As the end of the year approaches, you might be thinking about the holidays, gift giving and the festivities ahead. But now’s also the time to focus on some important tasks that could bring you some joy — or at least lower your pain — at tax time.
There are steps you can take before December 31 that might improve the tax efficiency of your investment portfolio. While you shouldn’t let tax considerations drive your investing decisions, here are some tax tips to think about:
Tax Tip 1: Get Smart About Annual Mutual Fund Distributions
It’s relatively easy for investors to comprehend the idea that they might owe capital gains tax if they bought a stock and sold it at a profit. But some are surprised to learn they might owe taxes on a mutual fund investment even if they didn’t sell that fund.
Why the tax hit? When a mutual fund sells a security at a profit, that sale creates a capital gain. By law, that gain must be distributed to a mutual fund’s shareholders. Assuming you’re holding that fund in a taxable account, that gain is taxable.
Here’s the good news: knowledge is power. Fund companies generally publish information on expected capital gains distributions in November or December. This information will give you a sense of how big that distribution might be and what you might ultimately owe in taxes in April as a result.
In general, “it’s always a good idea to do a tax projection in November and December so you won’t have surprises when you do your return,” said Barry Picker, a CPA with Picker & Auerbach. “Find out as soon as possible what your capital gains distribution will be.”
Having this information might trigger some action on your part. If you’re thinking about purchasing a particular mutual fund, you might wait until after the distribution is made. Conversely, you might consider selling a fund before the fund makes a distribution.
Keep in mind, however, there may be costs associated with selling that fund, such as paying capital gains on the sale of your fund shares. And you might have seller’s remorse if that fund were to go up in value after you sold.
Tax Tip 2: Harvest Your Losses
At a certain point it might be time to sell an underperforming asset. The argument becomes even more compelling if you’ve had capital gains over the course of the year.
Capital losses can be used to reduce capital gains, dollar for dollar. In addition, in any given year, if your capital losses exceed your capital gains, you can use up to $3,000 of capital losses to offset other kinds of income. The remainder of the loss can be carried forward to offset your income in future years.
“We had a client who earlier this year had a rental duplex and sold it,” said Michael Eisenberg, a CPA, and a member of the American Institute of CPAs’ (AICPA) National CPA Financial Literacy Commission. “We talked about what he could sell in his portfolio to offset some of the gains.”
It’s important to remember the IRS’ “wash sale” rule, which prohibits you from claiming a loss if you sell a security and then buy a “substantially identical” security within the 61-day period starting 30 days before the sale and ending 30 days after the sale.
However, you might be able to buy a similar mutual fund and not trigger the wash sale rule. “You can’t sell a fund one day and immediately buy that fund,” Eisenberg said. “But you might be able to buy one with similar holdings.”
Harvesting losses could be especially helpful to higher income investors who face higher capital gains rates, as well as the Net Investment Income Tax (NIIT).
The NIIT, which went into effect in January 2013, adds a 3.8 percent tax to certain net investments — such as dividends, interest and capital gains — for individuals, estates and trusts that have income above certain thresholds.
Tax Tip 3: Consider a Roth Conversion
The deadline for converting some or all of your traditional IRA into a Roth IRA is December 31. Why consider this year-end tax tip? Generally this move makes sense if you believe you’ll be in a higher tax bracket when you retire.
With a traditional IRA, contributions may be tax deductible in the year you make contributions, while withdrawals are taxed as ordinary income. With a Roth IRA, your contributions are not tax deductible, but qualified withdrawals are tax free.
You’ll have to pay income tax on the amount you convert, and the additional income could put you in a higher tax bracket. But if you change your mind after you convert to a Roth, you have an out: You can re-characterize — undo — a 2016 IRA conversion until October 15, 2017.
Tax Tip 4: Max Out Your 401(k)
Here’s a tax tip to remember all year round, but especially as the year comes to a close: Contributions to employer-sponsored retirement accounts, such as a 401(k) or a 403(b), reduce your taxable income — and you might receive a company match to boot.
For 2016, the maximum amount you can contribute to an employer-sponsored defined contribution plan is $18,000 and the catch-up contribution limit for employees 50 and above is $6,000. The deadline for 2016 contributions is December 31.
Tax Tip 5: Get Charitable With Your Investments
Consider taking an investment that’s appreciated in value and donating it to a charity.
“As long as you held the asset for more than one year…, you get a deduction for the current value — and you don’t pay tax on the appreciation,” Picker said.
In other words, you can do good for others and do well for yourself tax-wise. Now that’s a tax tip that could bring you joy as the year comes to a close — and far beyond.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
Investors should consult their tax or legal advisors.