Year-End Tax-Planning Tips

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The fourth quarter is upon us and, with it, some opportunities to save on your 2015 tax bill. Joining me to share some strategies on this front is Tim Steffen--he is director of financial planning for Robert W. Baird.

Tim, thank you so much for being here.

Tim Steffen: Good to be here again.

Benz: Let's talk about some stage-setting as we look upon 2015. Let's talk about the key tax differences relative to 2014. Are there any big things that investors should have on their radar?

Steffen: It's really been a pretty quiet year, at least from a legislative standpoint. There haven't been any significant new laws enacted. A few expirations, but that's about it. It's things that we've kind of gotten used to over the last several years. Nothing really significant this year. From an investment standpoint, what matters is what's happened with your portfolio this year. It's obviously been a pretty up-and-down market. We had a pretty big dip there for a while; but for those who hung on, we've picked a lot of that back up. For those who bailed at the bottom, they've got some planning opportunities that they should maybe take a look at.

Benz: I want to delve into those. As you said, it's been a little bit of a rollercoaster year for investors. As they are looking upon their portfolios and thinking about what kinds of things they can do to try to minimize their 2015 tax bill, let's talk about some of them. Starting with tax-loss selling, you often hear that you should look through your portfolio to see if there's anything that you can sell and maybe realize a loss.

Steffen: A lot of people like to look at tax-loss selling as a way of zeroing out their income. The first thing I always tell people is this: Before you think about selling for tax purposes, think of it from an investment standpoint. Everything should be driven by the portfolio first; you should have a good, solid investment reason for anything you're doing. Taxes [are a factor you'll want to think about], but it should be an investment decision first.

Now, if you're at this point of the year and you realize you've got a lot of capital gains, one thing that people will do is find some losses in their portfolio that they can then sell to offset those gains. But you've got to be careful of wash-sale rules and some of the other things that will prohibit you from getting back into those positions right away. You could double up on some of those and then sell the original lot so that you're not out of the position if it's something you still like. But yes, tax-loss selling is one way to at least offset the capital gains you've got. You have to be careful about trying to estimate what your gains are; you don't necessarily have full control over all of your gains for the year. Mutual funds tend to surprise people a little bit at the end of the year.

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Benz: I know that's one thing we've been watching. We've seen, for a few years now, funds have exhausted any losses they had left over from the bear market, and now some funds are distributing some pretty large capital gains to shareholders.

Steffen: Correct. The ones who stick with the fund are the ones who tend to get hit with those gains the most. We'll be hearing over the coming weeks as we get closer to year-end what those distributions are going to be, and then investors can plan around that. If you go into year-end with a strategy of how much you're going to sell to offset the gains you know about, just be aware that there may be gains you don't know about coming yet. Be prepared for those as well.

Benz: One thing I sometimes hear from investors is the question, "Is there anything I can do to dodge a big distribution from a fund that I hold and maybe want to hang on to?" Not really, right?

Steffen: The only thing you can do is sell the fund, but then you've got to wait to get back in--especially if you sell for a loss. Then, you definitely have to wait the 30 days to get back in. But even if you do sell for a loss and you stay out of it, who knows what those 30 days may be? They may be the greatest run that the fund has ever seen for all we know. But there may be expenses associated with selling in some accounts. We don't typically recommend selling out just to avoid those distributions.

Benz: One thing you saw a lot of people talking about during that third-quarter market sell-off was whether it potentially created some opportunities from the standpoint of Roth-conversion recharacterizations. Has that window closed now that the market has come back a little bit?

Steffen: I guess it depends on what you did with the account after you did the conversion. If you converted a traditional IRA to a Roth in, let's say, early August before we had that big sell-off and then you sold out of your position--so you didn't get to participate in the runup that's happened in the last couple of months--you're probably still paying tax on a higher value than what you have in the account today. If that's the case, then you probably want to look at doing a recharacterization and undoing the Roth. Now, you'll have to wait until after the first of the year to go back to the Roth conversion again for those dollars, but you can change your mind on those Roth conversions. You actually have until next October of 2016 to make a final decision on that.

Benz: So, what are the tax implications? If I made a conversion, do I have to pay those taxes even if I've recharacterized?

Steffen: No. The whole idea of a recharacterization is kind of a do-over.

Benz: A total do-over.

Steffen: You can undo the whole Roth conversion. The calculation of how much to move out of the Roth and back to the traditional can get a little complicated, especially if you did your conversion into an already existing Roth. We always encourage people who want to do a Roth conversion to do it into a new Roth at first. It makes the accounting a little bit easier if you ever decide to do a recharacterization. If you did convert into an existing Roth, that can get more complicated; but a recharacterization is a way to basically make the tax liability go away.

Benz: So, those are some portfolio considerations. You've got tax-loss selling and potentially relooking at Roth-conversion recharacterization. Let's talk about things that sort of fall under the "other" umbrella, starting with charitable giving. This QCD option has been very much on Morningstar.com readers' radar. They like to take their RMDs and steer them to charity. Is that still an option for 2015?

Steffen: So, QCD is a qualified charitable distribution--the idea of making a gift out of an IRA directly to a charity. It's one of those laws that's been in and out of the tax code many times over the years. Right now, it's out; it expired at the end of 2014. We're hopeful that it will be re-enacted again before the end of the year. We were hoping it was going to be in the budget bill that was signed recently. It didn't make it into there.

At this point, the technique is not out there. Now, that doesn't mean you can't just make a gift from your IRA to a charity--you can still do that. And if the law is re-enacted and made retroactive, you will be just fine. Even if it's not re-enacted or made retroactive, you'll still get the charitable deduction; you'll just have to report it as income.

QCD is one of those techniques that I think a lot of clients and a lot of investors really like. It's frankly not the most efficient way to make a charitable gift. There are other techniques that may be a little bit better--the idea of giving appreciated property, for example. But there are some people for whom QCD makes some sense. Right now, it's not around; but we're hopeful it will be back.

Benz: Let's just quickly discuss why that QCD may be more advantageous from a tax standpoint versus making a contribution and then deducting it on your tax return.

Steffen: Where QCD can really come into play is for people who are running up against some of the other limits that are out there. For example, if you don't itemize deductions, making a charitable gift isn't going to directly give you a charitable benefit because you're using the standard. Now, that's a small window of people, but it does apply. If you're somebody who takes a standard deduction, QCD can be pretty valuable.

If you're somebody who, on the other hand, makes a lot of charitable gifts and is bumping up against the [adjusted gross income] thresholds for deductions, which are generally 30% to 50% of income, depending on what you give. If you're running up against those, the QCD can be a great way to get an immediate tax benefit for that gift. Those are probably the two biggest areas.

There are also people who are subject to these itemized-deduction phase-outs. As high-income taxpayers' income goes up, they begin to lose some of their deductions. If you're subject to that, perhaps QCD might be valuable to you. Outside of those three groups, probably the more-efficient technique is usually giving appreciated stock at the end of the year. That way, you get the benefit of the tax deduction plus you avoid a capital gain.

Benz: Another topic that you think is worth keeping on investors' radars is retirement planning and the way that it can intersects with tax planning. You advise that people ought to use a two-year window for retirement planning and tax planning. Let's talk about that.

Steffen: Whenever you're talking about tax planning, generally the idea is should I be accelerating or deferring income, should I be accelerating or deferring deductions from this year to next year, or vice versa. So, whenever you're making that decision, you're impacting not just the current calendar year but the next one as well. If you decide to frontload charitable contributions for 2016 into 2015, make sure that you're getting a larger benefit this year than you would have gotten a year ago--taking into account that there is a year lag, so there is the time-value-of-money factor there. But if you're going to get a larger benefit for the gift this year than you would next year, then you probably want to accelerate it to this year. As for the inverse, if you're going to have a higher income next year and that deduction is worth more to you next year, you probably want to push it out into 2016--even though it will be a year later before you get the actual tax benefit. So, anytime you're looking at any kind of tax planning, you have to look at what the multiple-year impact is.

Benz: Looking forward to 2016, you noted it's an election year. What should people be watching out for as they think about their tax picture as next year unfolds?

Steffen: I would say it's going to be a famine and then maybe a feast. The way this starts off is that everybody is going to be focused on the election for roughly the first 10 months or so of the year. Then, certainly as we get closer and closer to November, the possibility of any major legislation is going go to be pretty much nil.

Once we get past the election, though, and we get into the last roughly two months of the year, you've got a lame-duck Congress that is maybe trying to push some things through before the end of their session. Then, you may see activity, especially if you see any kind of change in control coming as a result of the election--whether it's a new Republication president or maybe the Democrats take control of the Senate or the House. Then, you might see some rush to get some things done because of those looming changes in control. But I would expect the beginning of the year to be relatively slow.

Benz: Tim, tax planning is very much on Morningstar.com readers' and viewers' radars. Thank you so much for being here to share your insights.

Steffen: You're welcome. Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.