When investing for retirement or other long-term goals, people usually prefer tax-advantaged accounts, such as IRAs, 401(k)s or 403(b)s. Certain assets are well suited to these accounts, but it may make more sense to hold other investments in traditional taxable accounts.

Know the rules

Some investments, such as fast-growing stocks, can generate substantial capital gains, which may occur when you sell a security for more than you paid for it.

If you’ve owned that position for over a year, you face long-term gains, taxed at a maximum rate of 20%. In contrast, short-term gains, assessed on holding periods of a year or less, are taxed at your ordinary-income tax rate — maxing out at 37%. (Note: These rates don’t account for the possibility of the 3.8% net investment income tax.)

Choose tax efficiency

Generally, the more tax efficient an investment, the more benefit you’ll get from owning it in a taxable account. Conversely, investments that lack tax efficiency normally are best suited to tax-advantaged vehicles.

Consider municipal bonds (“munis”), either held individually or through mutual funds. Munis are attractive to tax-sensitive investors because their income is exempt from federal income taxes and sometimes state and local income taxes. Because you don’t get a double benefit when you own an already tax-advantaged security in a tax-advantaged account, holding munis in your 401(k) or IRA would result in a lost opportunity.

Similarly, tax-efficient investments such as passively managed index mutual funds or exchange-traded funds, or long-term stock holdings, are generally appropriate for taxable accounts. These securities are more likely to generate long-term capital gains, which have more favorable tax treatment. Securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options.

Take advantage of income

What investments work best for tax-advantaged accounts? Taxable investments that tend to produce much of their return in income. This category includes corporate bonds, especially high-yield bonds, as well as real estate investment trusts (REITs), which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and therefore taxed at your ordinary-income rate.

Another tax-advantaged-appropriate investment may be an actively managed mutual fund. Funds with significant turnover — meaning their portfolio managers are actively buying and selling securities — have increased potential to generate short-term gains that ultimately get passed through to you. Because short-term gains are taxed at a higher rate than long-term gains, these funds would be less desirable in a taxable account.

Get specific advice

The above concepts are only general suggestions. Please contact our firm for specific advice on what may be best for you.

 

Sidebar: Doing due diligence on dividends

If you own a lot of income-generating investments, you’ll need to pay attention to the tax rules for dividends, which belong to one of two categories:

  1. Qualified.These dividends are paid by U.S. corporations or qualified foreign corporations. Qualified dividends are, like long-term gains, subject to a maximum tax rate of 20%, though many people are eligible for a 15% rate. (Note: These rates don’t account for the possibility of the 3.8% net investment income tax.)
  2. Nonqualified.These dividends — which include most distributions from real estate investment trusts and master limited partnerships — receive a less favorable tax treatment. Like short-term gains, nonqualified dividends are taxed at your ordinary-income tax rate.

© 2018 Covenant CPA

Which criteria tell the real story

If you gave your retirement plan a report card, what would it look like? Does it do the job of preparing your participants for retirement? And how do you benchmark your plan’s performance? Let’s take a closer look.

Defining criteria

First, a quick reality check: What criteria do you already use to benchmark your plan’s performance? Traditional measures such as fund investment performance relative to a peer group, the breadth of fund options, benchmarked fees, and participation rates and average deferral rates (including matching contributions) are critical. But they’re only the beginning of the story.

Add to that list helpful administrative features and functionality, including auto-enrollment and auto-escalation provisions, investment education, retirement planning, and forecasting tools. In general, the more, the better.

A sometimes overlooked plan metric is average account balance size. This matters for two reasons. First, it provides a first-pass look at whether participants are accumulating meaningful sums in their accounts. Naturally, you’ll need to weigh that number in light of the age of your workforce, and how long your plan has been in existence. Second, it affects recordkeeping fees — higher average account values generally translate into lower per-participant fees.

Knowing your plan asset growth rate is also helpful. Unless you have an older workforce and participants are retiring and rolling their fund balances into IRAs, look for a healthy overall asset growth rate, which incorporates both contribution rates and investment returns.

What’s a healthy rate? That’s a subjective assessment and you’ll need to examine it within the context of current financial markets. A plan whose assets shrank during the financial crisis a decade ago could hardly be blamed for that pattern. Overall, however, you might hope to see annual asset growth of at least 15%.

Keeping participants on track

Ultimately, however, the success of a retirement plan isn’t measured by these discrete elements, but by aggregating multiple data points and others to derive an “on track to retire” score. That is, how many of your plan participants have account values whose size and growth rate are sufficient to result in a realistic preretirement income replacement ratio, such as 85% or more?

It might not be possible to determine that number with precision. Such calculations at the participant level, sometimes performed by recordkeepers, involve sophisticated guesswork with respect to participants’ retirement ages and savings outside the retirement plan, as well as their income growth rates and the long-term rates of return on their investment accounts.

Communicating with participants

So, after you analyze how your participants are doing, what can you do with the data? The most important thing is communicating each employee’s “on track” status directly and urgently to him or her.

A study by Empower Retirement, a retirement plan recordkeeping company, found, perhaps not surprisingly, that many retirement savers begin to increase their deferral rates when told their on-track statuses, expressed as an income replacement percentage. This preparedness metric proved to be significantly more motivational than merely being reminded of their account balances and growth rate.

Once you’ve given your participants their individual “on-track” statuses, you can also point them to tools that can generate projections of the impact on their on-track statuses of adjustments to their deferral rates. A sophisticated modeling tool would also project different forecasts based on varying asset allocation mixes.

Now what?

It’s unrealistic to expect a comprehensive on-track analysis to reveal that all your plan participants pass the test with flying colors. What’s important is finding and adjusting the right levers to increase your plan’s performance each year. Also, while doing so, it’s still critical to keep your eye on the ball with respect to the full range of fiduciary duties attendant to sponsoring a retirement plan.

 

Sidebar:Retirement preparedness: A national perspective

A large survey published early this year by Fidelity Investments offers some perspective about participants’ retirement readiness. Here’s a recap of the 2017 “America’s Retirement Score” report based on the survey’s four preparedness groupings:

On target.About one-third (32%) of American households fall into this category. Being on target means being on track to cover more than 95% of projected expenses in retirement.

Good.This group, defined as heading toward a capacity to cover 81% to 95% of their estimated expenses in retirement, comprises 18% of working American households. They’ll likely be able to cover essential expenses, but not discretionary ones such as travel and entertainment.

Fair.Slightly more than one in five (22%) are projected to be able to cover 65% to 80% of their expenses. Unless they improve their statuses, they’ll need to make “modest” lifestyle adjustments in retirement.

Needs attention.At 28% of American households, this group is the second largest, behind the “on target” group. Projected to cover less than 65% of their expenses, these people will need to make “significant” downward lifestyle adjustments to cover their expenses.

By generation, the largest “on target” cohort is Baby Boomers, in part because greater numbers of them are covered by traditional defined benefit pensions. Their average score is an 86. Gen X and Millennials are essentially tied at 77 and 78 ratings, respectively, according to the report.

©2018 Covenant CPA

Are you considering transferring real estate, a family business or other assets you expect to appreciate dramatically in the future? If so, an installment sale may be a viable option. Its benefits include the ability to freeze asset values for estate tax purposes and remove future appreciation from your taxable estate.

Giving away vs. selling

From an estate planning perspective, if you have a taxable estate it’s usually more advantageous to give property to your children than to sell it to them. By gifting the asset you’ll be depleting your estate and thereby reducing potential estate tax liability, whereas in a sale the proceeds generally will be included in your taxable estate.

But an installment sale may be desirable if you’ve already used up your $11.18 million (for 2018) lifetime gift tax exemption or if your cash flow needs preclude you from giving the property away outright. When you sell property at fair market value to your children or other loved ones rather than gifting it, you avoid gift taxes on the transfer and freeze the property’s value for estate tax purposes as of the sale date. All future appreciation benefits the buyer and won’t be included in your taxable estate.

Because the transaction is structured as a sale rather than a gift, your buyer must have the financial resources to buy the property. But by using an installment note, the buyer can make the payments over time. Ideally, the purchased property will generate enough income to fund these payments.

Advantages and disadvantages

An advantage of an installment sale is that it gives you the flexibility to design a payment schedule that corresponds with the property’s cash flow, as well as with your and your buyer’s financial needs. You can arrange for the payments to increase or decrease over time, or even provide for interest-only payments with an end-of-term balloon payment of the principal.

One disadvantage of an installment sale over strategies that involve gifted property is that you’ll be subject to tax on any capital gains you recognize from the sale. Fortunately, you can spread this tax liability over the term of the installment note. As of this writing, the long-term capital gains rates are 0%, 15% or 20%, depending on the amount of your net long-term capital gains plus your ordinary income.

Also, you’ll have to charge interest on the note and pay ordinary income tax on the interest payments. IRS guidelines provide for a minimum rate of interest that must be paid on the note. On the bright side, any capital gains and ordinary income tax you pay further reduces the size of your taxable estate.

Simple technique, big benefits

An installment sale is an approach worth exploring for business owners, real estate investors and others who have gathered high-value assets. It can help keep a family-owned business in the family or otherwise play an important role in your estate plan.

Bear in mind, however, that this simple technique isn’t right for everyone. Our firm can review your situation and help you determine whether an installment sale is a wise move for you. Contact us at 205-345-9898.

© 2018 Covenant CPA

Prepaying property taxes related to the current year but due the following year has long been one of the most popular and effective year-end tax-planning strategies. But does it still make sense in 2018?

The answer, for some people, is yes — accelerating this expense will increase their itemized deductions, reducing their tax bills. But for many, particularly those in high-tax states, changes made by the Tax Cuts and Jobs Act (TCJA) eliminate the benefits.

What’s changed?

The TCJA made two changes that affect the viability of this strategy. First, it nearly doubled the standard deduction to $24,000 for married couples filing jointly, $18,000 for heads of household, and $12,000 for singles and married couples filing separately, so fewer taxpayers will itemize. Second, it placed a $10,000 cap on state and local tax (SALT) deductions, including property taxes plus income or sales taxes.

For property tax prepayment to make sense, two things must happen:

  1. You must itemize (that is, your itemized deductions must exceed the standard deduction), and
  2. Your other SALT expenses for the year must be less than $10,000.

If you don’t itemize, or you’ve already used up your $10,000 limit (on income or sales taxes or on previous property tax installments), accelerating your next property tax installment will provide no benefit.

Example

Joe and Mary, a married couple filing jointly, have incurred $5,000 in state income taxes, $5,000 in property taxes, $18,000 in qualified mortgage interest, and $4,000 in charitable donations, for itemized deductions totaling $32,000. Their next installment of 2018 property taxes, $5,000, is due in the spring of 2019. They’ve already reached the $10,000 SALT limit, so prepaying property taxes won’t reduce their tax bill.

Now suppose they live in a state with no income tax. In that case, prepayment would potentially make sense because it would be within the SALT limit and would increase their 2018 itemized deductions.

Look before you leap

Before you prepay property taxes, review your situation carefully to be sure it will provide a tax benefit. And keep in mind that, just because prepayment will increase your 2018 itemized deductions, it doesn’t necessarily mean that’s the best strategy. For example, if you expect to be in a higher tax bracket in 2019, paying property taxes when due will likely produce a greater benefit over the two-year period.

For help determining whether prepaying property taxes makes sense for you this year, contact us. We can also suggest other year-end tips for reducing your taxes. Call us today at 205-345-9898.

© 2018 Covenant CPA

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