As we move closer to year end, we at Griffin Black start to focus on how we can help our clients close out the 2014 fiscal year in better financial shape than they would otherwise have been. Given the fact that marginal tax rates have risen sharply over the past three decades – from a 28% marginal federal tax rate as a result of the Reagan reforms of the 1980s to a 44.6% top marginal rate in 2014 (52.6% for California residents) – many of these suggestions are designed to help lower taxable income for the year. Others could simply put you in a more advantageous position in 2015. In either case, they are worth your consideration during this busy Holiday Season.
Moves for You to Consider
- Maximize your tax-deductible 401(k) contributions. If you’re an employee and haven’t already set up your paycheck to maximize your contributions this year – a standard contribution $17,500 plus a $5,500 ‘catch-up’ contribution if you’re over 50 – you may be able to request a special payroll deduction to make up the difference before the end of the year.
If you’re a small business owner and have a Solo 401(k) or Individual K, make sure that the allowable salary deferral contribution (again $17,500 plus $5,500 if you’re over 50) is made to your account before the end of the year. This will enable you to maximize the overall contributions to your plan for 2014, including whatever ‘profit sharing’ contribution you may be able to make. Assuming that you have the cash available to do so, do not make the mistake of waiting, thinking that you’ll simply make your 2014 contributions in 2015. Generally speaking, you can defer 100% of your salary up to the stated limits, and salary deferral contributions should be made in the applicable calendar year. Profit-sharing contributions, though convenient because you can wait to make them until 2015, are limited to 20% of your net self-employment income. So unless you had a highly profitable year, you probably won’t be able to make the maximum profit sharing 401(k) contribution of $52,000, and you’ll lose the ability to make your catch-up contribution of $5,500.
- If you set up a new business in 2014 and would like to make Individual K contributions for 2014, you must set up your plan before the end of 2014. If you wait until after January 1st, your only option will be to open a SEP IRA, which is inherently less flexible than an Individual K account. Indeed, there is absolutely no reason for anybody to have a SEP IRA any more, except that is is your only option if you wait and the Individual K alternative is no longer available to you. Individual K plans also have other tax-planning advantages vis-à-vis SEP-IRAs over the long term. Funds in your company 401(k) or Individual K accounts are not aggregated with IRA funds when calculating the taxable basis for a Roth conversion, for example. You can also continue contributing to a 401(k) or Individual K as long as you are working, which is more flexible than an IRA. (You can’t make regular contributions to a traditional IRA in the year in which you turn 70½ and thereafter.)
- Simplify your life by maxing out your IRA contributions for the year during the calendar year itself. While there is no tax advantage to doing this, I virtually guarantee you’ll thank yourself come tax time. The fact is that ‘late’ IRA contributions seem to be one of the most difficult things for clients to account for and keep track of – not to mention communicate to their accountants. Every year, we see clients forget that they made contributions to their IRA both in the calendar year itself and in the subsequent year, and at times this has lead to a loss of a tax deduction. Even if you remember to assign your contributions to the correct tax year, keeping track of which calendar-year contributions go to which tax year is an avoidable headache. Your tax-reporting life will be much simpler and easier if you simply contribute the maximum amount each year within the year itself. It may be tempting to make your contribution as late as possible, but don’t be fooled; you ‘pay a price’ for that option in complexity and the lack of transparency.
- While you’re thinking about your IRAs, you have another opportunity to simplify your life by setting your monthly IRA contributions to automatically max out in 2015. Once you’ve done this you won’t have to think about your IRA contribution program – everything will be automatic. If we manage your IRA(s), let us know and we can do this for you.
There is, however, an exception to this rule. Some individuals and families are in an income ‘grey zone’ in which it isn’t clear what the best & most appropriate kind of IRA contribution will be for the year, i.e., taxable regular contribution, tax-deductible regular contribution, or Roth contribution. Such clients will actually be better off if they wait until the end of the calendar year or until early in 2015 before making the contribution decision, because their best option depends on one’s actual earned income and other tax circumstances for 2014. If you don’t know how this issue affects you, let us know and we’ll review it with you.
- Consider a Roth IRA or Roth 401(k) conversion. Converting an IRA to a Roth-IRA, or a 401(k) to a Roth 401(k), can be an effective technique to minimize long-term taxes assessed on investment earnings. Though an upfront tax is due when an IRA or 401(k) is converted, none of the income earned inside a Roth vehicle is subject to income tax. Moreover, regular distributions from a Roth IRA are tax-free and are not subject to Required Minimum Distributions.
Yet as much as we think it is wise for many clients to acquire some truly tax-free (Roth) savings, it is also true that the decision to pay the up-front tax associated with the conversion is an investment decision like any other. In a high-income year the marginal cost associated with a Roth conversion can be more than 50%, as noted above. In order for such an investment to be profitable over the long term one needs to assume that the owner’s marginal tax rate in the future will be, on average, at least as high as the conversion tax rate. For many medium- to high-income individuals this is not likely to be the case. As a result, the best candidates for Roth conversions tend to be individuals whose annual income is unusually (and temporarily) small for some reason. Examples of such situations include: a small business owner who is expecting a large pass-through loss on his business; a family that sold an income property with a large suspended loss carryover during the year; someone who happened to be in job transition during the year and therefore had far less income than would typically be the case. In such cases, one can make a wonderfully effective use of the fact that there’s a tax loss (or at least a lower marginal rate) in order to ‘invest’ in the Roth IRA. If you think you fit into this category, let us know and we’ll help you decide what’s best for you.
- Did you, on the other hand, have unusually high income in the year that you’d like to shelter from taxation? This can easily be the case if one’s company enjoyed a liquidity event or if one simply had a lot of RSUs mature. If you have a fundamental charitable intent, one of the best ways to do this is to gift appreciated securities held for more than one year directly to a charity of your choice. Donors receive two types of tax benefits for gifting appreciated securities: First, the donor receives a federal tax benefit for the donation. For example, a donor in the 45% tax bracket making a $10,000 gift would receive a tax benefit of $4,500 ($10,000 x 45%) for the fair market value of the gift. The donor also eliminates the tax on the built-in appreciation. If they donated shares worth $10,000 that they paid $1,000 for and they were in the 33% long-term capital gains tax bracket, they would eliminate the capital gain tax on $9,000 of appreciation, saving $3,000 ($9,000 x 33%). If you have long-term investments (i.e., if you have held them for more than one year) with built-in gains (your purchase price is lower than the current market price) in your portfolio, you should consider donating these securities to fund your charitable contributions instead of making cash gifts.
If you’re not sure which charity you’d like to invest in, you do have the option of contributing (either cash or appreciated securities) to a Donor Advised Fund. Because this is an irrevocable gift, you will receive the same tax deduction you would if you had gifted the money directly to charity. The difference is that your contribution is held in an account, and invested, pending your eventual gifting recommendations. You can thus maximize your tax advantage while delaying somewhat your charitable decisions. Let us know if you’d like our help in establishing a Charitable Fund in your or your family’s name.
- If you’re sure that your own future financial needs are covered and want to lower the amount of tax you pay on your investment earnings, you can consider making annual or one-time gifts of up to the $14,000 ($28,000 per couple) to family members. If you have the financial means to afford additional gifts, consider transferring money in excess of the annual exclusion amount. While gifts above the annual exclusion amount are subject to gift tax, each individual is able to gift up to $5.34 million in excess of the annual exclusion (in 2014). This exclusion applies at the donor level and any gifts excluded due to the lifetime gift tax exclusion are counted against a donor’s estate tax transfer exclusion at their death. Gifts not only reduce your estate’s value, but can also reduce your family’s income tax liability by shifting assets and the related income generated on those assets to family members who may be in a lower tax bracket.
- Remember, however, that a portion of the investment income over a specified amount for children under the age of 25 may be taxed at their parents’ marginal tax rate, so consider sheltering gifts that will be used to pay for college expenses in a college savings plan (a.k.a. Section 529 Plan). Income earned inside a college savings plan is exempt from income tax if used to pay qualified educational expenses, and remains outside your estate. As us how we can help you set up 529 Plan for your child or grandchild.
- If your income is large and/or your situation complex, it’s always a good idea to visit your professional tax advisor and ask him/her to give you a pro-forma estimate of your 2014 tax return, along with any suggestions they may have on how to minimize your tax bite. Sometimes this is as simple as making your Q4 estimated state tax payment in December rather than in January. If you’re in AMT, it won’t make sense to ‘pull in’ deductions in the the current tax year, however. Even it there aren’t any obvious actions for you to take, the exercise will make your 2014 tax preparation easier and less daunting. Peace of mind is worth something.
- Year end is open enrollment season at work. One of the best things you can do is review your current elections for health insurance coverage in the light of (1) your current situation, and (2) prospective changes in coverage and cost. In particular, if you signed up for medical insurance through one of the new exchanges for 2014, you should be prepared to see a significant hike in your premiums next year. Many insurance providers offered ‘lowball’ rates for 2014 in the hope of capturing market share. Now, however, their costs (i.e., what they actually pay for your benefits) has risen significantly, and many are planning to quietly raise rates on existing plans. So if you want to keep your plan, at least be prepared for this change. Otherwise, you should consider changing plans for 2015.
- While you’re reviewing your health insurance coverage in general, consider whether a high-deductible plan coupled with an HSA may be appropriate for you. HDHP premiums are no longer the deal they once were, but the choice may still be a good one if (1) you typically don’t use a lot of medical services, and (2) you have the cash and inclination to contribute to an HSA account (or if your company is willing to help in this regard). The money you contribute to an HSA is an ‘above the line deduction’ on your tax return, meaning it isn’t taxable at all. The money in your HSA grows tax-free and can be used at any time for qualified medical expenses without tax impact. And yes, we can invest larger HSA accounts for the long-term on your behalf. The beauty of this is that is enables the young, healthy, and cash rich to very tax effectively save for their prospective out-of-pocket medical expenses later on in life. Those expenses, by the way, are estimated to be, on average, around $225,000 for a typical Boomer couple nearing retirement.
- If you’re already in the Medicare system, be sure to review your choices for 2015 as well. Most retirees don’t choose to make major changes in their choice of standard Medicare versus Medicare Advantage plans, but if you’re on standard Medicare you should review your Medicare D plan annually. We’ve seen annual costs go up by as much as $1,000 for the same plan from year to year simply because the vendor assumed that nobody would be paying attention. If you havn’t already done so, enter your drug list into www.medicare.gov and use it to compare Part D plans that are being offered for 2015. If you’ve still got a good deal, great. If not, now’s the time to change.
We welcome the opportunity to discuss these topics with you. As is the case with all planning topics, every person’s situation is different. So if you have questions about how any of these possibilities might pertain to you, give us a call.