Tax planning always is trickiest for senior Americans. And it will be especially tricky this year.
The tax law has a number of traps designed specifically to get seniors. The biggest trap is the tax on those Social Security benefits that used to be tax-free. If your adjusted gross income exceeds $32,000 ($25,000 for single taxpayers) up to 50% of your benefits will be taxed. If your AGI exceeds $44,000 ($34,000 for singles) up to 85% of Social Security benefits will be taxed.
That puts seniors in a tricky situation. Take a little bigger distribution from your IRA this year, realize some capital gains, or get an unexpected distribution from a mutual fund, and your tax bill climbs dramatically. You pay taxes on not only that additional income, but on the Social Security benefits that now are included in your taxable income. An additional dollar of income can result in an extra $1.50 or $1.85 of taxable income.
I regularly get letters from subscribers who discover that the tax rate on each additional dollar they earn is 50% or higher. In high tax states such as California and New York, the marginal rate could be 90% or higher. A few people are in an unfortunate income range that gives them a marginal tax rate above 100%.
If your income is in or near the range in which Social Security benefits are taxed, then tax planning is critical for you. You need to do an estimate of your taxes for the year. Then determine how much those taxes would increase if you made any changes in your income.
Many investors will get big surprises later this year. I expect a number of mutual funds will make large capital gains distributions, based on profits they took earlier this year. The market was running strong until early April, and has been flat to down since then. Though many funds have not distinguished themselves for the year, they likely took profits in some stocks after the market started to tumble in April.
You can call your funds and ask for estimates of distribution dates and amounts. But be prepared for vague answers. Some funds are not giving advance information about their distributions, since they don’t want shareholders roiling their portfolios by selling just before distributions.
If you might get large distributions, the best move is to take sell some losers. These will offset any gains for the year, including gains distributed from funds. And there is no harm done if the losses you take exceed the gains. Up to $3,000 of your excess losses can be deducted against your other income, and any additional losses can be deducted in future years.
You probably are showing paper losses in real estate investment trusts, small stocks, probably some bonds, and perhaps a few value funds. Consider selling some of these funds temporarily to realize the losses.
You can deduct the losses this year if you wait more than 30 days before buying back the fund shares. Or, to be sure you aren’t out of the market, buy shares in a similar but not identical fund. In the box on page three I list funds that are alternatives to my top choice recommended funds.
Roth IRAs also require year-end attention. There are two issues to consider.
You should consider converting regular IRAs into Roth IRAs. This issue got a lot of attention last year, because a special rule let you spread the tax payments from the conversion over four years. But IRA conversions still can be profitable without the four-year payment window.
Remember that Roth IRAs are completely tax free. Income and gains earned by the Roth IRA are not taxed, and in most cases distributions from the IRA are not taxed. The price for this tax break is that when you convert a regular IRA to a Roth IRA, you must pay taxes on the regular IRA as though you had taken the converted amount as a distribution.
You don’t have to convert an entire IRA. You can convert whatever percentage of the IRA you want. That lets you spread tax payments from the conversion over several years by converting a portion of the IRA each year.
You should consider converting a regular IRA to a Roth if you can pay the taxes with money outside the IRA and if you can leave the funds in the Roth IRA for at least 10 years. That lets the entire converted balance to accumulate tax free and pays for the tax bill. You cannot withdraw funds from the Roth IRA funds for at least five years after the conversion if you want the distribution to be tax free.
You also should consider converting to a Roth IRA when your tax bracket today is less than your expected tax bracket in the future.
Remember that your adjusted gross income can be no more than $100,000 (before considering any conversion income) to be able to do a conversion.
Be sure to check your state’s tax law before doing a conversion. Most states follow the federal rules on Roth IRAs. But a few have special features.
If you did a conversion earlier this year, review that decision. You are allowed to undo the conversion by the due date of your tax return.
You need to undo a conversion done earlier this year if it turns out that your adjusted gross income for the year will exceed $100,000. Otherwise, you’ll pay a penalty.
You also should consider undoing a conversion if the value of the IRA has fallen. You pay taxes on the IRA’s value as of the date of the conversion. But the law allows you to undo the conversion, then convert again at the new value of the IRA. This is called a recharacterization followed by a reconversion. You can do this only once a year.
If the IRA’s value has fallen since the initial conversion, undoing the conversion could save a bundle in taxes.
You also might want to reverse a conversion if you realize that your tax bracket will be lower next year than this year. You can convert next year and save.
If you are looking for last-minute deductions to save taxes, the best deductions these days are charitable contributions. The best charitable contributions allow you to take deductions without giving away any cash.
A popular charitable contribution to consider is the conservation easement. In this strategy you give up development rights to all or part of property you own. You generally give this easement to a charity or public body which then can enforce it. When you grant the easement, you get a current tax deduction equal to the reduction in value of the property. You continue to live in the property or use it as you have. All you have given up is the right to have the property developed in the future.
Most conservation easements are granted by owners of large parcels of land or historical properties. But it is more and more common for owners of small properties in crowded areas to grant the easements. In many areas, land trusts or public conservation trusts are formed by local governments to hold the easements. I covered conservation easements in more detail in the June 1999 issue.
Another alternative is to give away appreciated property you own, such as mutual fund shares or stock. You owe no capital gains on the appreciation in the property, and you get to deduct the full fair market value of the asset. This is an effective strategy for those who are inclined to make charitable contributions.
But be careful when planning charitable contributions. Once again, Congress put a big trap in the law. As your income rises, you lose a portion of your itemized deductions, including charitable contributions. The itemized deduction reduction kicks in when your adjusted gross income exceeds $126,600. Then you lose 3% of the amount by which your adjusted gross income exceeds that amount.