Careful Coordination of Assets Can Achieve Tax Efficiency in Investment Portfolio
Finding Opportunities and Knowing What to Look Out For
Investors are beginning to put greater focus on the strategic thinking and coordination of assets that is necessary to achieve tax efficiency in their portfolios. It’s not always a matter of sheltering financial assets in tax-free instruments. Sometimes understanding how varying approaches to certain actions can result in different tax consequences is critical to tax efficiency.
An often overlooked piece of investment management is the opportunity to keep the same investments but move them into a different type of account to become more tax efficient over time.
The concept of tax efficiency is broad and complex, but the following strategies are common to many individuals’ portfolios.
Strategies for Tax Efficiency
The charitable giving deduction has enabled taxpayers to reduce taxes by contributing to the charitable and philanthropic organizations that align with their personal values. Though the Tax Cuts and Jobs Act (TCJA) of 2017 effectively restricted the use of the charitable deduction by many lower- and middle-income taxpayers, the deduction is still an important tax efficiency tool for high-income taxpayers.
Of particular value is the qualified charitable distribution, which is available to taxpayers aged 72 or older who transfer Required Minimum Distributions (RMDs) from their IRAs directly to qualified charities. Even if you don’t need your RMDs to live on, you are still required to take them each year and that income is taxable. By giving the RMD directly to charity, you avoid reporting it as Adjust Gross Income and may also help minimize the impact to the amount of premium you pay for Medicare as discussed later.
However, by utilizing the qualified charitable distribution, the funds are transferred directly from the investment house that manages your IRA to the qualified charity. By transferring the funds in this manner, the entire amount is tax-free.
The maximum amount that can be donated through a qualified charitable distribution is $100,000 per IRA owner. So, a married couple who both have IRAs could each donate the maximum.
The Coronavirus Aid, Relief and Economic Security (CARES) Act waived the need to take RMDs in 2020, but they are reinstated for 2021.
Use of Tax-Free and Tax-Deferred Instruments
Municipal bonds are tax-free, whereas annuities are tax deferred. Municipal bonds are securities issued by or on behalf of a local taxing authority such as a State, City, or School District. The interest income from these securities is not taxable by the IRS however may be taxable to the state. Municipal bonds are often used as a conservative approach to tax free income.
Annuities are contracts between an investor and an insurance company that requires the insurer to make payments to the investor either immediately or in the future. The interest, dividends and/or gains are tax deferred until the money is withdrawn from the annuity on a last in, first out basis. This income is considered “ordinary income” versus capital gain tax treatment which is taxed a lower rate.
Life Insurance as a Retirement Plan
Also known as a LIRP, utilizing life insurance to fund retirement involves heavily funding a life insurance policy and allowing the assets to grow. At retirement, you may borrow funds from the policy to live on. Such loans are not considered taxable income. When you die, the policy utilizes the life insurance death benefit, which also are not taxable, to pay off the amount borrowed.
Tax Loss Harvesting
Tax loss harvesting allows you to sell investments that you own outside of retirement accounts (Qualified) that are down in value relative to what was paid. These positions are sold and replaced with similar investments but allow us to take an income tax deduction for the loss. These losses can be used to offset gains from the sale of other assets and even reduce other income up to $3,000. The remainder of the losses are carried forward to be utilized in future years.
Funding a Roth IRA
Your income is likely higher than the statutory limits for starting a Roth IRA, but there is a back door method that has become widely used that allows taxpayers with higher income to realize the Roth IRA benefits.
A Roth IRA is funded with after-tax dollars and is subject to the same annual contribution limits as a traditional IRA. If time and age requirements are met, the growth of the assets is tax-free.
To create a Roth IRA if your income is over the limit, start with a non-deductible traditional IRA and, after a certain amount of time of growth, convert the IRA to a Roth. Please consult an advisor regarding eligibility for Roth IRA’s, non-deductible IRA’s as well as the amount of time necessary before doing the Roth conversion. As the rules are complicated Conversion triggers an immediate tax liability, but in this situation where the investor funded a non-deductible IRA and had cost basis equal to the contribution amount, the only tax is on the growth of the IRA from the time it was invested in the non-deductible IRA to the conversion.
Another consideration with Roth IRA’s is to convert traditional IRAs to Roth IRAs in years when your income is below average and/or the market value of the account has dropped. We want to take any opportunity to utilize lower income tax brackets when possible.
The long-term benefits of conversion may be worth it if your retirement horizon is several years away.
Donor Advised Fund
Donor advised funds are funds established at investment companies where investors contribute cash or securities and generally take an immediate tax deduction. Those funds can be invested allowing for the investor to take grants from the fund during their lifetime. At death the remainder of the assets goes directly to the charity of choice.
The Medicare Risk
An important part of tax efficiency is knowing what to look out for. Unfortunately, many taxpayers are snared by IRMA – an Income Related Monthly Adjustment that can occur when they sell a valuable asset or have other significant income as the amount of premium you pay is based on your Modified Adjusted Gross Income.
Selling a valuable asset like a large piece of land to help fund retirement may seem like a good idea. But it can trigger a significant increase in the amount of your Medicare premium through an IRMA.
When you’re on Medicare, you pay a premium based on your income. For most people, the premium is about $150 per month. But if you sell a large piece of land or some valuable stocks, it can result in higher Medicare premiums. The increased premium is deducted from your Social Security check, so the impact is often thought to be a decrease in Social Security benefit when in fact it’s a higher cost of health insurance. If both a husband and wife are accustomed to paying $150 a month are suddenly paying $500, that’s a big adjustment if you’re not prepared for it.
If you would like to discuss the tax efficiency of your investment portfolio, please contact your Adams Brown advisor.