Tax season is done and dusted for another year, but did you know that there are ways for investors to improve their tax situation at any time of year? Whether you got burned with an unexpected bill, or you received a sizeable refund in April, now is a great time to make sure next year’s tax season doesn’t present you with any surprises.
Reviewing your tax situation is a good idea in every calendar year — however it is especially important this year. 2018 brings with it a large amount of changes due to the new tax legislation (the Tax Cuts and Jobs Act) which goes into effect for this year.
It is very important to review your situation with a CPA or professional tax preparer, as they are the most qualified to provide personalized advice. However, there are a few things anyone can do to improve their tax situation. Some of these make sense for almost any year, and some of them are more specific to 2018 because of the recent tax changes.
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Reduce your taxable income where possible. The simplest way to do this is by taking advantage of tax-advantaged investment vehicles. If you have access to a workplace retirement plan like a 401(k) or 403(b) plan — consider increasing your contributions to the plan. The dollars you defer to the plan are deposited pre-tax. The assets then grow tax-free until you withdraw them from the plan.
Be aware of the maximum allowed contribution limit — for 2018 you can defer $18,500 to a 401(k) plan and an additional $6,000 if you are older than 50.
Also make sure to consider your cash flow in relation to your retirement savings. Although there is a huge benefit to growing your retirement savings and minimizing your taxable income, don’t get carried away if your monthly income cannot support it. Avoid a situation where you would need to take an early withdrawal from a retirement account, because there are often hefty penalties and costs.
Evaluate the tax-efficiency of your investment portfolio. In the past have you had a lot of short-term gains? Or large capital gains distributions from your mutual funds? If so, there are two aspects of your portfolio to review.
Do your funds have a high turnover ratio, or large capital gains distributions? First, look at your individual holdings. Some mutual funds have a very high turnover ratio, and pay out large amounts of capital gains near year end. This is tax-inefficient since the price of the mutual fund tends to drop by almost the identical amount of the payout, on the same day. This, in essence, forces you to realize capital gains at a time which is completely out of your control.
Consider both the turnover ratio of any mutual funds inside of your taxable portfolio, and the capital gains payout history of those funds. For funds with high turnover and payouts, it may make more sense to hold these in a tax-deferred account — a Roth IRA, 401(k) or 403(b) — than a taxable brokerage account.
Are you trading frequently? Your trading strategy may also be making your tax burden worse. Consider how long you have held an investment before you sell it. Investments held for less than 12 months do not receive any special tax rate — they are taxed at the same rate as your ordinary income.
While your effective tax rate may have gone down as a result of the new tax bill, the rate assessed for short-term gains is still higher than the long term capital gains rate for any investment held for more than 12 months.
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Make sure your cash reserves (savings) account is sufficiently funded. Whether you keep your emergency savings in a bank account or in a low-risk money market fund in your portfolio, it is critical to have a safety net of savings. This avoids forced sales (and taxes) from your taxable portfolio in the event you need to access extra cash in a single month. It also keeps realized gains (especially short term realized gains which are taxed at a higher rate) in check.
Typically, keeping an amount equivalent to three to six months of your core expenses in cash reserves is a good idea.
Don’t let the tax tail wag the portfolio dog. Don’t be afraid of gains in your portfolio simply because it will generate a tax bill. We all want gains in our portfolio — the key is to minimize the tax costs in doing so.
If your allocation is wildly out of line with what is appropriate for your specific financial situation, some rebalancing can be essential.
Beware bitcoin, precious metals and other alternative assets. Every time you complete a transaction using a cryptocurrency like bitcoin, there is a tax implication.
In fact if you were paid for something in bitcoin, that transaction is taxed as ordinary income — so may be subject to both federal and state income tax. The IRS ruled that currencies like bitcoin are not considered currencies from a tax perspective — they are classified as property. When you get rid of bitcoin, you will have a capital gain or loss. Bitcoin now generates a report and reports to the IRS on these transactions.
So if you dabble in bitcoin, just know that your situation is likely to be a little more complicated come tax time and be careful to keep detailed transaction records. Some “wallet” providers help with this tracking and reporting.
Precious metals also need to be handled carefully from a tax perspective because they are classified as a collectible, and may be taxed at the maximum collectible rate of 28 percent, even for long-term gains. For short-term gains, income rates still apply.
Review your charitable giving strategy. Perhaps your giving plan has been sporadic and opportunistic, for example, when a friend is running a race for a specific charity. The new tax bill eliminates many of the deductions that you could previously itemize.
One way to still take advantage of itemized deductions is to consider lumping your charitable giving together into a single transaction. Several brokerages offer donor-advised fund accounts that allow investors to receive a deduction in a single year at the time of deduction, and then invest and grant out the funds to various registered charities over time.
[See: 10 Investing Themes to Remember for 2018.]
These are just a few ideas to get you started in reviewing your tax situation with your CPA. The steps you take now can make tax time much less surprising next time around.
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8 Ways Investors Can Avoid a Tax Surprise originally appeared on usnews.com
