Nobody likes paying taxes, and clients will be especially grateful for your proactive advice on how they can avoid shelling out any more than what’s legally required.
Here are three steps you can take before the end of 2021 to reduce the tax bill your clients will get on April 15 and two more you may be able to use to reduce their taxes in future years.
Sell the Losers
Go through each client’s taxable accounts to identify any positions that currently hold an unrealized loss. Selling those positions with losses will reduce the client’s taxes in the following manner: First, the client can use any realized losses to offset the taxation of any realized gains in the same tax year. Then, up to $3,000 of additional realized losses can be used to offset ordinary taxable income in the same tax year. And the realized losses can be carried forward into the future until the realized loss amounts are exhausted.
A couple notes of caution on selling investments to realize losses, though. Make sure that you haven’t bought any of the same security for the client within 30 days before or after the loss-incurring sale, which would then trigger the “wash sale” rules and disallow the loss for tax purposes. This is an especially treacherous situation when a client has a mutual fund in a taxable account with automatic reinvestment of capital gains and dividend distributions, so you may want to disable that practice in the client’s account until the wash sale period has expired.
Second, make sure the client is aware that the security in question may rise in value after the sale but before the wash sale period expires and the security can be repurchased. The prospective increase may offset any tax advantages of selling.
Avoid the Winners’ Distributions
Many mutual funds make distributions of dividends and net realized capital gains in the fourth quarter of the calendar year. If you purchase shares of a fund in a taxable account for a client, and the fund then distributes these amounts, your client could be liable for taxes on the distribution, even if they weren’t along for the ride up in share value.
There are a couple of ways you can mitigate the damage from this situation or avoid the distributions altogether. First, until the fourth quarter has passed, consider making any new fund investments only in tax-sheltered accounts, like IRAs and Roth IRAs.
If you must invest in funds within a taxable account, first check with the intended fund to see if any gains will be distributed, when that might happen and how much the gains may be. Then discuss with the client why they may want to delay making the investment.
Finally, there may be a “mulligan” if your client receives a larger taxable distribution shortly after making a purchase. When a fund makes a distribution of dividends or capital gains, the funds’ net asset value drops by a commensurate amount. So, if the client receives the distribution, they can (in theory) sell the fund at the new lower price to help offset the distribution of the gain. The client still needs to avoid making a sale of the same security within 30 days before or after the purchase because of the aforementioned wash sale rule.
More to the 401(k)
You will be surprised by how many working clients have the money and the room to make larger pretax contributions to their at-work retirement plans—like 401(k)s and 403(b)s—but haven’t taken the action to do so.
For 2021 the maximum annual contribution to these plans is $19,500, with an additional $6,500 added to the limit for workers who are 50 or older in 2021. Certain state and government employees who also have access to a 457(b) plan have an extra opportunity, as they can then contribute to both their 403(b) and the 457(b), thereby doubling the potential amount that can be deferred. Some employers might limit how much workers can withhold on a per-paycheck basis, so to get the greatest effect for 2021, it’s better for clients to raise their contributions sooner rather than later.
Two for the Future
For clients who are already otherwise in a low or no taxable income situation in 2021, there are some moves to be made before the end of the year to take advantage of their favorable status—especially if the clients expect to be in a higher-income tax bracket in future years.
Start by realizing any long-term capital gains, on which the federal tax rate could be as low as 0% depending on the amount of the gain and the client’s other income. Then you can immediately repurchase the same security, thereby establishing a new higher cost basis on the position.
Those clients with low income and IRAs should also strongly consider converting a portion of their IRAs to Roth IRAs before the end of the year. Ideally, the client will not withhold any portion of the converted amount for prospective taxes and will instead pay any corresponding tax liability from current personal savings.
There are a few online calculators you and your clients can use to estimate the potential tax cost and savings of these strategies, such as the tax calculator at efile.com and the capital gains tax calculator at smartasset.com.
If you want the numbers run by an expert, ask your clients for permission to contact their tax preparer for some estimates as to the benefit of these moves. Not only will it be less work and liability for you, but it also makes it more likely that the figures will be correct.
Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).