With tax reform proposals from the White House and the new Congress likely to spark debate, any potential tax code changes will face close scrutiny. Today, tax-efficient planning strategies take on heightened importance.
When planning in 2015, consider these five strategies that may help investors mitigate their tax bills.
1. Invest in municipal bonds to generate tax-free income. Municipal bonds become more attractive on a relative tax basis for taxpayers who may be subject to the 3.8% surtax on investment income and who may also be subject to the highest marginal rate (39.6%). For those taxpayers, 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.
2. Utilize strategies to reduce or avoid taxable income. There are several ways to reduce adjustable gross income (AGI), including contributing to a retirement plan or IRA, funding a flexible spending account (FSA), or deferring compensation income. Limiting AGI can prevent a taxpayer from reaching key income thresholds that may result in a higher tax bill. Maximizing the use of tax deductions such as charitable contributions or mortgage interest can also offset income. Investors also need to be mindful of certain transactions, like the sale of any highly appreciated asset, which may increase overall income above the thresholds for the 3.8% surtax, the income phaseout of itemized deductions, or the new highest marginal tax rates.
3. Consider Roth IRA/401(k) contributions or conversions. A thoughtful strategy using Roth IRA accounts may help investors hedge against the direction of future tax rates in light of the longer-term federal budget deficit challenge. Younger investors or taxpayers 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% surtax, and is also not included in the calculation for the income threshold to determine if the surtax applies.
4. Allocate assets by tax status. In general, consider placing a larger percentage of stock holdings outside of retirement accounts and a larger percentage of fixed-income holdings inside retirement accounts. With respect to stock investments, allocating a greater proportion of buy-and-hold or dividend-paying investments to taxable accounts may increase an investor’s ability to benefit from a lower tax rate on qualified dividends and long-term capital gains.
5. Be mindful of irrevocable trusts and taxes. Because of the low income threshold ($12,300 for 2015), which will subject income retained within an irrevocable trust to the highest marginal tax rates and the 3.8% Medicare surtax, trustees may want to reconsider investment choices inside of the trust (municipal bonds, life insurance, etc.) Or they could consider — if possible — distributing more income out of the trust to beneficiaries who may be in lower tax brackets.
As with any complex tax strategy, investors should consult a qualified tax or legal professional and their financial advisor to discuss these strategies as they prepare for the risk of higher taxes in the future.