Saturday, October 11, 2014

Year-end retirement planning strategies

October marks the start of the fourth quarter: the perfect time to think about year-end planning strategies and tactics that can help save or make a buck or two. Though not an exhaustive list, here’s what experts say you should consider or do now.

Put your financial house in order
The last quarter of the year is a great time to review how much money you’ve spent during the past 12 months or to otherwise create a plan to track your annual expenses for the coming year, said Randy Bruns, a certified financial planner with HighPoint Planning Partners. “Understanding your annual expenses is crucial for calculating how much should be set aside in savings in the case of a job loss, how much term life is needed to protect your family should you die, and ... to help calculate a target nest egg.”

Consider purchasing Quicken or using free online tools such as Mint.com.

Project your tax bill
Once you get a handle on your income and expenses, now would be a good time to estimate your 2014 tax bill, especially if there have been or will be large differences from previous years. Items to look for, according to Joseph Clemens, a certified financial planner and owner of Wisdom Wealth Strategies, include:

Increased medical expenses. “Since medical mileage/travel is potentially deductible, did you travel a lot for medical purposes?” he asked “This can be especially important since those 65 and over have through 2016 before their threshold jumps up to the rest of the population from 7.5% to 10%.”
Have you made large purchases such as a vehicle and the funding came from a taxable account? If so, this could increase tax liability, said Clemens.
Are you making enough in estimated payments? “If you think you won’t be, one trick is to do a withdrawal from an IRA to cover the difference and withhold 100%,” Clemens said. “Since IRA withholdings are treated as being contributed to throughout the year, this trick can help avoid the underpayment of tax penalty.” FYI: If you don’t want the income from the IRA that is required to do this, you could replace the moneys into the IRA account from their bank as a “once per year 60-day replacement” or take the funds from a Roth, Clemens said.
“Once you get a tax projection, then a retiree will be in a better position to analyze the usual year-end strategies, such as charitable stock gifting and tax harvesting,” said Clemens.

Consider a Roth IRA conversion
Part of getting a handle on your potential tax bill means getting a sense of what your taxable income will be for 2014, said Scot Hanson, a certified financial planner with EFS Advisors. That would be line 43 on Form 1040.

Millennials on money: 'Trust no one'(2:05)
Roughly 23% of millennials "trust no one" when it comes to advice about money. MarketWatch's Catey Hill discusses on Lunch Break with Tanya Rivero. Photo: Getty

One possible tactic. Taxpayers who expect to land in the 15% tax bracket or less (married couples filing jointly in 2014 with taxable income of $73,800 or less, for example) might consider converting part (or all) of their traditional IRA into a Roth IRA, but not so much that they move into the 25% tax bracket.

“It is no fun to report income and pay the extra taxes, but at 15%, you are most likely never to be in a lower tax bracket for the rest of your life,” said Hanson.

One benefit: “Any amount you convert now and move to Roth IRA will not have required minimum distributions (RMDs) that start at age 70½ with most other retirement accounts, so you are blunting that future impact,” Hanson said.

And the worst of it is this: You’re prepaying taxes so that children inheriting your Roth IRA will not have to pay any taxes, Hanson said.

Also, consider asking your children to help pay whatever tax you might owe on the Roth IRA conversion. “If I am your son or daughter and can expect the future IRA at death, I would be willing to help with those taxes at 15%, because I would not want to pay those same taxes at a much higher tax bracket if in a higher tax bracket,” Hanson said.

Another benefit: By converting to a Roth IRA before reaching age 70½ you might be reduce how much your Social Security benefit is taxed. “RMDs (from your traditional IRA) often cause more of your Social Security to be taxed,” said Hanson.

How so? If you’re married and filing a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits and if you have combined income more than $44,000, up to 85% of your benefits may be taxable. Of note, combined income equals your adjusted gross income, plus nontaxable interest, plus one-half of your Social Security benefits. RMDs would be included in your adjusted gross income.

By contrast, you won’t ever have to take an RMD from your Roth IRA. And if you do take a distribution from a Roth IRA, it won’t be included in your adjusted gross income.

Mark Luscombe, a principal analyst with Wolters Kluwer, CCH, said Roth conversions can also be a good strategy, especially if IRA distributions might push the taxpayer into a higher tax bracket or push adjusted gross income (AGI) up sufficiently to make the taxpayer subject to the 3.8% tax on net investment income. “The taxpayer might want to spread out the conversions over several years, again to keep AGI as low as possible,” he said.

And, Luscombe said, “Roth conversions also make more sense for taxpayers who do not anticipate needing the converted funds in retirement, at least not right away, and if the taxpayer has other funds to pay the tax on conversion.”

Speaking of what planners often refer to as tax-bracket planning, consider this tactic too. Long-term capital gains are taxed at 0% if you are in the 10% or 15% federal income tax brackets. So, if you fall into those tax brackets, Ryan Pace, a certified financial planner with D3 Financial Counselors, recommends realizing enough long-term capital gains to take you to the top of the 15% tax bracket.

Maximize, maximize, maximize
Another way to trim you tax bill? Make sure you’re on pace to contribute as much as possible, even the maximum allowed, to your retirement accounts, such as your 401(k) and the like, as well as, if you have one, your health saving account (HSA), said Pace.

You can contribute up to $17,500 in your 401(k) plus an additional $5,500 if you are age 50 or older.

As part of this exercise, Bruns recommends reviewing your financial plan to determine whether you’re saving enough for retirement, and then making the appropriate changes to your contribution rates for this and next year.

Pace also recommends: contributing to a 529 college savings plan if your state offers an income tax deduction for contributions and enrolling in a flexible spending account (FSA) if your employer offers one. FYI: The government changed modified the “use-it-or-lose-it” rule for health flexible spending arrangements. Participants now can carry over up to $500 of their unused balances remaining at the end of a plan year. So make sure to spend as much as you need to bring your balance down to $500. Otherwise, you’ll lose any amount over $500.

What’s the benefit of maximizing your contributions to 401(k)s, HSAs and the like? You’ll lower your income tax bill.

Deductions and credits anyone?
You might be able to reduce your tax bill by increasing your charitable contributions. Pace recommends the following: cleaning out your garage and closets to make noncash donations to charity; donating your most appreciated assets to charity (by doing so you avoid realizing capital gains); and front-loading charitable contributions by gifting cash or stock into a donor-advised fund.

Also, if a family member has higher education expenses, Pace recommends taking advantage – if possible – of the American Opportunity Credit (it’s a tax credit of up to $2,500 of the cost of tuition, fees and course materials paid during the taxable year) or the Lifetime Learning Credit (it’s a tax credit of up to $2,000). Read American Opportunity Tax Credit: Questions and Answers. Also read Lifetime Learning Credit.

Tax-loss harvesting
For some, tax-loss harvesting might be another way to keep your tax bill in check. “Tax-loss harvesting is a way to reduce your taxes by selling an investment that is trading a significant loss and replacing it with a comparable investment,” said Dustin Obhas, a certified financial planner with CLA Financial Advisors.

Two caveats: One, the IRS will disallow the loss if the same or substantially identical asset is purchased within 30 days. That’s called the “wash-sale rule.” And two, only up to $3,000 of loss can be used to reduce your taxable income ($1500 each if married filing separately). Given this caveats, consider talking with a qualified tax professional who can determine in advance whether tax-loss harvesting makes sense for you.

Rebalance your portfolio
Consider the pros and cons of tax-loss harvesting in the context of your overall portfolio. You might be able to accomplish two goals — rebalance your portfolio to its intended target and tax-loss harvest — at the same time.

“If the stock market is booming and the bond market is flat, chances are you’ve now got more exposure to stocks than you did when the year began, which adds risk to your portfolio,” Bruns said. “A disciplined rebalancing strategy is a simple and easy way to remove emotion from your investment decisions by forcing you to sell high and buy low.”

Examine too the fees you’re paying for your investments. “Review your mutual fund expenses at year-end and dump those with unnecessarily high fees,” said Bruns. “Decades of academic research has shown that high mutual fund expenses are a major headwind to future performance.”

What to do: Own mutual funds with expense ratios well below 1%. “Low-cost providers such as Vanguard offer mutual funds with expense ratios below 0.10%,” said Bruns.

Also, as part of this process, update your investment policy statement, your blueprint for your investments. “You want to make sure your investment match your risk tolerance and goals,” said Obhas. “Ask yourself if you’re taking on too much risk or being too conservative.”

Take your RMD
If you’re over age 70½ and you own traditional IRAs and/or 401(k)s don’t forget to take your required minimum distributions (RMDs). “Miss the Dec. 31 deadline and you’ll face a steep penalty of 50% of the amount that you should have taken,” said Bruns.

Remember too that taking your RMD is taxable income, said Obhas.

Update your estate plan
Use the final three months of the year to update your estate plan, including your will, trusts, and powers of attorney. Make sure they reflect any material changes such as divorce, or children leaving your home, or a sibling who was listed as your executor or trustee dying.

“Also make sure the beneficiaries are up-to-date on your various financial accounts,” Bruns said. “A lot can change after you open an account.”

Others agree with the need to review your estate documents. “Chances are it’s been years since you updated your estate planning documents,” said Obhas. “Life happens, things change.”

Watch Congress
Taxpayers already in retirement, Luscombe said, should watch whether Congress extends expired provisions, particularly the provision that permits taxpayers over age 70½ to make IRA distributions directly to a charity without taking the distributions into income.

“This keeps AGI lower which could help reduce tax on Social Security benefits and perhaps also help the taxpayer qualify for other tax breaks that phase-out as AGI increases,” said Luscombe.

Of note: Luscombe said the last time Congress waited until the end of the year to extend this provision, they let required minimum distributions made in December be treated as if they were made directly to a charity and allowed distributions to charity made in January of the following year to be treated as if made on Dec. 31. “It is not certain what Congress might do this time around,” he said.