Thursday, June 30, 2016

When tax-loss harvesting isn’t the best idea

Tax-loss harvesting isn’t like harvesting corn.
Harvesting corn results in cash. But when a tax loss is harvested, it is replaced by a somewhat similar holding with a newer lower basis.
This means that the harvester is actually just pushing a future gain down the road, a potentially greater gain that will inevitably be taxed at some point.
As Michael Kitces, partner and director of research at Pinnacle Advisory Group in Columbia, Md., says, such deferrals can make sense and even save investors money, but he adds that many advisers “continue to overstate the benefit of tax-loss harvesting” by “confusing tax savings with tax deferral.”
Harvesting tax losses can make sense, for instance by converting a loss into a long-term gain that doesn’t have to be realized or taxed for years later when the taxpayer might be in a lower income bracket. But the process also can add costs, such as transaction fees or the bid-asked spread, he says.
“There is also certainly a question about the optimal frequency for harvesting losses,” Kitces says. “If you only harvest annually, for example, in a volatile market you can miss some great tax loss harvesting opportunities, but if you harvest losses weekly, you can end up doing needless trades with greater transaction costs.”
Kitces’ suggestion for those who use the strategy: “Harvest losses on a quarterly basis.”
However, he warns tax loss harvesting isn’t for everyone.
“Anyone in the 10% to 15% tax rate income bracket has a capital gains rate of zero, so tax loss harvesting doesn’t make sense. At that income level, you should be harvesting gains, not losses, and it’s completely irrelevant for people who only have tax-advantaged portfolios,” Kitces says.
Alex Benke, vice president for financial advice and planning at Betterment, agrees.
“Anyone in the lower tax brackets should not be tax loss harvesting,” he says.
But, “if you’re young and earning less than you will be in the future, you do get to take up to $1,500 per year [$3,000 per couple] in losses and deduct that from your income,” Benke says.
Even in the case of wealthy clients for whom tax loss harvesting would ordinarily be advantageous, “if they have assets all over the place, some not being handled by the adviser, they should avoid tax-loss harvesting,” he says.
“They won’t know what the risks are of running afoul of [Internal Revenue Service] rules against wash sales,” Benke says. “An adviser is responsible for avoiding violating the IRS wash rule for portfolios he manages, but any monitoring of accounts outside the adviser’s control is the responsibility of the client.”

Wednesday, June 29, 2016

Which Tax Documents Do I Need to Keep?


Preparing your tax returns is an ordeal for millions of Americans. Yet even after you've finished your returns, you also need to know which records you should hold onto just in case the IRS comes back to you with questions. Below, we'll take a look at the rules governing documentation and which tax documents you should keep.

Documents you used to prepare your tax return
In general, the most important tax documents to keep are the ones that you used to justify the numbers on your final tax returns. The most common of those documents is your Form W-2, which shows your job income along with a record of taxes withheld from your paychecks. The W-2 is important because for most people, it has the bulk of their taxable income, and it also represents the lion's share of the money that goes to the IRS on your behalf to cover your income tax liability.

For investors, 1099 forms have most of the information you'll need, including records of interest received, dividend income, and the basis and sales proceeds from investments that you've sold so that you can calculate your taxable capital gain or loss. Brokerage statements can also confirm these items, as well as contributions to IRAs and other retirement plans.

On the deduction side, you'll want to hang onto forms you used to justify deductible expenses. Form 1098 is the most common, relating to home mortgage interest. But other records, such as payments for state and local real estate taxes or documentation of charitable donations, can also be valuable to prove to the IRS that you deserved all the deductions you claimed.

One of the newer requirements related to your taxes is related to the Affordable Care Act. In order to avoid a penalty, you need to establish that you had creditable health insurance coverage or qualified for an exemption. Keeping the records that prove your coverage with your tax records will ensure that if the IRS challenges your decision not to pay a penalty, you can establish why.

Finally, keeping your tax returns as filed can be extremely valuable in the future. By doing so, you can prove that you haven't taken inconsistent positions in future years, and that can save you a lot of trouble if the IRS questions your handling of various income items over the years.

How long should you hang onto your records?
The length of time you need to keep these tax documents depends on the nature of the document. The key question is how long the IRS will have to challenge you on the figures that each document contains.

For most tax returns, the statute of limitations is three years from the due date of the return or the filing date, whichever comes later. Therefore, many of the supporting documents that went toward preparing the return are no longer necessary once that time has run, because the IRS can't come back and make a challenge.

However, there are different statutes of limitations that apply in different situations. If you underreport your income by at least 25%, then the IRS can audit the return up to six years after the date of filing. Cases involving fraud don't have any statute of limitations, so you'll need to hold onto your records indefinitely if you fear that the IRS might allege you've taken a fraudulent position on your return.

In addition, you should hold onto some records for longer simply because of the nature of the record itself. For instance, with records of investment purchases and sales, keeping statements that document the gains and losses you claimed can be valuable not just now but for future investments as well. Especially in situations in which you make repeated investments in a particular stock or fund, such as with a dividend reinvestment plan or automatic investments in a mutual fund, the complexities of dealing with tax basis make it extremely useful to keep your own records of which shares you sold at what time.

Be smart with your tax documents
Holding onto paper records can be a hassle, and ensuring that you keep access to electronic records can be even more challenging. It's generally safer to keep all your tax documents, but by knowing for certain which documents you'll absolutely need and which are arguably less important, you can use your judgment to decide the best course of action for your situation.

Tuesday, June 28, 2016

Top Insurance Strategies For Small Business Owners


As financial advisors, we've all encountered small business owner clients who are living the American dream: After years of saving and strategizing, all while working very long hours, their small business is finally starting to take off, and the entrepreneur now serves as the primary or sole breadwinner in his or her household.

Now, here’s the bad news: Many other entrepreneurs before them have experienced similar triumphs, only to see all their hard work go up in smoke because they didn’t take the necessary steps to properly insure their success against a range of unexpected turns, from medical emergencies, to acts of God, to, in some instances, just plain bad luck.

So when advising the successful entrepreneur who’s married with children and serving as the primary or sole breadwinner, what are the best ways to help them insure themselves and their business across an array of worst-case scenarios?

The following are the top four areas of insurance each advisor should explore with their small business owner clients:

1) Health insurance. Most people appreciate the importance of having medical insurance. Without it, of course, there’s a tax penalty, but aside from that, a large and unexpected personal medical bill can decimate the finances of even the most successful small business owner, and, thus, their business. But there are specific ways to make the expense of health insurance happen in a tax-savvy way.

For most small businesses with predictable revenues, it probably makes the most sense to pursue a group medical plan. Such plans not only allow the owner to gain coverage for themselves and their family but typically offer money-saving tax incentives as well.

Also, as we all know, even with insurance, prescriptions for medication, visits to the doctor and hospital stays aren’t free. A health savings account (HSA) is a good way to complement existing insurance coverage, particularly for those enrolled in a high-deductible plan, which are less expensive but cover fewer costs.

HSA contributions are tax deferred, and though they have yearly caps of approximately $3,350 for individuals and $6,650 for families depending on the plan, the balance rolls over, year over year, and can be invested in market-based solutions like ETFs and mutual funds to maximize growth. Because of this, HSAs are an ideal vehicle for both tax planning and preparing for future medical costs.

2) General liability insurance. If clients rent commercial space, have them check their lease agreement because the property owner may cover minor injuries resulting from slips and falls. But even if that’s the case, every business needs a general umbrella liability policy, whether it utilizes a commercial space or is home based. It’s far from a guarantee that a personal home policy will cover business-related liabilities if the owner or any of their employees are injured in a work-related accident—even if the accident happens in one's garage or basement.

Also, as part of any umbrella liability policy, consider business interruption insurance. Large snowstorms, earthquakes, floods and other acts of God can shut down operations for an extended period, robbing the business of revenue and endangering employee pay. Think of the destructive flooding that occurred in Houston earlier this year. How would your client be compensated if something similar happened in their area?

3) Errors and omissions insurance. If a client runs an advice-driven business, like a consulting practice of any kind, a marketing firm or offers another set of intellectual capital-based services, they will need coverage that keeps operations up and running in the event of negligent acts, including data theft and other cybersecurity lapses.

The risks tend to vary depending on the business type, so the level of coverage will be different in almost each case. Some industries, like our own business of financial advice, will have their own regulatory authorities that require a baseline level of coverage. Other industries, however, operate more in a grey area. But just because an industry may not mandate coverage, doesn’t mean your client can afford to go without protection.

A good rule of thumb: An effective errors and omissions policy should cover losses equal to at least the value of the client's total personal and professional assets. That way, they won’t get wiped out as a result of a lawsuit. While it’s a best practice to review business and personal insurance policies on annual basis, it’s especially critical here. As a small business owner, their net worth will likely fluctuate year-to-year, and it’s imperative to confirm that they will continue to have enough coverage at all times.

4) Life insurance on a business and personal basis. Obviously, this is a concern for people in all walks of life, not just small business owners. If someone has a family and a job, they need life insurance. (What type of policy is highly situational, depending on a client’s age, health, level of income, among many other factors.) But what many people don’t know is that life insurance policies are a common way to fund buy-sell agreements, a key transition and succession-planning tool for small businesses with multiple partners.

There are many ways to accomplish this. For example, partners can take out policies on one another based on the value of the business. Then, if something should happen, not only is the transition smoother and more seamless, but the remaining business partners have the capital to finance a buyout. A disability policy is another option. This approach ensures that if a partner becomes disabled or incapacitated, businesses will have the cash flow to fund a buyout.

Another thing to consider is the purchase of a "key man" policy, which is exactly what the term suggests—coverage that protects the business in case an irreplaceable employee or key man dies. This is typically the owner, with the beneficiary being the business, but such policies are sometimes applicable to other valuable employees, like a top salesperson.

The first few years for almost any small business can be a fight for survival, a grueling uphill climb just to keep your head above water. When fortunes start to turn, however, it can be a bit like finishing a marathon: It’s an exhilarating and, in many cases, life-defining evolution.

But when that happens, it can be easy to relax, pat yourself on the back and forget about potential landmines lurking around the corner, whether it’s a personal medical emergency, a lawsuit or some other event that could upend or, worse, spell a permanent end for the business. Take the step today to make sure that doesn’t happen to your clients.

Monday, June 27, 2016

2 ripple effects a large capital gain can trigger in your financial plan

For investors who make a savvy move and wind up with a sizeable capital gain, there can be few things that are more satisfying. Perhaps the only downside is the tax bill you may face from the gain (those in the 10 percent and 15 percent tax bracket get to enjoy a zero percent tax rate on their capital gains).

If the capital gain is unusually high, you may find that the costs associated with the gain are higher than you expected. A caller to our radio program recently found himself in that predicament and asked us the following question: I had a large capital gain last year, but my taxes are higher than what I expected. What other taxes could a large capital gain trigger?

We often refer to these unexpected costs as "ripple effects." By that, we mean that the primary, expected expense sends ripples throughout your financial plan that can create unintended consequences. We thought we'd cover two of the most common ripples you should be prepared for.

Net Investment Income Tax

One possible tax you may trigger, in addition to the capital gains tax, is the Net Investment Income Tax. This is a relatively new tax that was incorporated as a means to help pay for the Affordable Care Act in 2010. The NIIT is a flat, 3.8 percent surtax that is assessed if you exceed certain modified adjust gross income, or MAGI, thresholds ($200,000 if filing single and $250,000 if filing jointly).

The NIIT isn't assessed on all of your income. It's assessed on the lower of either 1) the amount your MAGI exceeds the NIIT threshold or 2) your Net Investment Income for the year. For example, Maggie files single with a MAGI of $250,000, including $30,000 in Net Investment Income. In this instance, the $30,000 of Net Investment Income is less than the $50,000 that exceeded the MAGI threshold ($250,000 in MAGI minus the $200,000 earnings threshold). Maggie would face an additional tax bill of $1,140 from the NIIT on that $30,000.

Net Investment Income may include interest, dividends, capital gains, rental income and non-qualified annuities. Not all income sources are subject to this tax; wages, self-employment income, Social Security benefits and tax-exempt interest are some common sources of income that are exempt. For a complete list of what is and isn't considered Net Investment Income, you should contact the IRS.

Medicare Premiums

The premiums you pay for Medicare Parts B and D are affected by your MAGI, and a large increase in your MAGI can lead to large increased in your premiums.

Based on this year's Medicare premiums, someone filing single and earning $75,000 will pay $121.80 monthly Part B premiums. If that same person has a $50,000 capital gain, giving them a MAGI of $125,000, their Medicare Part B premiums would double to $243.60. Add to that the fact that your Part D monthly premiums would increase by $32.80, and you're looking at over $1,800 in higher Medicare premiums.

To make matters even more confusing, there's a two-year lag between when your income is reported and when it's reflected on your premiums. For example, the income you earned last year in tax year 2015 will affect your Medicare premiums in 2017. So if you had a large capital gain last year, there may be higher Medicare premiums on the horizon for you next year.

These ripple effects, in many circumstances, translate into unexpected costs, making them an extremely frustrating component of financial planning. That's why if you're expecting higher than usual income this year, it may be beneficial for you to consult with your tax adviser first to make sure you're aware of the potential ripples that may be triggered and begin preparing for them.

Sunday, June 26, 2016

What is an IRS Offer in Compromise?

It happens sometimes that a taxpayer gets into a situation where it seems insurmountable to pay off a tax debt that has been created. Whether it is because the taxpayer is self-employed and had income that did not have withholding, or some other unfortunate circumstance, the debt to the IRS seems insurmountable and may even be growing.

You may have even heard advertisements on the radio or late night television for firms that will help reduce or eliminate your tax obligation with the IRS.

The IRS has a provision in place which allows qualified individuals with an unpaid tax obligation to potentially settle that debt for less than the amount owed. The process is called an Offer in Compromise or OIC.

The objective of the OIC program is for a negotiated compromise to result that is in the best interest of both the government and the taxpayer. This is NOT just a method to run up a debt with the government and then easily walk away from the obligation.

At least one of three specific conditions must be met to qualify for the OIC Program.

There must be doubt as to the validity of the liability. If the taxpayer can show reasonable doubt that the assessed tax liability is correct there may be relief through the OIC Program. The taxpayer will need to establish that they have not otherwise had the ability to dispute the tax liability.

An Offer in Compromise based on this premise does not require financial information to be submitted. However, the IRS sends out numerous communications to a taxpayer prior to finalizing the assessed balance, so this approach generally is not used successfully very often.

The second condition that may qualify for Offer in Compromise relief is the Doubt as to Collectability approach. If the debtor can show that the debt is likely uncollectible in full by the IRS under any circumstances there may be a compromise available.

The IRS has an established formula involving disposable income of the taxpayer has available to make payments on the debt. A taxpayer must complete a form provided by the IRS based on the nature and type of their income and essentially provides a financial statement to the IRS which identifies all assets and liabilities as well as income and expenses.

The third and final manner to qualify under the OIC program is called the Effective Tax Administration condition. In this condition the debtor does not contest the liability or the collectibility, but must demonstrate extenuating or special circumstances whereby the collection of the debt would create an economic hardship or would be unfair or inequitable.

This condition is available to all taxpayers but is primarily used by the elderly, disabled, or those with extenuating circumstances.

Negotiating an Offer in Compromise will not automatically release a tax lien, and it is only after the full amount of the offer has been paid in full that any IRS tax liens will be released. Once offer has been paid, the taxpayer must request that the IRS remove the lien.

It is also important to note that there are numerous unscrupulous promoters that claim to settle tax obligations for “pennies on the dollar.” When a company requests payment from the taxpayer upfront to begin the process, this may end up proving to be money down the drain for the taxpayer.

A taxpayer is not required to obtain outside representation for an OIC, and it may be in the taxpayer’s best interest to negotiate the offer themselves.

If the initial offer is not accepted the taxpayer may apply again, and the taxpayer may also appeal a rejected Offer in Compromise as well.

Saturday, June 25, 2016

Does a Stretch IRA Always Make Financial Sense?


When balanced against the income tax treatment of a nonqualified portfolio of investments, post-death distributions from qualified plans and individual retirement accounts (retirement benefits) will generally produce a significantly inferior result.  There are many reasons for this, including:  (1) retirement benefits receive no step-up in income tax basis at the participant’s or owner’s death, (2) retirement benefits must be distributed post-death according to an established set of required minimum distribution (RMD) rules, whereas a nonqualified portfolio of investments includes no such post-death mandatory distribution requirement, and (3) retirement benefit distributions are taxed at ordinary income tax rates, as opposed to the now as little as one-half as high capital gain or dividend tax rates on distributions from nonqualified portfolios.1
Let’s explore options for minimizing this disparate post-death income tax treatment.  For illustrative purposes, let’s work with an example of a male account owner, age 60 and in excellent health.  He owns a taxable IRA account in which he’s invested $500,000 and that has a current appreciated value of $1 million. Assume the account owner lives to his approximate life expectancy of age 80 and that all investments grow at a 5 percent (principal plus income) compound rate. Also assume a combined 40 percent federal and state ordinary income tax rate and a 20 percent combined capital gains tax rate.  Finally, for simplicity purposes, assume an RMD each year (beginning at age 70 1/2) of 5 percent, or the same as the assumed total return rate, because 5 percent approximates the average annual RMD for individuals ages 70 through 80. 
Alternative 1:  Only Withdraw RMDs During Owner’s Lifetime
This is probably the most prevalent retirement benefit withdrawal plan today, that is, to take only the RMDs during the owner’s lifetime, at least for larger IRAs.  But question:  Is this the smartest financial plan?    Assuming all after-tax RMDs beginning at age 70 1/2 (approximately $80,000 per year, gross and $48,000 per year, net of tax) are reinvested in a portfolio of securities producing no current taxable income but 5 percent overall growth, at age 80, the owner’s original $1 million taxable IRA would look something like this:

As the above table indicates, approximately 73 percent of the of the owner’s $2.2 million portfolio at age 80 would be growing at an eventual combined 40 percent federal and state income tax rate and wouldn’t be eligible for basis step-up at death, while only 27 percent of his portfolio would be growing at the lower combined 20 percent federal and state capital gain tax rate and would be eligible for full basis step-up at death.  There would be an income tax basis step-up of only $120,000 on the non-qualified portfolio if the owner were to die, while there would be no income tax basis step-up on the $1.6 million taxable IRA.  RMDs would continue on the taxable IRA after the owner’s death, but there would be no requirement to liquidate the smaller, nonqualified portion of the portfolio in the hands of the owner’s spouse or other heirs.
Note that, under the above-described plan, the owner’s original $500,000 investment in the IRA would have already been withdrawn, over ages 70 through 80, and appropriately taxed to him at ordinary income tax rates, because he received a deduction for a like amount off of ordinary income.  An additional $300,000 would have also been withdrawn under the RMD rules, again all taxed at ordinary income rates, even though no prior income tax deduction was received for this amount and even though the IRA may have been invested entirely in the stock market.  The after-tax reinvested sum (or $48,000 per year) would have grown, outside of the IRA, to $600,000 and would be properly eligible for income tax basis step-up at the owner’s death.   
The challenges presented are:  (1) how can the IRA owner plan now to effectively avoid taxing all growth in his IRA at ordinary income tax rates as opposed to capital gain rates; (2) how can the IRA owner proceed at present to effectively achieve an income tax basis step-up for a portion of the IRA balance at his death; and (3) what actions can the IRA owner immediately take to effectively cause a portion of the IRA balance to be taxed, if at all, at the more favorable capital gains income tax rates to his heirs?
Alternative 2:  Convert All or a Portion of the IRA to a Roth IRA
Converting the $1 million IRA at age 60 will obviously mean that the entire amount will be taxed at a higher combined federal and state income tax rate, which for our purposes we’ll assume is 45 percent.  This leaves $550,000 to grow inside of the Roth IRA, which, after 20 years at 5 percent compounded, will equal approximately $1.459 million.2
Although this plan arguably solves all of challenges (1) through (3), described above, it does so in a manner that, at age 80, actually leaves the owner and his family with slightly less than the after-tax value they would have received under Alternative 1 ($1.48 million, assuming the IRA was liquidated at the same 45 percent combined federal and state income tax rate and a step-up in income tax basis for the nonqualified portfolio).  Thus, it appears that a complete Roth conversion isn’t the answer to the issues we have with the unfair manner in which post-death IRA distributions are taxed.
Smaller and annual partial IRA conversions may provide a slightly better result than a complete conversion at age 60, primarily because of the lower income tax rate on the smaller withdrawals.3 For example, if at age 60, the owner were to begin withdrawing $50,000 from the taxable IRA each year and convert the net amount after 40 percent ordinary income taxes, or $30,000, into a Roth, the Roth account would grow to approximately $1 million by the time the owner reached age 80.  Added to the after 45 percent tax rate value of the approximately $1 million still remaining in the taxable IRA, at age 80, the after-tax value of the owner’s portfolio would be approximately $1.55 million,  $70,000 more than the original result in Alternative 1, above.
Alternative 3:  Immediately Begin Taking Small Distributions from the IRA and Invest the After-Tax Amount into Life Insurance
This plan is similar to the annual Roth conversions option discussed under Alternative 2, but instead of transferring the $30,000 net amount into a Roth IRA each year, the net amount is used to purchase as much face value life insurance as possible. To preserve some of the IRA for the owner’s lifetime needs, the premiums are intentionally kept smaller and only paid for 10 years.4
            Under the plan, at age 80, the owner’s financial situation is projected as: 5


Assuming a 45 percent combined federal and state income tax rate if the taxable IRA were liquidated in full and a stepped-up income tax basis on the owner’s nonqualified portfolio, the after-tax value of the owner’s portfolio, if he were to die at age 80, would be approximately $2.027 million or $477,000 (approximately 31 percent) more than the best of the two Roth conversion options described in Alternative 2, above ($1.55 million) and $547,000 (approximately 37 percent) more than the original result in Alternative 1 ($1.48 million).  What’s potentially even more significant, under Alternative 3, the owner’s family would have $1.477 million growing at capital gain tax rates (or at no tax, to the extent the assets are not sold during life), compared to only $600,000 growing in this favorable tax environment under Alternative 1. 
In taxable estate situations, Alternative 3 presents the additional possibility of having the income tax-exempt life insurance policy held inside an irrevocable life insurance trust (ILIT), which, unlike a taxable IRA or Roth IRA, would render the proceeds estate tax-exempt.  If access to the policy’s cash surrender value is deemed necessary (which would be unlikely, in today’s high federal estate tax exemption environment), the ILIT can be structured as a spousal access trust or as a wealth, retirement and asset protection trust.6
One potential disadvantage of Alternative 3 is that, during the owner’s lifetime, he’ll have less available funds to spend.  For example, when the owner reaches age 80, the cash value of the life insurance product assumed in this article is projected to be only approximately $200,000.  This amount, when added to the remaining after-tax value of the IRA (assuming the maximum 45 percent combined tax rate) and the after capital gain tax value of the nonqualified portfolio, would equal approximately $1.1 million, whereas under Alternative 1, the owner would have approximately $1.45 million available to spend at age 80, after taxes.  If this lifetime use issue is a significant concern to the owner, he may elect to structure the life insurance policy so that it will produce a larger cash value, but a lower projected death benefit. 
Another potential disadvantage to Alternative 3 is that the owner may live substantially beyond age 80, in which case an unchanging face amount life insurance policy may not keep pace with the value of otherwise available investments.  To address this concern, the universal policy can be structured to provide an increasing death benefit, rather than a stagnant $1.1 million face amount.
The Advisor’s Marching Orders
Whether the tax advisor looks to the Roth IRA solution, the life insurance solution or some other solution or combination of solutions, the disparity in the post-death income tax treatment of nonqualified portfolios of investments versus qualified portfolios must be addressed.  While it’s fair and proper to eventually tax the owner’s pre-tax contributions to a qualified plan or IRA at ordinary income tax rates, taxing all growth in the same at the ordinary income tax rates can’t be justified, especially when compared against the much more favorable income tax treatment of nonqualified portfolios.  The planner’s goal should be to use all resources at her disposal to achieve post-death tax results that mirror as closely as possible the capital gain tax rates and income tax basis step-up available generally for nonqualified portfolios.