Benz: A Year-End Tax-Planning Checklist

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Year-end is upon us, and Tax Day--[which is April 18 next year]--will be here before we know it. It's a busy time of year. But it's also a great time to take last-minute steps to reduce your tax bill for 2015.

During the course of this presentation, I'll be sharing some steps that investors can take if they'd like to try to reduce their tax bills. I'm going to take these items one by one, but I'll start with a quick overview of what I'll be covering during the course of this presentation.

I'm going to start by talking about taking capital losses in your portfolio. You can hunt around for losing securities and use those losses to offset capital gains--or if they exceed your capital gains, you can use them to offset ordinary income. I'll also talk about tax-gain harvesting, which can be appropriate for certain investors, especially those in the lowest tax brackets. I'll talk about mutual fund capital gains distributions, which are the bane of many fund shareholders. While there is not a lot you can do to avoid them, there are some steps that you can take to reduce the tax pain associated with them.

I'll talk about fully funding your retirement-plan contributions before year-end. And for people who are subject to required minimum distributions, or RMDs, I'll talk about some ways that you can use those RMDs to actually improve your portfolio to improve its risk/reward profile. I'll talk about making charitable gifts, which is relevant to investors of all ages. And finally, I'll spend a few minutes talking about flexible spending accounts and how you want to try to liquidate those balances if you possibly can before year-end.

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I'm going to start out by talking about tax-loss selling. Before we get into the nitty gritty of tax-loss selling, it's important to remember that this will only be beneficial in your taxable accounts. It typically won't be a great strategy for IRAs or other account types. But if you do have taxable accounts and you have securities in that portfolio that are selling below the price that you paid for them, you can use those losses to offset capital gains if you have them--or if those losses exceed your capital gains, you can use them to offset ordinary income. So, when it comes to lowering your tax bill, those capital losses can be very, very effective.

Using a simple example of how capital losses would work and how you could use them to offset capital gains, let's assume you just have a very simple two-stock portfolio. You've got stock one, which you've purchased and you've had great gains in it, and you've had stock two, which hasn't performed as well during your holding period. So, you have a $6,000 loss in stock two, and you have a $5,000 gain in stock one. What you can do is use that $6,000 loss, if you sell stock two, to offset your $5,000 gain in stock one. You still have $1,000 left over; you can use that amount to offset ordinary income tax. That's a very quick illustration of how tax-loss selling can work for you.

If you are looking for tax-loss sale candidates in your portfolio and you're primarily a fundholder, you want to look to those categories that are depressed, currently. Some places where investors might look around for tax-loss sale candidates would be emerging-markets equity funds--or perhaps to cut things even more narrowly, if you have a Latin America equity fund. Those have been particularly hard-hit categories over the past year.

Emerging-markets bond funds, I know, appear in many investors' portfolios. They have not performed well either. That might be another category to look to for some potential tax-loss sale candidates. The whole category of energy and basic materials was also a very hard-hit area, so investors might look to energy-equity funds that they hold, broad commodities-tracking investments that they hold in their taxable accounts. Master limited partnerships is another category that was very hot a couple of years ago, but recent performance has not been good. That might be another area that investors could look to for potential tax-loss sales.

Equity investors have even more opportunities to cherry-pick tax-loss sale candidates. You can be surgical about pruning individual securities that are selling below your purchase price. I recently did a screen on Morningstar.com for companies with market capitalizations of $10 billion or more that had lost 10% or more in the past year. There were roughly 400 individual stocks that fit that description, so these aren't fly-by-night companies--they're widely held companies that probably appear in many investors' portfolios. I did a similar screen for companies that were trading at more than 20% losses in the past year. There were roughly 200 companies that fit the bill.

So, take a look within your portfolio and see if you have potentially any securities that you could sell to harvest a tax loss. You might take a closer look at the energy sector--that's been a particularly hard-hit sector, whether for fundholders or individual stockholders. Basic materials is other area that's been pretty hard-hit. I've just named a couple of companies on this slide; but certainly if you have exposure to those sectors in your portfolio, it's a good bet that at least some of your holdings are trading below your purchase price.

Your ability to benefit from tax-loss selling is going to depend on your cost basis. Cost basis is pretty straightforward; it's the amount that you paid for a security, adjusted for any commissions that you paid, adjusted for stock splits if it's an individual stock, and adjusted for any reinvested dividends and capital gains if you're a fundholder. To use a very simple example, say you purchased 100 shares of Microsoft (MSFT) for $28, your cost basis is $28--assuming no commissions in this particular case--and your total cost basis is $2,800. So, it's fairly straightforward.

Cost basis gets a little more complicated if you have purchased the security in multiple lots. This is something a lot of investors do. They purchase securities in batches. They don't buy it all in one go. This is particularly common for fund shareholders who are using an automatic investment program where they're purchasing fixed dollar amounts at regular intervals. There are a few different methods of calculating cost basis if you are making multiple purchases. I've just got a short list on this slide. At the top of the list are some of the most common methods: the specific share identification method as well as the averaging method, which is available for fund shareholders. I'm just going to spend a little bit of time on those two strategies.

The specific share identification method is one that I often talk about on Morningstar.com. I think it tends to be the most advantageous method of cost-basis accounting for shareholders because it allows you to pick and choose which lots you sell if you are looking at tax-loss selling. Using a simple example, let's say you purchased 400 shares of a stock at some different price points--some higher, some lower. If the stock price is currently $7, you can see that selling those highest-cost lots will tend to be the most advantageous for you from the standpoint of tax-loss selling.

Selling those $13 and $10 lots will net you a tax loss that you can use to offset capital gains. So, the specific share identification method gives you a high level of control over your tax position. In the past, one of the big knocks against this method was that it was more cumbersome. Investors had to set up Excel spreadsheets documenting all of their purchases. Now, brokerage firms and fund companies are doing that work for you, so really I think the advantage is there for investors who want to exert control over their tax position. The advantage is there for the specific share identification method.

The averaging method is a cost-basis method that a lot of fund shareholders choose. It may be the default method for many fund companies unless you tell them you want to do something other than average your purchase prices. In this case, your prices simply get averaged together, and so you may be able to find some opportunity to engage in tax-loss selling. But it may be less easy to do so than would be the case with the specific share identification method.

So, assuming that we made purchases at the same intervals as on the preceding slide, you can see that the average cost basis is $9.60. So, we would be able to do some selling; we'd be able to sell that whole position if we wanted, and net a tax loss. But it might not be as great as if we were engaging in specific share identification and merely pruning those high-cost-basis shares from the portfolio.

So, that's just a quick look at some of the common methods of cost-basis elections. A couple of must-knows about cost basis: As I mentioned, fund companies and brokerage firms are doing this work for investors now, so that's a good thing. It takes the onus off of investors to keep track of all of their purchases. But it is important to keep track of what the default methods of cost-basis accounting in play at your financial-services firms are. You can override it and switch to one that you prefer. It's also important to check with a tax advisor to make sure that the method of calculating cost basis is the right method for you based on your own tax picture.

It's also important to note that you don't have to use the same method of cost-basis calculation throughout all of your accounts. You can apply different methods of cost-basis calculation for various account types that you might have.

One thing you might be thinking about as I'm talking about tax-loss selling is that some of the securities in your portfolio that look ripest for tax-loss selling might also look like the most undervalued currently. Unfortunately, you can't sell a security and turn around and rebuy it right away without disallowing your tax loss. If you wanted to rebuy the same security, you would need to wait more than 30 days to rebuy it if you want that tax loss to be allowable.

One thing you can do if you want to obtain and retain exposure to a given market sector is to buy a security that provides similar exposure to that market sector. Stock investors certainly have a lot of latitude to stay in a given sector while swapping securities around. To use a simple example, say you are a Wal-Mart (WMT) holder; you've had losses in the stock, but you wanted to retain exposure to that discount-retailing space. You could buy Costco (COST) instead. Of course, you'd want to be as convinced in the attractiveness of Costco, its valuation, and everything else before making that trade; but you could essentially maintain exposure to that same general market space.

Fund shareholders also have some latitude: Say you have a depressed emerging-markets exchange-traded fund in your portfolio and you wanted to obtain and retain exposure to that same sector, you could sell that emerging-markets ETF and buy an actively managed emerging-markets fund instead. So, investors do have quite a lot of leeway to retain exposure to a given segment of the market even as they are booking tax losses.

You want to be careful, as I said, of those securities that are substantially identical in the IRS' eyes. An example of a security where the tax loss would be disallowed would be if you sold Berkshire Hathaway Class A (BRK.A) shares and you immediately bought the Class B shares. Those securities are substantially identical even though their purchase prices would be different, so the tax loss would be disallowed. By the same token, selling an S&P 500 index fund and immediately supplanting it with another S&P 500 index fund or exchange-traded fund would not be allowable under the wash-sale rules.

So, you need to be careful here. If you have any questions, it's a great idea to check with a tax advisor to make sure that you're thinking through the right variables. It's also important to note that you cannot sell one security from your taxable account and immediately rebuy it in your IRA. That would be subject to the wash-sale rule as well. So you need to be careful--get some tax advice if you are doing anything that seems like it could run afoul of these rules.

Here's another task to keep in mind--and it's not time-sensitive. It doesn't have to be done by Dec. 31. But it does fall under the heading of selling and cost basis. It's the idea of potentially tax-gain harvesting if you're an investor who's in the lowest income tax bracket.

If you're in the 10% or 15% income tax bracket, that means that you pay zero percent on long-term capital gains. That gives you an opportunity, if you have highly appreciated securities in your taxable portfolio, to sell them and rebuy them right away. The advantage of doing that is that you're resetting your cost basis, so your cost basis is now higher. And if at a later date if the tax rules change or if, for whatever reason, you're in a higher tax bracket--if you are on the hook for capital gains taxes--you'll be paying those taxes off of a higher cost basis. This is a strategy worth considering only for investors who are in the 10% or 15% income tax brackets who are not currently paying taxes on long-term capital gains.

Let's take a quick look at how this would work: Let's say you were lucky enough or smart enough to have purchased Apple (AAPL) shares back in 2006, and you paid just $8 a share. Well, those shares are worth a lot more now--right around $120 as of late November 2015. The idea is that if you are in the 10% or 15% tax bracket, you could sell those securities at the higher price and rebuy them right away. The beauty is that you have a new higher cost basis. So, when you do eventually sell those securities, your tax bill will be that much lower, provided you are subject to capital gains taxes at that point. So, it can be an effective strategy, but it's not something to engage in unless you're absolutely certain that you will be in the 10% or 15% income tax brackets. There are a lot of tools online to help you estimate your tax bracket. This is an area in which you would want to make sure that you're getting some concrete tax advice and thinking through all the variables before you undertake this tactic. But it is something to consider as a means of potentially lowering your tax bill for future dates.

The next thing to focus on if you have taxable accounts is taking a look at whether any mutual funds that you hold are expecting to make big capital gains distributions between now and year-end. Mutual fund companies have begun publishing estimates of their impending capital gains. We've also been writing about impending capital gains distributions on Morningstar.com. We're going to be seeing most of these distributions coming from U.S. stock funds. The reason is that we've had a multiyear rally in U.S. stocks. Even though 2015 hasn't been a super year for U.S. stock investors, a lot of funds have substantial capital gains built up.

We'll be seeing fewer capital gains, by and large, from bond funds, certainly, as well as from international-equity funds. U.S. equity funds tend to be paying out the lion's share of distributions this year, so check out your fund companies' websites just to see if there are any capital gains distributions on the way.

It's important to note that these distributions will only be significant for taxable investors. So, if you hold a mutual fund in an IRA or in a company retirement plan, you will see your net asset value drop at the time of the distribution; but from a tax standpoint, these distributions will be a nonevent for you. They will be much more impactful if you hold a fund in a taxable account and it makes a big capital gains distribution.

The trouble with capital gains distributions is that they're not necessarily correlated with your own gain or loss in a fund. You personally may have a loss over your holding period on a fund, but you can still get socked with a big distribution. You may have just recently purchased a fund and may not have been around to enjoy any of the gains, but you can still get socked with a distribution, which you, in turn, must pay taxes on.

This is one reason so many investors hate these capital gains distributions. They effectively force them to prepay taxes on securities. Even on securities where they're reinvesting those capital gains, they still owe taxes on those distributions. One thing to remember--one small silver lining associated with capital gains distribution season--is that you do get to adjust your cost basis, or your fund company will do it for you. So, you are able to nudge your cost basis up based on the capital gains distribution. The net effect of that is that, yes, you'll pay taxes on that distribution in the year in which you receive it, but you won't pay taxes on that distribution in subsequent years.

Investors often say, "I'm about to receive this big capital gains distribution from my mutual fund--what should I do?" Well, on this slide, I have some dos and don'ts that investors should bear in mind if a fund that they've held for many years is about to make a big distribution. Certainly, if that's the case, it's valuable to scout around for any tax-loss sale candidates. We talked about that on earlier slides. See if you can find any offsetting losses to help take care of those gains that you're about to receive.

One thing you want to be careful about, though, is preemptively selling that fund before it makes a distribution. Unless it's something you wanted to sell otherwise because you wanted to reduce its importance in your portfolio or because you didn't like its fundamentals--or for whatever reason--generally speaking, you've got to be careful about preemptively selling because you may have a capital gain in that fund yourself. So, even though the fund is about to make a big distribution and you might dodge that distribution, your own selling can trigger a capital gain of its own. You've got to be careful on that front. This is also a valuable reminder, if you're about to receive a big distribution, to give some consideration to how you can make that taxable portfolio more tax-efficient going forward.

When we think about tax-efficient taxable portfolios, we're often thinking about broad-market index funds, exchange-traded funds, certainly individual stocks can be a good fit, and tax-managed funds. If you're a bond investor inside of a taxable account, certainly municipal bonds can make sense, especially if you're a higher-income investor. Think about, on a going-forward basis, what steps you can take to make that portfolio more tax-efficient. The thing you want to be careful about, though, is that that tax-efficient makeover can trigger tax costs of its own. So, as you look forward and think about repositioning that taxable portfolio with an eye toward making it more tax-efficient, make sure that you're not inadvertently triggering big capital gains as you do that repositioning.

The next step on your year-end tax-planning to-do list is to make sure that you're funding your company retirement plan accounts before year-end. You have until Dec. 31 to make those contributions--whether it's to 401(k), to a 403(b), or a 457 plan. You have a little more leeway if you're contributing to an IRA or to a health-savings account; you have until your tax-filing deadline, which is April 18, to make those contributions. But Dec. 31 is your deadline for those other account types.

The contribution limit for 2015 is $18,000 for investors who are under age 50. It's $24,000 for investors who are over age 50. They are able to make those additional catch-up contributions. The contribution limits are going to be staying the same for 2016. So, check with your company and check your latest pay stub to see if, in fact, you're on track to make the largest possible contribution that you can for the 2015 tax year.

If you're making traditional contributions, meaning that those contributions go in on a pretax basis, that's going to be one of the best ways to lower your tax bill for the 2015 tax year.

I wanted to just say a word about aftertax 401(k) contributions. Due to some new IRS rules, those aftertax contributions will be more attractive for higher-income investors than perhaps they were in the past. The reason is that once that employee who has been making those aftertax contributions either separates from service--in other words, leaves the employer or retires or is able to take an in-service withdrawal--those amounts can be rolled over into a Roth IRA. So, for people who have been maxing out their IRAs and their 401(k)s, this is another avenue to explore because the total contribution is very, very high. You can contribute up to $53,000 in total--whether to a traditional or Roth 401(k) or whether to an aftertax 401(k). This is certainly something to explore if you are someone who is a higher-income investor and you've been maxing out those other account types.

Next, I want to spend a little bit of time talking about required minimum distributions, which affect investors who are over age 70 1/2 who have traditional IRAs and traditional 401(k)s. They have to begin taking those RMDs once they turn age 70 1/2. They actually have until April 1 of the year following the year in which they turned age 70 1/2. But they need to begin taking those RMDs, and they need to take them by Dec. 31 of every year after that initial RMD.

It's important not to mess around with RMDs, as many IRA account holders know. If you miss an RMD, you are subject to a penalty equal to 50% of the amount that you should have taken but didn't. So, you want to make sure that you take those RMDs and that you take them on time--by Dec. 31 of each tax year. Roth IRAs are not subject to RMDs. Roth 401(k)s actually are subject to RMDs, but Roth IRAs are not subject to RMDs. Taxable accounts aren't subject to RMDs either. They're only an issue for people who have traditional IRAs and traditional 401(k).

On this slide, I have just a few more facts about RMDs. It's important to note that the balance that determines how much to take out of your IRAs is your balance the year prior. So, for 2015 RMDs, you'd look back to your IRA or 401(k) balance as of the end of 2014; you can then take that amount and use an RMD calculator--a lot of financial-services providers have them--or you can use the IRS' tables to calculate your RMD. You simply divide your RMD balance by a factor that goes along with your life expectancy.

Whatever way you use to calculate your RMDs, you find that amount and determine how much to take out of each account type. So, if you have a 401(k) as well as an IRA, you need to calculate those RMDs separately. One thing I often say, though, is that investors can tie in their RMDs with the upgrades or the changes that they hope to make to their portfolios. They can use those RMDs to actually upgrade their portfolios to get them more in sync with their asset allocations.

This slide is just a simple illustration of how someone could use a portfolio's RMDs to help restore its asset allocations back to its targets. In this simple example, let's assume an investor had a $1 million IRA portfolio back in 2012; it consisted of 40% in a U.S. equity index fund, 20% in an international-equity index fund, and then another 40% in a bond index fund. At the end of 2014, the contents of her portfolio would have shifted around a little bit. The portfolio has appreciated a little bit and certain portions of the portfolio have appreciated more than others.

So, in this particular example, the U.S. equity index fund has been the star--it's now about 50% of the portfolio. The international piece has performed all right but certainly not on the level of the U.S. equity piece. And the bond piece has been the laggard. If this investor needs to take RMDs and wants to restore that portfolio back to those target allocations. The U.S. equity piece would be a logical place to strip those RMDs from. If the investor didn't need the money that she took from the account for spending needs, she could actually take that money and reinvest it. The most common avenue for most RMD-subject investors would be back into a taxable account; but for some investors who are subject to RMDs and who still have an earned income--either their own income or maybe their spouse has enough of an earned income to cover the contribution amount--they can actually get that money into a Roth IRA.

So, that investor, assuming that she wanted to further bulk up her bond position to help restore it to her target allocations, could take the money from the RMDs and reinvest it either in a taxable account or into a Roth IRA.

How about RMDs you don't need? I frequently get this question from investors who are in the lucky position of not needing the money that they're pulling from their RMDs. As I said, you can't unfortunately put the money back into a traditional IRA. But you can get it back into a taxable account or you can potentially, if you have enough earned income to cover the amount of the contribution, get it into a Roth IRA. Those are a few avenues to consider.

I often hear from investors who are concerned that their RMDs are going to take them over their planned spending rate from their portfolios. If you reinvest the RMDs, that won't be an issue. You can stay within your spending parameters, while also meeting the RMD requirements.

Another tactic that RMD-subject investors should keep in mind is what's called a qualified charitable distribution, or QCD. The basic idea with a QCD is that you direct your financial-services provider to steer your RMD or a portion of it directly to the charity of your choice. The beauty of the QCD is that that money never hits your adjusted gross income and, therefore, you might be eligible for credits and deductions that you otherwise might not be eligible for.

For that reason, the QCD is often considered preferable to pulling the money from your IRA, sending it to a charity, and then deducting that charitable contribution on your tax return. The problem with a QCD is that Congress has been in the habit of waiting until the very last days of a given calendar year to renew it.

So, one idea for investors who are thinking about the QCD who would like to take advantage of it is to go ahead and instruct your financial-services provider to make the distribution to the charity of your choice; then, if it turns out that the QCD is renewed, you will be able to take advantage of it. If the QCD is not renewed for whatever reason, you won't be able to take advantage of it, but you'll still be able to deduct that contribution on your tax return. So, it's a win-win. There's really no way to lose by using this method if you're charitably inclined and you're also subject to RMDs.

Charitable giving isn't just relevant for RMD-subject investors; investors of all ages can make charitable contributions, which, in turn, can be deducted on their tax returns up to a percentage of their adjusted gross incomes. The specific percentage will depend on the type of charity.

You can donate property as well. But if you are doing so, just remember that that property must at least be in good, used condition and that you must also have proper documentation on that charitable contribution of physical property. You have to fill out a form. Check with a tax advisor to make sure that you've got the right form and that you're properly documenting that contribution. And no matter what, make sure that you're coming away from any charitable contributions with receipts to document the contributions that you've made.

The final task on your to-do-list is to take a look at your flexible spending account, if you have one for health expenses. Take a look at that FSA balance and make sure, if you possibly can, that you are spending as much of that balance by Dec. 31 as you can. You can use that FSA account to pay for copays and deductibles; you can use them to pay for vision and dental expenses that aren't covered by your insurance program; you can use them for prescription drugs.

It's also important to remember what your FSA doesn't cover. You cannot use the FSA assets for insurance premiums; you can't use them for over-the-counter drugs or vitamins; nor can you use them for cosmetic items--teeth whitening, for example, wouldn't be an allowable expense under an FSA.

Most plans now do have a provision that allows participants to carry forward a portion of their balance into the next year, or they might give them a little bit of a grace period in the following year to spend that FSA balance. But still, if you have a substantial balance built up, it's a good idea to start hatching a plan about how you will spend those FSA assets--if not before year-end, then early in 2016.

If you've completed all the preceding tasks, it's still a great time to do a little bit of additional planning to get yourself in good shape for the April 18 tax-filing deadline. One thing that makes sense for a lot of investors is to make sure that you're organizing your 2015 tax paperwork in a single place. If you have documentation about deductions that you'll be taking on your 2015 tax return, if you've got healthcare expenses that you plan to deduct or charitable contributions that you plan to deduct, start gathering that paperwork into a single place.

It's also a great time to think about doing a rough calculation of what your tax burden will be for the 2015 tax year. It's always better to know in advance if you need to raise some funds to help meet your tax obligations. It's better to know that sooner rather than later.

It's also a great time to make sure that you're familiar with any credits or deductions that you might be eligible for. These tend to change around a little bit from year to year, based on your own personal tax picture as well as the IRS' regulations. Among the most commonly overlooked deductible expenses are expenses related to job hunting or relocation for a first-time job, Medicare premiums for the self-employed, money spent on financial and tax advice, as well as any investment-related subscriptions such as your Premium Membership to Morningstar.com.

That concludes my presentation today. I hope you found some ideas in the course of this presentation to help you lower your 2015 tax bill. Best wishes for a happy year ahead!