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Tax Techniques

October 06, 2016

There are many simple tax planning techniques that can be highly beneficial. Some relate to allocating certain types of assets between taxable and non-taxable accounts, while others relate to not unnecessarily paying tax. Here are a few of these techniques:

1. 3.8% Medicare Tax — Certain types of passive income can be taxed at federal rates as high as 43.4% (39.6% top marginal income tax rate plus 3.8% medicare tax). These include interest, dividends on real estate investment trusts (“REIT’s), oil and gas royalties, and many types of real estate rental income. In order to minimize the impact of the medicare tax, high income individuals should consider holding the investments generating these types of income in tax-sheltered vehicles such as 401(k) plans and IRA’s.

2. Foreign Company Shares — If you want to invest in a foreign company that pays dividends subject to tax withholding in the foreign company’s home country, you should consider holding the shares in a taxable account rather than in a 401(k) plan or IRA. By holding them in a taxable account, you can claim a foreign tax credit for the withholding tax, reducing the amount of your federal income tax. If you hold them in a 401(k) plan or IRA, you will, in general, pay the foreign tax but never get the benefit of the foreign tax credit. There can, however, be exceptions. For example, Germany does not withhold on dividends paid to a 401(k) plan or IRA.

3. Capital Loss Utilization — If you realize capital gains and own securities that have depreciated in value, you should consider selling those securities in order to offset the gains with capital losses. It almost never makes sense to pay tax on capital gains. This is especially true of short-term gains, which can be taxed at federal rates as high as 43.4%, but it is also true of long-term gains, which can be taxed at federal rates as high as 23.8% (20% top capital gain rate plus 3.8% medicare tax). State income taxes at regular rates also generally apply, whether the gains are short-term or long-term. If you are hesitant to take a loss because you like the depreciated security as a longer term investment, you can buy it back after the 30-day wash sale rule period expires. Three points should be kept in mind. First, especially in up markets, mutual funds can declare significant capital gain distributions late in the year. You should monitor this possibility closely and be prepared to take capital losses late in December to offset any gains that a mutual fund distributes. Second, embedded losses in securities do not survive your death since the securities get a new basis equal to their value at the time you die. This is good news for appreciated securities since the new basis wipes out the embedded capital gain, but it is bad news for depreciated securities since the new basis wipes out the embedded loss. Three, irrespective of whether you have capital gains, you can use capital losses to offset up to $3,000 of ordinary income each year, so it generally makes sense to realize enough capital losses to take advantage of this provision.

4. IRA Charitable Contributions — As long as you are at least age 70 ½, you can use your IRA to make charitable contributions up to $100,000 each year. The money that you transfer from your IRA to charity is not taxed to you and it counts against your required minimum distribution. Using your IRA to make charitable contributions is often more tax-efficient than taking a distribution from the IRA and making charitable contributions in cash. First, IRA distributions are fully taxable and can have a negative ripple effect by, for example, moving you into higher tax brackets and reducing the value of various deductions. Second, for higher income individuals the deduction for cash charitable contributions is devalued because it is subject to the cutback generally applicable to itemized deductions. Both of these effects are avoided to the extent you use your IRA to make charitable contributions. Before 2015 Congress authorized the IRA rule for one-year periods only and did so near the end of the year, making it difficult to plan ahead. Now, however, Congress has made the rule permanent, so advance planning is much easier.

There are many more income tax-planning opportunities. We would be happy to work with you and your financial advisor or accountant to develop tax-saving strategies.

Please note that this newsletter is intended for general informational purposes only and does not constitute legal advice. You should consult with us or another advisor to determine whether any of the techniques described in this newsletter are appropriate given your particular situation.