Tax figures for 2016 were mostly unchanged from 2015, but that does not mean an individual’s financial situation will not change. It is not too early to start planning for this year’s taxes.
Here are five tax-smart strategies that investors may consider for 2016:
1. Invest in municipal bonds to generate tax-free income.
For taxpayers who may be subject to the 3.8% investment income surtax and the highest (39.6%) marginal tax rate, municipal bonds may become more attractive on a relative basis. The tax-equivalent yield — the yield an investor would require in a taxable bond investment to equal the yield of a comparable tax-free municipal bond – has increased for those taxpayers.
2. Utilize strategies to reduce or avoid taxable income.
There are several strategies taxpayers may use to try to reduce adjusted gross income (AGI) and possibly avoid reaching key income thresholds that may result in a higher tax bill. To reduce income, consider contributing to a retirement plan or IRA, funding a flexible spending account, or deferring compensation. Maximizing the use of tax deductions can offset income as well. Taxpayers shoud be mindful about transactions that generate taxable income, such as the sale of a highly appreciated asset.
3. Consider Roth IRA/401(k) contributions or conversions.
Roth accounts can be an effective way to hedge against the direction of future tax rates. Younger investors in lower tax brackets may consider using Roth accounts to create a source of tax-free income in retirement. Like all income from retirement accounts, Roth income is not subject to the 3.8% investment income surtax and is also not included in the calculation for the $200,000 income threshold ($250,000 for couples) to determine if the surtax applies.
4. Don’t forget about tax liabilities from irrevocable trusts.
The tax threshold for income retained within an irrevocable trust, which would trigger the highest marginal tax rates and the 3.8% Medicare surtax, is $12,400 for 2016. Because the threshold is low, trustees may want to reconsider investment choices inside of the trust, such as municipal bonds or life insurance, that would not be subject to the tax. Another strategy would distribute more income out of the trust to beneficiaries who may be in lower tax brackets.
5. Allocate assets by tax status.
Where investors “locate” assets can make a difference in tax liability. Consider placing a larger percentage of stock holdings outside of retirement accounts and a larger percentage of fixed-income holdings inside retirement accounts. In general, allocating a greater proportion of buy-and-hold or dividend-paying stocks to taxable (non-retirement) accounts may increase a taxpayer’s ability to benefit from a lower tax rate on qualified dividends and long-term capital gains.
Before choosing investment strategies that may impact an individual’s overall financial plan, it would be important to meet with a qualified tax or legal professional and a financial advisor. It is critical to work with a professional who has knowledge of an individual’s goals and financial situation. For more details and ideas, read “Ten income and estate planning strategies for 2016.”