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As we race through Fall and life accelerates into the holiday season, it is good to remember that there are a few opportunities and deadlines approaching at year end. Below is a partial list of some of these items which may be applicable to your individual situation.
- Required Minimum Distributions: For IRA account holders over the age of 70½, the IRS mandates annual distributions from your IRA. These distributions are typically taxable as ordinary income and must be completed by December 31. If the distribution is not taken, the IRS may impose penalties of up to 50% of the required distribution amount.
- Charitable Gifts: By donating shares of appreciated stock (rather than cash) to qualified charities, you can avoid realizing the capital gains associated with those shares. While the gift may or may not result in a reduction of current year taxes (depending on if you end up itemizing your deductions or taking the standard deduction), this method of gifting is one of the few ways you can avoid capital gains taxes on appreciated shares. Please note that the processing teams at brokers/custodians tend to get busy at year end, so the sooner you initiate any planned gifts the less likely you are to run up against the Dec 31 deadline for inclusion on this year’s taxes.
- Qualified Charitable Distributions: With tax reform likely to lead more taxpayers to use the standard deduction, it is good to remember there is another option for charitable donations for taxpayers age 70½ or older who are not itemizing. The IRS now allows for charitable donations, up to $100,000 per year, to be made directly from your IRA . The benefit is that any amount donated counts toward satisfying your Required Minimum Distribution amount but is not included in taxable income for that year.
- Roth IRA Conversions: With last year’s updates to the tax code, there have been some changes to the process of converting traditional IRA funds to Roth format. While you can still convert funds (with the amount converted added to ordinary income for the year), the ability to undo part or all of the conversion has been removed. This means that many investors have been waiting until closer to year end to convert so that they have a better sense of their total taxable income before settling on a conversion amount. We always suggest that you consult with your CPA or tax advisor before conversion. Again, bear in mind that brokers/custodians tend to see a large increase in requests toward year end, so we recommend that you initiate the process prior to Dec 15th if possible, to allow plenty of time for processing.
- Tax Loss Harvesting: Here at Scharf we generally believe that harvesting losses year after year to reduce realized capital gains only serves to defer that gain into the future. One of the primary points of confusion regarding tax loss harvesting is the source of the perceived savings. When losses are harvested and the original security is bought back after the 30-day window, the new position’s cost basis is generally lower due to the depressed price of the security. If the investment is later sold, the investor will pay a larger tax due to this lower basis. Therefore, the tax is not avoided, just deferred to a future year.
Example: Assume a stock was purchased for $50,000 and is now worth only $40,000 after a 20% decline in stock price. The investor harvests the $10,000 capital loss resulting in a $3,500 current tax ‘savings’ at a 35% tax rate. However, after harvesting the loss and reestablishing the position (assuming no price change), the same investment only has a cost basis of $40,000. If the stock ever recovers to the original $50,000 purchase price, once it’s sold there will be a $10,000 gain and a $3,500 tax liability, offsetting the tax ‘savings’ from the original sale.
The true value of harvesting is therefore not in paying less in taxes but in the timing of paying those taxes and the opportunity to invest the cash that was initially saved. With money market rates below historic inflation rates, you would have to invest the proceeds in a riskier asset to produce any substantive value. The exceptions to this strategy can occur if you have a year with abnormally large income or gains (i.e. sold a long-held piece of real estate, received a large one-time bonus) or if you expect your income/tax rate to drop significantly next year (i.e. retirement).
- Updating Beneficiaries: Year end is also a good time to review the beneficiaries for your retirement accounts and update as needed.
We recommend consulting with your CPA or tax advisor regarding your individual tax situation.
Happy Holidays from all of us at Scharf Investments.