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Tax-Saving Tactics for Your December To-Do List

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar.

2011 is heading toward the history books, but investors still have time to do a little maneuvering to help maximize their tax savings and bolster their retirement accounts.

 Here with me to offer some tips and a short list of year-end 'to-do' items is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: People have a lot of lists, a lot of things that they need to get done before the end of the year.

But there are some important, and in some ways, not too difficult tasks they can do to really get their financial house in order. The first one has to do with some tax savings that you can get by tax-loss selling or tax harvesting. It sounds like a complicated concept. Can you break it down for me?

Benz: Well, it's been a volatile year in the market if you are an investor. So the goal of tax-loss selling is that you're actually looking for securities in which you have a loss within your taxable account. So you are holding them at a price that’s below what you paid for them. And you can actually sell the security, book a loss, and use that loss first to offset any capital gains elsewhere in your portfolio, and if you've cleared out your capital gains and zeroed those out, if you still have money left over [from the tax-loss selling], you can use that tax-loss to offset ordinary income. If you have done all that and still have tax losses left over, you can apply them to future years' capital gains and, in turn, income.

Stipp: So this is primarily a tax-saving maneuver, it’s something that you'd likely be doing in your taxable accounts. What if you have some losses in tax-advantaged accounts like IRAs? Would you want to do something similar in those accounts or is it more complicated?

Benz: It's definitely more complicated. First of all you cannot do any tax-loss selling in 401(k). So just take that off the table.

There is a possibility to do tax-loss selling in your IRAs, but you do really need to make sure that it's worth your while. So you would need to clear out or sell all of the IRA type, all together. So if you have a large IRA asset pool, that’s probably not going to make sense for you, because you’ll only be able to recontribute $5,000 or $6,000 a year depending on your age. So that’s one hindrance to using tax-loss selling in an IRA.

The other is that those losses are only deductable to the extent that they exceed 2% of your adjusted gross income. So they're not going to be nearly as valuable for you as will those losses from your taxable accounts. [For more, click to read: Should You Take a Loss in Your IRA?]

Stipp: So doable in an IRA but definitely some caveats there.

Christine, I think you would also agree that you don’t necessarily want to have the tax cart before the horse in your investments. So you don’t want to always have taxes dictating your plans. If you have a portfolio plan and you see some losses in a certain area, but you still want to have exposure to that area in your portfolio, how should I manage that? Should I just sit tight and say, "I'm going to deal with these losses and forget about any tax advantages I could get."

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Benz: Well, you may want to do that. For simplicity's sake, that that might be the thing to do. But the IRS does actually give you so leeway in terms of replacing securities that you've sold and realized a tax loss with other securities that maybe occupy the same part of the market.

So you could take an emerging-markets index fund, for example, and replace it with an actively managed emerging-markets fund, and you could do that right away. So right after selling the one, you could replace it with the other.

The IRS would not allow you to essentially sell one security and swap in something that is nearly identical. So an example would be Berkshire Hathaway Class A, I'm going to sell that and buy Class B--no, you can't, because the IRS would ... not allow that tax loss because you really have not lost exposure to that very security. So you need to be careful that you don’t trigger what's called the "Wash-Sale Rule."

The other thing, Jason, is, if for whatever reason you want to maintain exposure to that identical security, you can always wait 30 days and re-buy it. So if there is a specific fund, you really want that manager or you really want a given stock, if you are willing to wait that 30 days and know that the security could go up in value during that period, you can re-buy after that time has elapsed.

Stipp: Another important thing that needs to be on the checklist of our retired viewers is RMDs, Required Minimum Distributions. What are these?

Benz: Well, these are amounts that retirees or anyone over age 70 1/2 has to take by year-end from their company retirement plan--so, 401(k)s, 403(b)s, 457s--as well as IRAs.

So you’ve got to take that amount. Essentially the IRS or the government has allowed tax-deferred compounding on this money. But at some point, they say, "OK, we can't let this go on indefinitely; you need to start taking money out and giving us a cut of our income."

Stipp: So how much do you need to take out? Is it different for everybody or are there standard rules that are applied?

Benz: Well, the standard rule is that you look back to the balance in your account at the end of 2010 [i.e., the prior year] in each of your account types. So you would calculate a different RMD for IRAs and 401(k). So you look back to your balance and you divide it by a factor that is based on your life expectancy or perhaps your life expectancy and that of your beneficiary.

So there are lots of tables and worksheets online that can help you calculate with some precision the amount of RMD you should taking. And you really need to take care to hit this 12/31 deadline because the penalty is huge if you don’t. So you'll owe not just ordinary income taxes, as you would on any of these distributions, but you would also owe a penalty equal to 50% of what you should have taken but did not.

Stipp: So let's assume that I have a traditional IRA and I also have a 401(k); both would be subject to RMD. Do I have to take some sort of proportionate amount from each one or could I take all of them for example out of the traditional IRA and zero out of the 401(k), provided that I took enough out of that IRA?

Benz: You need to calculate your amounts separately. So, for the purpose of this rule you would need to take distributions from both account types, but within a given account type--so say you have multiple IRAs, you’ve got some with Schwab, some with Fidelity, accounts all over the place. You can be surgical within a given account type. So if you have multiple IRAs, you could say, well, I'm just going to pull my RMD from this one particular account; I like my accounts over here, so I'm going to leave them alone. So you have some flexibility within a given account type.

Stipp: So Christine, given that this is basically selling that you have to do anyway, are there ways to be strategic then about what you sell and what you choose to make up that RMD?

Benz: Absolutely, Jason. So I think this is a great idea to the extent that people are doing some rebalancing around year-end and looking at areas where they want to lighten up on or add to, the RMDs can help you. If you wanted to sell a certain asset class anyway, you can start there for your RMDs, and maybe get your account balance back into line with your targets. So it's great to try to sync those two processes up to the extent that you can.

Stipp: So that Dec. 31 deadline is an important one for RMDs. It's also an important one in most cases for flexible spending accounts. These are something that you sign up for through your work. What do I need to keep in mind about those FSAs?

Benz: Well, you need to keep in mind that you've got to clear it out. And Jason, you alluded to the fact that different companies and different plans have different rules for this. Some do give you a grace period to spend that money by say March 15 or whatever it is. So check with your plan to see specifically what the rules are.

And with your FSA, you can direct FSA money toward co-pays, prescription drugs, vision care, dental care--those are some of the key categories that are FSA allowable. One category that is not allowable for 2011, starting in 2011, would be over-the-counter drugs. So vitamins, any non-prescription drugs that you need, you cannot use FSA money toward it unless you have a doctor's prescription. So, again, check on the rules, but typically those expenditures would not be FSA allowable.

Stipp: So let’s say I am in a situation where I do have a pretty big balance left in my FSA, and I'm going to do my best to spend that obviously this year, but I'm thinking ahead to next year and how much I want to put in. How could I be better at estimating how much I might use in such an account?

Benz: Unfortunately, my guess is that open enrollment for a lot of people for 2012 has already ended, but I do think it really makes sense to take an audit of what you're spending within your FSA. If you do find that you're in this mad scramble at year-end to buy expensive pairs of glasses and things that you don't really need, that is a good reason to consider scaling back how much you're putting into these accounts.

I was talking to a financial planner the other day. She noted that people are often pretty conservative, that they actually under-invest in their FSAs. So it's very individual, but it does make sense at this time, if you find this happening year-after-year where you've got a lot of money to spend at year-end, put in less and don't spend money on things you don't need, obviously.

Stipp: Christine, is the FSA something where companies might match some the amount that you put in the FSA? Is that something you would want to consider as to whether you want to contribute, and how much you want to contribute?

Benz: Absolutely. That's a great point, Jason. If your employer is making matching contributions to that FSA, I would at least try to meet that match because most of us just in our day-to-day activities can probably find some FSA-eligible expenses in our lives.

Stipp: Speaking of employer plans and employer benefits, the 401(k) and other such employer-sponsored plans have a year-end deadline for contributions. What should I keep in mind there?

Benz: Well, the maximum amounts are $16,500 if you are under 50; $22,000 if you are over 50. So that's the 2011 amount. If you possibly can ratchet up your contributions in these last few days of the year--maybe on your last paycheck, if you can afford to do that, to jack up your contribution to get as close as you can to hitting that maximum allowable input--I think that's a great thing to think about doing.

And also if you are recalibrating your contributions for 2012, bear in mind that we are getting a little bit of a bump-up in terms of maximum allowable contributions. So it will be $17,000 for savers under 50 in 2012 and $22,500 for people over 50. So consider, if you can, increasing your contribution to meet that new maximum.

Stipp: So this year-end deadline applies to 401(k), 403(b). What about for IRAs, do you have that same deadline to worry about there?

Benz: You don’t. So you actually have until your tax filing deadline, which in 2012 is going to be April 17, to make your IRA contributions. What it is a deadline for is, for self-employed folks, Jason, they have, December 31 as their deadline to set up solo 401(k)s and Keogh plans. So you don't have to fund them, you don't have to contribute to them, but if you want to contribute to one of those plans for the 2011 tax year, you need to have it set up by year-end.

Stipp: So set it up, but you could still put some money into after it’s set up after December 31, but make sure you have at least the set-up done by the end of the year.

Benz: Exactly.

Stipp: Okay, Christine, last thing that you have a few tips for involves the home; homeowners might want to take a look at some of the tax incentives that they have there. What are you top tips?

Benz: Well, if you are trying to maximize your deductions for the 2011 tax year, one idea would be to consider prepaying your January mortgage in December. That way you can get one extra mortgage interest deduction on the 2011 books. You might also consider if you have a property tax bill due in the first half of 2012, prepaying that as well. I think the trade-off here, though, is that you are forking over assets prematurely. You really have to consider how much those extra deductions are worth to you.

The other thing to keep in mind is that there still are some energy-efficiency credits that are available to people. So this credit is allowable, it would cover up to 10% of expenditures on energy-saving improvements that you might make to your home such as new windows, new doors, new furnace, AC equipment, any number of things; insulation would be covered by this credit. So it's 10% of what you spent up to a lifetime limit of $500.

Stipp: All right, Christine. Some great year-end tax tips. Thanks for helping us get organized today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.