Jason Stipp: I am Jason Stipp for Morningstar, and welcome to the Friday Five.
It's Oct. 1, and it's the beginning of the fourth quarter. We all know how time flies, so to make sure that you get everything done that you need to, Morningstar's Christine Benz, director of personal finance, is here to tell us about five key portfolio maneuvers to undertake in the fourth quarter.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So, today Christine, we're going to talk a little bit about tax planning and your purchases and sales.
We are going to talk about maximizing those tax-sheltered accounts.
We are going to talk about not forgetting your estate plan.
Making any Roth conversions that you think would be a good idea for you.
And finally taking full advantage of those energy efficiency credits that are out there.
So, number one, Christine, I think this is something that you might recommend on any given year as something to consider, a strategy to consider, but it could be particularly important in our current environment and that's considering your tax plan and your purchases and sales. Why is that so important this year?
Benz: Yes, Jason, it's arguably something you should do anytime in the fourth quarter, but with tax rates set to go up in 2011, I think it's a particularly good time to take stock of any holdings that you have, where you have big gains in those holdings and you were considering selling anyway, for whatever reason. So, you can take the gain now and pay taxes at a lower rate than would be the case in 2011, which would be a really smart move.
Stipp: Particularly, if that's a long-term gain anyway, so go ahead and take it when the rates are likely to be lower.
Then on the selling side, because you may have a bigger tax bills in the future, an important tool for you to potentially have to give you flexibility is harvesting tax losses, so how would that work?
Benz: Right. So, I always say scour your portfolio for tax-loss candidates, so things that you had wanted to sell anyway and so you can use those losses to offset capital gains or if you don't have any capital gains, you can use them to offset ordinary income and they can also be carried forward into subsequent years. So, those losses can be really valuable from a tax-planning perspective.
Stipp: This also brings up an important point about keeping track of your cost basis, which is something that can be a headache, especially if you haven't been as meticulous about it as you should be.
Benz: Well, especially if you are dollar cost averager it can really get to be a headache. So, I say, keep a simple spread sheet in which you are tracking your cost basis, so when you make purchases or sales or have dividends or capital gains reinvested, keep track of that. Increasingly I am finding that fund companies and brokerage firms are making it easier for clients to keep track of cost basis, too, so that's a help.Read Full Transcript
Stipp: Certainly good news.
The second one also involves taxes to some degree and that's your tax-sheltered accounts, and making sure that you are really stuffing those as much as you can. What's your advice on that?
Benz: Right. So, look at 401(k)s, 403(b)s, 457s, if you are under 50, $16,500 is your limit, if you are over 50, $22,000, so make sure you are funding those to the maximum possible advantage.
IRA is $5,000 for savers under 50, $6,000 if they are over 50.
The other thing I think people should look at, particularly those at higher income levels, who have not been able to contribute to Roth IRAs, should look at what I call, doing a backdoor IRA.
So, essentially what you do is that you open a traditional IRA, then you do a conversion right away to a Roth. So, for those individuals who don't have anything in that Roth column, that helps them start building a nest egg of assets that will not be taxable upon withdrawal, which could be really valuable if we're in for a higher tax rate environment in the future.
For number three, this is something that – like you said, the tax environment is still a little bit uncertain – another thing that's uncertain is the estate planning and the estate tax environment as well, and I think for a lot of folks they might think, while there is a still a lot to be settled here, I'm just going to put off the estate plan until all that dust is settled. That's not necessarily a good idea, though?
Benz: I don't think so. So, in 2011 what is said to happen, unless Congress takes action, is that, the estate tax exemption will be $1 million. And it's easy to see how even upper middle class households quickly hit that $1 million figure. If you have some real estate and a few retirement accounts, you can easily get to that $1 million.
So I think it's a mistake to put off estate planning simply because there is so much that we don't know. I think a year ago people said, well, this will all be settled, but Congress didn't take action, and in fact, we got in for the year that we're in, where there is no estate tax, I think we could easily see inaction again this year and end up with that fairly onerous estate tax system in place.
Stipp: And if you're worried about estate tax coming back in the future, what kind of steps might you think about to mitigate that?
Benz: Well, first of all, check with an attorney. I usually say this is an area not to set out on your own to try to do estate planning. But one mechanism that households often take advantage of is called a bypass trust, sometimes called a credit shelter trust, and essentially that lets married couples both take full advantage of that estate tax exemption for themselves. So it's one way to pass a little more to their heirs estate tax free.
Stipp: Certainly concrete steps you can take. Don't necessarily put it off just because there is some uncertainty. Make sure you have a plan in place.
For number, four, Christine, you'd mention before about the backdoor to getting into a Roth IRA for some folks. Conversions, obviously, overall, have been a big issue this year. There has been a lot of talking about it. What should I be thinking about as I realize the clock is ticking and I might want to convert and take advantage of that that I hadn't been able to do before?
Benz: Right. So, one reason to look at a conversion particularly in 2010 is that there is a special rule that allows [for] any conversions ... the income tax you owe on any conversions due to a conversion in 2010, you'll be able to pay in 2011 and 2012. So that is an important advantage if you don't have the cash on hand to pay the taxes due on that conversion this year. So I think it's worth looking at for 2010. It's worth doing the math, no matter what.
And one other thing I wanted to mention, Jason, is that there was a Small Business Act that Congress passed this week, President Obama signed it on Monday, and it has an interesting provision that actually lets people start doing conversions with part of their 401(k) balances. So that's all traditional money right now. So that's all going to be taxed upon withdrawal. But if you are over 59 1/2, you'll actually be able to convert your own contributions plus employer contributions. If you're under 59 1/2, you'll only be able to convert the portion that is represented by your employer's contributions on your behalf.
Stipp: So that flexibility of those of being able to spread the payments certainly something to consider as you're looking forward, although, like you say, if you wanted to do the math on that if tax rates are higher in the future…
Benz: Right. You might not want to take advantage of that. So, does your head hurt yet? Mine does a little bit.
Stipp: Just a little bit. For number five, Christine, there is obviously a lot of movement out there socially to be more green. It can pay this year as well, though, and what should you keep in mind about that and the credits you can get?
Benz: Right. So there is this energy efficiency tax credit. It's going to be expiring at the end of this year. And essentially what it lets you do is, if you make energy efficient improvements to your house, so this might be new windows, new doors, new heating and cooling units, you can take a credit that is equivalent to up to 30% of the expenditures that you made up to $1,500. So tax credits can be really valuable come tax time. So it's a chance to kind of upgrade the quality of your home and also get a little bit of a tax break.
Stipp: Go green and save some green as well.
Stipp: Christine, thanks so much for joining me.
Benz: Thank you, Jason.
Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.