The new tax law has upended tax planning for investors. With 2018’s higher standard deduction, fewer tax brackets and new tax treatments for some, now is the time to prepare to cut next year’s investing tax bill.
Here’s the Cliffs Notes version of the new tax law. There are fewer tax brackets — reduced from seven to three. The standard deduction has grown while all personal exemptions have been eliminated. The new standard deductions are $12,000 for singles, $24,000 for married filing jointly, $12,000 for married filing separately and $18,000 for head of household.
In the past, a single filer was entitled to a $6,500 standard deduction and a $4,150 personal exemption for a total of $10,650 in income exclusions. Now, the single filer gets a $12,000 standard deduction.
In exchange for the larger standard deduction, several itemized deductions have been eliminated, including tax preparation and investment management fees (more on that below). At the same time, the new tax law showers some investments with more generous tax breaks than before while setting up a potential ticking time bomb at the end of 2025, when many of the law’s tax cuts expire. As a result, investors need to think strategically about minimizing taxes both in the near-term and several years from now.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
Tax efficiency starts with where the asset is held. Some investment tax strategies remain the same. For instance, “asset location is key,” says Patrick Collins, partner and managing director of Greenspring Advisors in Towson, Maryland. Tax-inefficient investments, like taxable bonds and bond funds that distribute income, still belong in tax-deferred accounts such as IRAs and 401(k)s.
Tax-efficient investments should be held in a taxable brokerage account. Fund investors should look at a fund’s turnover ratio and capital gains distributions for prior years to get an idea of how tax-friendly it may be, says Clint Walkner, co-owner of Walkner Condon Financial Advisors in Madison, Wisconsin. In general, stock index funds and exchange-traded funds are tax-friendly, with lower distributions for capital gains and dividends, and should be placed in taxable accounts.
Tax-loss harvesting still matters. “In 2018, tax rates are still higher on short-term gains versus rates on long-term gains,” says Nathan B. Rex, chief investment officer at New York-based Eigenvector Capital. Nevertheless, gains on long-term investments may be substantial given the stock market’s string of strong years recently. Whenever taxable gains can be offset with losses, investors benefit.
Still, tax-loss harvesting is a tax deferral strategy, not a tax avoidance strategy. “Since you effectively lower your cost basis, you get a tax benefit now by taking the loss but create a larger tax liability in the future when you sell the [appreciated] asset,” assuming it continues appreciating, Collins says. If you expect your tax rate to increase in the future, you might think twice about using this strategy to reduce your current tax bill.
Some charitable gifts are a good idea whether you itemize or not. Donating appreciated assets to charity remains an excellent tax reduction strategy for investors, Collins says. This involves donating investments bought at a low price and that are now more richly valued.
By donating these investments, you avoid paying taxes on the capital appreciation. If your charitable deductions are large enough to increase your itemized deductions past the standard deduction, your tax bill will be lower still. “Using a donor-advised fund to give appreciated assets is much more administratively feasible and allows you to structure the timing and ultimate distribution of your gifts with more freedom,” Collins says.
Investment management fees will hurt more than ever. In the past, investors who paid management fees for a financial advisor or a robo advisor could deduct them, but no more. Now, if you pay $5,000 in investment management fees, instead of reducing your taxable income by $5,000, you’ll pay tax on that money. Mario Hernandez, principal at Gemmer Asset Management in Walnut Creek, California, suggests that investors consider taking management fees directly out of a retirement account to avoid having to sell securities in a taxable brokerage account and be taxed on the capital gains.
Most real estate investors have cause for celebration. The new tax law hands real estate investors a gift, whether they own rental properties or invest through real estate investment trusts.
[See: The 10 Best REIT ETFs on the Market.]
REIT investors, for example, get a deduction that didn’t exist before. Starting in 2018, REIT investors can deduct 20 percent of REIT-qualified dividends from their earned income, says Dane Bowler, chief investment officer at 2nd Market Capital Advisory Corp. in Madison, Wisconsin. For taxpayers in the highest bracket, this results in a maximum income tax rate of 29.6 percent, compared to the prior 37 percent tax rate on REIT-qualified dividends.
Meanwhile, REIT investors should review an existing benefit, the tax deferral of some REIT dividends, during their tax planning to see if it’s worthwhile. When a portion of REIT dividends is tax-deferred in the form of a return of capital, this reduces the cost basis by the dividend amount, and you can defer taxation until you sell the REIT, Bowler says. Be aware, however, that this tax benefit has longer-term implications because when you eventually sell your REIT shares, you’ll have a larger taxable gain due to the lowered cost basis of the REIT shares.
The new tax law also cuts taxes for many owners of rental real estate who own their property though a pass-through entity. Specifically, landlords who own their real estate as sole proprietors, through limited liability companies, or via partnerships pay tax at their individual rates as their profits pass through to their personal tax returns. Charles Comer, managing member of Family Office Advisors in New York, says that “the net rental income might be eligible for a 20 percent reduction before it hits the investor’s 1040.” According to a Nolo analysis of the law, the landlord benefit allows investors eligible for the deduction to be taxed on only 80 percent of their rental income. For taxpayers in the top 37 percent tax bracket, that amounts to an effective tax rate of 29.5 percent.
But if you own a second home and don’t rent it out, you may want to reconsider that decision, Hernandez says. Under the new law, state and property tax deductions are now capped at $10,000 for homeowners whereas in the past, those property taxes were fully deductible. So if you’re in a high-tax state, owning a second home may have just become more expensive. By renting it out, however, you can qualify for the more generous landlord tax benefits.
You may be better off with a Roth IRA. If you believe taxes will rise in the future, Walkner recommends that you consider converting an individual retirement account into a Roth. “As the current tax code is highly likely to change after 2025 due to the expiration of tax cuts, investors should look closely at the tax brackets and consider whether a Roth conversion strategy makes sense,” Walkner says.
[Read: 3 Ways the Tax Law Affect an IRA.]
This strategy does require paying taxes on your IRA today if you convert it to a Roth, a tax bill that can be substantial. Ultimately, though, the conversion could pay off thanks to the Roth’s many benefits. Roth investors have no required minimum distribution, can pass the account on to heirs and make tax-free withdrawals after age 59½. “With taxes likely to be trending lower in the coming years, it may make sense to pursue a strategy to actually pay more in taxes now rather than take on tax uncertainty in the future,” Walkner says.
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Cut Your 2018 Investing Tax Bill originally appeared on usnews.com
