At the end of a year of sideways markets, many tax advisors are focusing on the ramifications of the two recently passed tax acts. There is, however, a roster of other year-end strategies that are worth looking into.
Retirement planning is obviously a topic high on most financial advisors' lists. The prospect of higher tax brackets after the 2010 sunset year has some recommending against the regularly disciplined annual contributions.
"I'm very careful of having to make the annual contribution decision," says Mary Katherine Dean, CPA/PFS, CFP, of the San Diego-based firm that bears her name. "With the low tax rates, it doesn't make sense for some people to defer taxes on more income."
The decision to save money outside tax-deferred retirement vehicles makes big sense for one particular client, according to Dean. The couple has seven years to retirement and all but $40,000 is tied up in traditional retirement accounts. The pension payments pay all but the mortgage for the couple. "That means they'd have to take money out of their IRA for the mortgage," said Dean. "They'd have to take out the amount to pay the mortgage, the amount to pay the taxes on that, and then more to pay the taxes on the taxes."
Counseling against the ingrained annual contribution habit takes some briefing on history as well as forward-looking tax planning. The stepped-up basis upon death for many non-retirement assets favors those accounts for estate planning purposes. Dean also brings back a dismal chapter in tax history to support less deferral. "I remind clients that in the early 1980s, the federal top tax rate alone was 70 percent," she said. "The sunset provisions could end up to be a best-case scenario, because rates might go up even more."
The prospect of higher rates sometime in the future forced a look at current retirement distribution plans, combined with low capital gains rates.
"A significant number of retirees have capital gains that can be realized," said Benjamin Tobias, CFP, CPA, of Tobias Financial Advisors, in Ft. Lauderdale, Fla. "They can take lower distributions from plans this year and realize the gains at 15 percent this year."
Investors with concentrated stock positions might find this year to be a window of opportunity. "We're checking all clients with potentially large capital gain liability," said Mark Balasa, CPA, CFP, of Balasa Dinverno & Foltz LLC, in Itasca, Ill. "If the White House changes hands we might see seismic changes for people with low cost-basis stock."
Advisors are also taking action in anticipation of mutual fund distribution season. Some funds might be paying out hefty gains that investors can avoid. Balasa's firm looks especially to small cap value and small cap international funds for gains distributions in 2004. "We're checking the mutual funds for expected payouts this year," said Balasa. "For those that make sense relative to the purchase price of the shares, we sell out and put clients in an exchange-traded fund to wait to buy back."
Tax losses are managed similarly at BD&F. "We grab losses for a client even if they want to own the stock," Balasa said. "We advise them to sell and keep their market exposure in an ETF for the required days to avoid the wash sale, and then buy back into the stock."
The topic of tax losses still focuses on the amount of carryover losses that clients still have from the recent market bust. Advisors that aggressively harvested those losses from 2001 to 2003 have tools to shelter gains for this year.
But not everyone feels that that's a good move.
"If the tax rates go back up, those losses become more valuable in the future," said Tobias. "We think that might happen no matter who gets elected."
Other losses - and deductions
In his firm, Tobias finds some non-investment-related deductions that could help balance off gains as well. The ferocity of this year's hurricane season left a few clients with losses not covered by insurance. "After [Hurricane] Andrew, the system of deductibles completely changed," said Tobias. "Homeowners have to cover out of pocket everything up to at least 2 percent of their home values. Homes on the beach have even higher out-of-pocket costs."
Given markets this year, investors are not looking at significant tax bills because of portfolio rebalancing. The focus on value investing has brought Dean's client more taxable income to plan for. "I've got more in value stocks now, and those pay fairly high dividends," said Dean. "But clients still have some tax losses from a few years ago, and we do use those to reduce the income."
The investing situation is changing, however.
Dean's clients might fund future tax bills from shifting out of the high-performing value stocks into the ever-cheapening S&P 500. The combination of lower prices and higher earnings has driven the price-to-earnings ratio of the index to around 20 from loftier levels of 30 and more. As the P/E approaches historical norms of around 15, Dean will be selling value and buying into the tax-efficient index funds. "Getting out of value will generate tax gains, and that's a problem," says Dean. "But most clients have the popular index fund somewhere in a tax-deferred vehicle and that's the first place I'd look to make these changes."
The end of the year is the deadline for taking advantage of the new solo 401(k)s and contributing to other special accounts, like 529 plans. Tobias points out that for the self-employed client with no employees, the solo 401(k) is a boon. Contribution limits are higher and it's easy to set up and administer through the prototype accounts offered by most major brokers. Balasa reminded all clients that their children's or grandchildren's 529 plans need to be funded before the end of the year.
Looking ahead to next year's tax preparation also helps catch other details that might have gone missing, like Balasa's client who had been gifting shares of the family limited partnership to children, but hadn't documented the moves.
