy the step-up in basis at your death. If they sell the property shortly after your death, before it’s had time to appreciate much more, they’ll owe no or minimal income tax on the sale.

Minimizing your own income tax

Don’t gift property that’s declined in value. A better option is generally to sell the property so you can take the tax loss. You can then gift the sale proceeds.

Capital losses can offset capital gains, and up to $3,000 of losses can offset other types of income, such as from salary, bonuses or retirement plan distributions. Excess losses can be carried forward until death.

Choose gifts wisely

No matter your current net worth, it’s important to choose gifts wisely. Please contact us to discuss the gift, estate and income tax consequences of any gifts you’d like to make.

529 Plans Offer Two Tax-Advantaged Education Funding Options

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Section 529 plans are a popular education-funding tool because of tax and other benefits. Two types are available: 1) prepaid tuition plans, and 2) savings plans. And one of these plans got even better under the Tax Cuts and Jobs Act (TCJA).

Enjoy valuable benefits

529 plans provide a tax-advantaged way to help pay for qualifying education expenses. First and foremost, although contributions aren’t deductible for federal purposes, plan assets can grow tax-deferred. In addition, some states offer tax incentives for contributing in the form of deductions or credits.

But that’s not all. 529 plans also usually offer high contribution limits. And there are no income limits for contributing.

Lock in current tuition rates

With a 529 prepaid tuition plan, if your contract is for four years of tuition, tuition is guaranteed regardless of its cost at the time the beneficiary actually attends the school. This can provide substantial savings if you invest when the child is still very young.

One downside is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school. Another is that the plan doesn’t cover costs other than tuition, such as room and board.

Fund more than just college tuition

A 529 savings plan can be used to pay a student’s expenses at most postsecondary educational institutions. Distributions used to pay qualified expenses (such as tuition, mandatory fees, books, supplies, computer equipment, software, Internet service and, generally, room and board) are income-tax-free for federal purposes and typically for state purposes as well, thus making the tax deferral a permanent savings.

In addition, the Tax Cuts and Jobs Act expands the definition of qualified expenses to generally include elementary and secondary school tuition. However, tax-free distributions used for such tuition are limited to $10,000 per year.

The biggest downside may be that you don’t have direct control over investment decisions; you’re limited to the options the plan offers. Additionally, for funds already in the plan, you can make changes to your investment options only twice during the year or when you change beneficiaries.

But each time you make a contribution to a 529 savings plan, you can select a different option for that contribution, regardless of how many times you contribute throughout the year. And every 12 months you can make a tax-free rollover to a different 529 plan for the same child.

Picking your plan

Both prepaid tuition plans and savings plans offer attractive benefits. We can help you determine which one is a better fit for you or explore other tax-advantaged education-funding options.

Charitable IRA Rollovers May Be Especially Beneficial in 2018

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If you’re age 70½ or older, you can make direct contributions — up to $100,000 annually — from your IRA to qualified charitable organizations without owing any income tax on the distributions. This break may be especially beneficial now because of Tax Cuts and Jobs Act (TCJA) changes that affect who can benefit from the itemized deduction for charitable donations.

Counts toward your RMD

A charitable IRA rollover can be used to satisfy required minimum distributions (RMDs). You must begin to take annual RMDs from your traditional IRAs in the year you reach age 70½. If you don’t comply, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. (Deferral is allowed for the initial year, but you’ll have to take two RMDs the next year.)

So if you don’t need the RMD for your living expenses, a charitable IRA rollover can be a great way to comply with the RMD requirement without triggering the tax liability that would occur if the RMD were paid to you.

Doesn’t require itemizing

You might be able to achieve a similar tax result from taking the RMD and then contributing that amount to charity. But it’s more complex because you must report the RMD as income and then take an itemized deduction for the donation.

And, with the TCJA’s near doubling of the standard deduction, fewer taxpayers will benefit from itemizing. Itemizing saves tax only when itemized deductions exceed the standard deduction. For 2018, the standard deduction is $12,000 for singles, $18,000 for heads of households, and $24,000 for married couples filing jointly.

Doesn’t have other deduction downsides

Even if you have enough other itemized deductions to exceed your standard deduction, taking your RMD and contributing that amount to charity has two more possible downsides.

First, the reported RMD income might increase your income to the point that you’re pushed into a higher tax bracket, certain additional taxes are triggered and/or the benefits of certain tax breaks are reduced or eliminated. It could even cause Social Security payments to become taxable or increase income-based Medicare premiums and prescription drug charges.

Second, if your donation would equal a large portion of your income for the year, your deduction might be reduced due to the percentage-of-income limit. You generally can’t deduct cash donations that exceed 60% of your adjusted gross income for the year. (The TCJA raised this limit from 50%, but if the cash donation is to a private nonoperating foundation, the limit is only 30%.) You can carry forward the excess up to five years, but if you make large donations every year, that won’t help you.

A charitable IRA rollover avoids these potential negative tax consequences.

Have questions?

The considerations involved in deciding whether to make a direct IRA rollover have changed in light of the TCJA. So contact us to go over your particular situation and determine what’s right for you.

Tax Planning for Investments Gets More Complicated

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For investors, fall is a good time to review year-to-date gains and losses. Not only can it help you assess your financial health, but it also can help you determine whether to buy or sell investments before year end to save taxes. This year, you also need to keep in mind the impact of the Tax Cuts and Jobs Act (TCJA). While the TCJA didn’t change long-term capital gains rates, it did change the tax brackets for long-term capital gains and qualified dividends.

For 2018 through 2025, these brackets are no longer linked to the ordinary-income tax brackets for individuals. So, for example, you could be subject to the top long-term capital gains rate even if you aren’t subject to the top ordinary-income tax rate.

Old rules

For the last several years, individual taxpayers faced three federal income tax rates on long-term capital gains and qualified dividends: 0%, 15% and 20%. The rate brackets were tied to the ordinary-income rate brackets.

Specifically, if the long-term capital gains and/or dividends fell within the 10% or 15% ordinary-income brackets, no federal income tax was owed. If they fell within the 25%, 28%, 33% or 35% ordinary-income brackets, they were taxed at 15%. And, if they fell within the maximum 39.6% ordinary-income bracket, they were taxed at the maximum 20% rate.

In addition, higher-income individuals with long-term capital gains and dividends were also hit with the 3.8% net investment income tax (NIIT). It kicked in when modified adjusted gross income exceeded $200,000 for singles and heads of households and $250,000 for married couples filing jointly. So, many people actually paid 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%) on their long-term capital gains and qualified dividends.

New rules

The TCJA retains the 0%, 15% and 20% rates on long-term capital gains and qualified dividends for individual taxpayers. However, for 2018 through 2025, these rates have their own brackets. Here are the 2018 brackets:

  • Singles:
    • 0%: $0 – $38,600
    • 15%: $38,601 – $425,800
    • 20%: $425,801 and up
  • Heads of households:
    • 0%: $0 – $51,700
    • 15%: $51,701 – $452,400
    • 20%: $452,401 and up
  • Married couples filing jointly:
    • 0%: $0 – $77,200
    • 15%: $77,201 – $479,000
    • 20%: $479,001 and up

For 2018, the top ordinary-income rate of 37%, which also applies to short-term capital gains and nonqualified dividends, doesn’t go into effect until income exceeds $500,000 for singles and heads of households or $600,000 for joint filers. (Both the long-term capital gains brackets and the ordinary-income brackets will be indexed for inflation for 2019 through 2025.) The new tax law also retains the 3.8% NIIT and its $200,000 and $250,000 thresholds.

More thresholds, more complexity

With more tax rate thresholds to keep in mind, year-end tax planning for investments is especially complicated in 2018. If you have questions, please contact us.

The Tax Deduction Ins and Outs of Donating Artwork to Charity

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If you’re charitably inclined and you collect art, appreciated artwork can make one of the best charitable gifts from a tax perspective. In general, donating appreciated property is doubly beneficial because you can both enjoy a valuable tax deduction and avoid the capital gains taxes you’d owe if you sold the property. The extra benefit from donating artwork comes from the fact that the top long-term capital gains rate for art and other “collectibles” is 28%, as opposed to 20% for most other appreciated property.

Requirements

The first thing to keep in mind if you’re considering a donation of artwork is that you must itemize deductions to deduct charitable contributions. Now that the Tax Cuts and Jobs Act has nearly doubled the standard deduction and put tighter limits on many itemized deductions (but not the charitable deduction), many taxpayers who have itemized in the past will no longer benefit from itemizing.

For 2018, the standard deduction is $12,000 for singles, $18,000 for heads of households and $24,000 for married couples filing jointly. Your total itemized deductions must exceed the applicable standard deduction for you to enjoy a tax benefit from donating artwork.

Something else to be aware of is that most artwork donations require a “qualified appraisal” by a “qualified appraiser.” IRS rules contain detailed requirements about the qualifications an appraiser must possess and the contents of an appraisal.

IRS auditors are required to refer all gifts of art valued at $20,000 or more to the IRS Art Advisory Panel. The panel’s findings are the IRS’s official position on the art’s value, so it’s critical to provide a solid appraisal to support your valuation.

Finally, note that, if you own both the work of art and the copyright to the work, you must assign the copyright to the charity to qualify for a charitable deduction.

Maximizing your deduction

The charity you choose and how the charity will use the artwork can have a significant impact on your tax deduction. Donations of artwork to a public charity, such as a museum or university with public charity status, can entitle you to deduct the artwork’s full fair market value. If you donate art to a private foundation, however, your deduction will be limited to your cost.

For your donation to a public charity to qualify for a full fair-market-value deduction, the charity’s use of the donated artwork must be related to its tax-exempt purpose. If, for example, you donate a painting to a museum for display or to a university’s art history department for use in its research, you’ll satisfy the related-use rule. But if you donate it to, say, a children’s hospital to auction off at its annual fundraising gala, you won’t satisfy the rule.

Plan carefully

Donating artwork is a great way to share enjoyment of the work with others. But to reap the maximum tax benefit, too, you must plan your gift carefully and follow all of the applicable rules. Contact us to learn more.

You Might Save Tax if Your Vacation Home Qualifies as a Rental Property

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Do you own a vacation home? If you both rent it out and use it personally, you might save tax by taking steps to ensure it qualifies as a rental property this year. Vacation home expenses that qualify as rental property expenses aren’t subject to the Tax Cuts and Jobs Act’s (TCJA’s) new limit on the itemized deduction for state and local taxes (SALT) or the lower debt limit for the itemized mortgage interest deduction.

Rental or personal property?

If you rent out your vacation home for 15 days or more, what expenses you can deduct depends on how the home is classified for tax purposes, based on the amount of personal vs. rental use:

Rental property. If you (or your immediate family) use the home for 14 days or less, or under 10% of the days you rent out the property, whichever is greater, the IRS will classify the home as a rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules.

Your deduction for property tax attributable to the rental use of the home isn’t subject to the TCJA’s new SALT deduction limit. And your deduction for mortgage interest on the home isn’t subject to the debt limit that applies to the itemized deduction for mortgage interest. You can’t deduct any interest that’s attributable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction (subject to the new SALT limit).

Nonrental property. If you (or your immediate family) use the home for more than 14 days or 10% of the days you rent out the property, whichever is greater, the IRS will classify the home as a personal residence. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years.

If you itemize deductions, you also can deduct the personal portion of both property tax and mortgage interest, subject to the TCJA’s new limits on those deductions. The SALT deduction limit is $10,000 for the combined total of state and local property taxes and either income taxes or sales taxes ($5,000 for married taxpayers filing separately). For mortgage interest debt incurred after December 15, 2017, the debt limit (with some limited exceptions) has been reduced to $750,000.

Be aware that many taxpayers who have itemized in the past will no longer benefit from itemizing because of the TCJA’s near doubling of the standard deduction. Itemizing saves tax only if total itemized deductions exceed the standard deduction for the taxpayer’s filing status.

Year-to-date review

Keep in mind that, if you rent out your vacation home for less than 15 days, you don’t have to report the income. But expenses associated with the rental (such as advertising and cleaning) won’t be deductible.

Now is a good time to review your vacation home use year-to-date to project how it will be classified for tax purposes. By increasing the number of days you rent it out and/or reducing the number of days you use it personally between now and year end, you might be able to ensure it’s classified as a rental property and save some tax. But there also could be circumstances where personal property treatment would be beneficial. Please contact us to discuss your particular situation.