With Reform Looming, Look at These Year-End Tax To-Do's

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. It's November, and that means that investors have fewer than two months to make any changes that would affect their 2017 tax bills. Joining me to share some tips on that front is Tim Steffen. He is director of advanced planning for Baird Private Wealth Management.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: Let's talk about how tax reform or potential tax reform should affect how investors are approaching their own tax and financial plans as 2017 winds down.

Steffen: If you look at some of the big themes in the tax reform bill, it would be a lowering of marginal rates for most tax brackets. Most people would see on the margin anyway, it was a lower tax rate in 2018 than they are in 2017. Also, elimination or scaling back of many itemized deductions. If you look at our general rule of thumb when it comes to year-end planning, all things being equal--defer income, accelerate deductions--that may make even more sense under this proposal. Lower rates next year, fewer deductions allowed next year. It may make sense to look at accelerating some of those deductions and deferring income for this year end.

Benz: A lot of people as the year winds down start looking at capital gains and capital loss planning. Let's talk about that, how investors should be thinking about their plans as 2017 winds down and maybe with a look forward to what tax reform could potentially mean from the capital gain and loss standpoint?

Steffen: The common thing we talk to a lot of our clients about when it comes to capital gain and loss planning is netting your gains and losses. If you had a lot of gains during the year, maybe you find if you have any losses in your portfolio--and hopefully, you don't but if do--realize some of those to help offset some of the gains and then reduce the tax liability on that. When it comes to capital gains, you've also got these bracketed rates. You've got a 0% rate for people who have low levels of income, then the 15% and then the 20%, with that 3.8 Medicare kind of slipped in there somewhat.

Benz: Exactly.

Steffen: If you are somebody who is eligible for that 0% capital gain rate because your income is low--and for married couples we are talking about taxable income in the $75,000 or so range, singles would be about half of that, so $37,000-ish--if you could realize some gains at a 0% rate, it might make sense to do that. Take advantage of it. Even if you wanted to buy back again right way, you can. There is no such thing as a wash sale when it comes to gains. So, don't worry about that.

Benz: Let's discuss why you'd want to look at that. What would be the advantage of looking at that strategy?

Steffen: If you've got a position that's got a gain in it and you can--normally, we wouldn't tell you to sell something, realize a gain and then buy right back again; it doesn't make much sense--but if you can do it and not pay tax on it because you are in that 0% rate then there's some advantage to doing it and there may be a reason to do that. You have to be careful with that though, because while that gain itself might be tax-free, there is this thing, this ripple effect that happens through your tax returns. So, you recognize something over here, and it might impact something over here. For example, the gain might be tax-free, but because it's part of your income, it drives up your AGI, your adjusted gross income. That might go up, which might limit your ability to take deductions like medical expenses or miscellaneous deductions. It could impact how much of your Social Security is taxable. It could impact a Medicare premium in a couple of years down the road.

There's a lot of reasons that you have to be careful about executing a transaction just because of one tax benefit. Now, there might be a lot of other things that are impacted by it as well.

Benz: That tax gain harvesting might be attractive for a subset of investors, but other investors who have significant gains on their books, especially if they are very high-income folks, if there's tax reform, they may actually want to hold off on realizing any gains.

Steffen: They might. Yeah, absolutely.

Benz: OK. Let's talk a look at charitable contributions. We always tell investors to take stock of any charitable contributions they might make and do that by the end of the year. Let's talk about things that people should have in mind as 2017 winds down.

Steffen: If you're making cash gifts, make sure you get those checks in the mail at least by the end of the year. As long as it's in by the end of the year, in the mail or delivered to the recipient, your deduction is good for this year. In many cases, we recommend folks use appreciated property to make those gifts. For example, if you are going to make a large gift to a church or a school or something like that at year-end, rather than writing a check, transfer them shares of stock or a mutual fund or something. If those shares of stock or a fund are at a gain, you get the deduction for the fair market value of that position; you don't have to report the gain; the charity doesn't have to report the gain. It's kind of a double benefit in that case. You get the full tax deduction plus you avoid the gain. There's lot of advantages using appreciated property.

The other technique that we get asked about a lot is this idea of making gifts out of your IRA to charity. The qualified charitable distributions, yeah, QCD is what they call it. That's one that hid for a while, was going in and out of the tax code. At the end of 2016, they made it permanent. We don't have to worry about whether it's coming or going anymore. If you are thinking about making a charitable, maybe look at whether the QCD makes sense. In a lot of cases, it does, but it's not for everyone. Sometimes appreciated property can still give you a better benefit than the QCD.

Benz: And RMDs, you mentioned that if you're doing this QCD that actually it can satisfy your RMDs, your required minimum distributions.

Steffen: If you are over 70 1/2 in 2017, you are required to take a distribution from your IRA for the year. If you've just turned 70 1/2 this year, you actually have until April of 2018 to take that distribution. You can figure out what's the right year for you to take that 2017 or 2018.

Benz: But then you have to take another one, right?

Steffen: Exactly. Then you'd be doubling up in 2018. You'd have to figure out is it better to have one each year or none in the first year and two in the second year. For those who are well beyond 70 1/2 and have been in RMD mode, then they have to take it before the end of the calendar year. Dec. 31 is their deadline. They have to make sure they take it out, but it can be given to charity directly from the IRA and that can provide some tax benefits under those QCD rules.

Benz: Let's talk about this concept of bunching deductions. People wonder what this means. I know you've written about this topic. How would investors approach that and why would they do that?

Steffen: Some deductions, some deductible expenses, are only provided tax benefit if they exceed a certain threshold. For example, medical expenses are the most commonly thought of one. Kind of unique with medical expenses is there's been this transition to a new rule on medical expenses where they have to be more than 10% of your income.

Benz: And that's for everyone? For a while, seniors were grandfathered into the 7.5% threshold?

Steffen: That's exactly right. So, last year, 2016 was the last year of the 7.5%. This year everybody is at 10%. And that's a high threshold. Not everybody can get over that. But if you can time expenses to get one year with a larger level of expenses and the next year with not as many, maybe you can get over that threshold. As opposed to just missing it every year, maybe you can get over it every other year. This is kind of a unique year with medical expenses, partly because of the tax reform proposal that would eliminate medical expense deductions for 2018, so there's even more incentive to maybe bring those into 2017 this year.

Benz: Right. And of course, sometimes people don't have control over when they have medical procedures. But if you have elective things on your radar, it might be deductible.

Steffen: Elective things, dental appointments, prescriptions, you want to double, fill up before the end of year, those kinds of things. On the margin, you might be able to make a difference.

Benz: Let's talk about Roth IRA conversions and recharacterizations. Let's talk about why people might want to have that on their radar as 2017 winds down?

Steffen: During the course of the year, you may have had an individual who has converted from a traditional IRA to a Roth IRA, paying the tax now in order to get tax-free treatment in the future. What many people will do is they will do a conversion and then wait to see how the rest of the year pans out, determine do they really want to keep the money there, or do they want to pay the tax on it. Perhaps the value in the account has fallen, and they can change their mind and not pay tax at the higher value, but take it back out, try it again later at a lower value, called a recharacterization. And those are pretty common planning strategies that we talk about. If you did a conversion in 2017, you have until October of 2018, Oct. 15, to change your mind on that.

One of the issues with the tax reform proposal is it would eliminate recharacterizations beginning at 2018. For those who did a conversion in 2017 and are kind of at the back of their minds thinking they might want to recharacterize it, you might want to look at doing it before the end of the year. The big reason people do this is when account values fall in value after the conversion. Fortunately, that hasn't been much of an issue. We had some nice runs in the market the last few years. That hasn't been really the driver of recharacterizations. But in individual circumstances, it still might be.

Benz: Tim, you say it's very individual-specific. You've given some good basic advice here, but everyone should approach their own situation, maybe get some tax advice or financial planning advice. You also advise people to work on a two-year basis when approaching their tax plans. I want to talk to you about what you mean by that and how investors would do that.

Steffen: On the first part of that, we give all this great advice that is good in general and applies to most people, but everybody's situation is different. You may be somebody who is retiring where your income is falling, in which case, maybe there's things you should be doing differently than what you would have done before. Maybe your marital status has changed. You've gone from single to married or married to single, in which case, the planning might be a little bit different. So, everybody's situation is different there.

In terms of the two-year thing, remember that tax planning isn't done in a vacuum. Whatever you do now essentially has an equal and opposite impact on the next year. For example, a charitable gift you were going to give in 2018 that you give in 2017, you move that deduction. You don't have that deduction in the next year. Yes, it may make sense to move a deduction up to this year because you get a tax benefit for it, but it might have been a better tax benefit in the following year. It's important to really look at anything you do, what is the impact over a two-year period. It might be better to move income out of one year and into the next and move deductions, etc. It's a lot harder this year because of the …

Benz: We don't know what 2018 will look like.

Steffen: Exactly. The software makers haven't gotten to that point. Maybe if you're a whiz with Excel, you can put together a modeling for 2018. But we don't know exactly how it's all going to pan out. We know it's a proposal. This two-year planning for year-end planning is a little harder this year than it's been in the past, but you can't ignore it either. You got to keep it in mind.

Benz: OK, Tim. Great advice. Thanks so much for being here.

Steffen: Thanks, Christine.

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