Given the extent to which stocks and bonds have declined this year, tax loss harvesting can be a practical but meaningful planning opportunity for investors holding positions with unrealized losses in taxable accounts. Tax loss harvesting is a strategy of selling securities at a loss to offset capital gains tax.
If capital losses exceed gains in any given year, they can be used to offset up to $3,000 of ordinary income per year. What is less widely known by physicians is that an unlimited amount of capital losses can be applied against capital gains in future years on federal tax returns for the remainder of one’s lifetime. These losses can be used to offset gains in an investment portfolio or from the sale of other assets with capital gains, such as the sale of real estate or a physician practice.
According to a study published in the CFA Journal*, tax loss harvesting can generate 108 basis points (1.08%) of annual tax savings. When combined with other tax-smart investing strategies such as asset location and tax-efficient withdrawal optimization, aggregate annual tax savings can be up to 2% or more each year. Such savings compounded over multiple years can translate into significant additional after-tax wealth for physicians.
At Forme Financial, we daily review opportunities for tax loss harvesting using tax-smart technology.
Analyze Mutual Fund Year-End Capital Gain Distributions
Mutual funds are required to pass along capital gains to fund shareholders. Regardless of whether the fund shareholder actually benefited from the fund’s sale of underlying securities, the shareholder will receive the capital gain distribution if the mutual fund is held as of the dividend record date.
Mutual fund families typically provide estimates for year-end dividend distributions over the course of October and November, with such distributions most commonly paid in December.
Capital gain distributions can be either short-term or long-term. Short-term capital gain dividends are treated as ordinary income and thus cannot be offset by realized losses; in contrast, long-term capital gain dividends are treated as capital gains and can be offset by realized losses.
It is important to review unrealized gains and losses across mutual fund holdings in taxable accounts and to compare those figures against capital gain distribution estimates to determine if selling a mutual fund position before the year-end distribution would produce tax savings.
Because mutual funds are inherently tax inefficient, Forme Financial generally doesn’t recommend the purchase of mutual funds for our physician clients. If your investments are managed elsewhere, consider having us run a tax optimization analysis to determine the impact of taxes on your portfolios, including mutual fund capital gain distributions. To learn more, click here.
Manage Charitable Donations
Charitable donations represent one of the better planning tools which doctors can use to manage their overall tax picture.
In higher income years, it may make sense to give a greater amount to charity. This can be particularly true for physicians who are nearing retirement, where taxable income may fall several tax brackets after retirement. Conversely, in lower income years, it may make sense to pare back or delay charitable gifts.
For doctors who are charitably inclined but who now take the increased standard deduction ($12,950 for single; $25,900 for married filing jointly) rather than itemizing deductions, it could make sense to use a “bunching strategy” whereby a taxpayer gives multiple years’ worth of charitables in a single tax year to itemize deductions in that year and then foregoes charitable gifts over the next several years while taking the standard deduction.
In conjunction with the bunching strategy, donor-advised funds (DAF) have become increasingly popular as a charitable vehicle to obtain a current year tax deduction for DAF contributions, while allowing the donor to control the pacing/timing of grants from the DAF to qualified public charities. Some physicians will use a DAF to offset the tax impact from the sale of real estate or a practice in the year in which the sale was made. Contact us here to learn more about how Forme Financial can help you set up a DAF.
Also, physicians should not overlook the enhanced benefit of gifting long-term appreciated securities, as the charity receives the same economic benefit as a cash donation. Concurrently, the taxpayer receives a tax deduction for the full market value of the gift and, importantly, avoids paying capital gains taxes on the gifted security.
Analysis assumes taxpayer subject to highest federal tax bracket (37%) and capital gains
subject to 23.8% federal tax rate. Analysis assumes charitable gifts are long-term appreciated securities and are made to qualified public charities.
Keep in mind that gifts of long-term appreciated securities to qualified public charities (including donor-advised funds) are limited to 30% of adjusted gross income (AGI) while similar gifts to a private foundation are limited to 20% of AGI. Charitable gifts in excess of the AGI limits result in a charitable carryforward which can be used over the next five years.
Satisfy Required Minimum Distributions using the IRA Charitable Rollover
The SECURE Act raised the beginning age for required minimum distributions (RMDs) to 72, from age 70½, previously. However, it did not adjust the age 70½ requirement for taxpayer eligibility to make a Qualified Charitable Distribution (QCD).
Under this provision, a taxpayer may gift up to $100,000 each year from an IRA to qualified 501(c)(3) charitable organizations (donor-advised funds, private foundations and supporting organizations are excluded). A qualified charitable distribution neither counts as an itemized deduction nor as taxable income, though it does count towards satisfying the RMD for that year.
This strategy may be beneficial for charitably inclined individuals who receive a greater tax benefit from the increased standard deduction rather than itemized deductions. Forme Financial can help you to determine if a QCD is in line with your goals.
Consider a Roth Conversion
With equities down sharply for the year and with income tax rates at historically favorable levels, the timing may be opportune for some physicians to execute a Roth conversion.
Doctors who believe their future tax rate might be higher than their current tax rate might consider converting a portion – or all – of existing Traditional IRA assets to a Roth IRA. Assuming the Traditional IRAs have no basis, the amount of the conversion is treated as taxable income; in exchange, the Roth IRA grows tax-free with qualified distributions also treated as tax-free.
Physicians with notable assets but with lower-than-usual income in 2022 might consider this strategy, as it allows them to essentially pay a reduced rate on the conversion while taxable income is low.
This strategy can be particularly beneficial for physicians with a taxable estate, as the tax cost of the conversion effectively reduces the size of the estate, while the named beneficiaries one day receive a very tax-favorable asset, compared to inheriting a Traditional IRA. In some cases, high net worth physicians might consider pairing a Roth conversion with accelerated charitable giving, as the charitable deduction will help to offset the effective tax cost of the conversion.
Note that there are a number of factors (time horizon, overall net worth, tax bracket, etc.) to evaluate to determine whether a Roth conversion might ultimately be beneficial. Forme’s tax planning analysis can help you determine if a Roth conversion makes sens for you.
Utilize Annual Exclusion Gifts
Individuals are allowed to make “annual exclusion gifts” which do not have gift tax implications. In 2022, the annual gift tax exemption is $16,000 per donee (increasing to $17,000 in 2023).
For high net worth physicians with – or likely to one day have – a taxable estate, utilizing annual exclusion gifts is an effective way to reduce their taxable estate while also helping loved ones.
As an example, consider Drs. Mike and Mary Jones – a very wealthy physician couple with two married children (four spouses total) and five grandchildren. In 2022, the Joneses, as a couple, could gift $32,000 to each of the nine individuals for a combined total of $288,000, without such gifts counting against their lifetime gift tax exemption. In making these annual exclusion gifts each year, the Joneses are able to carve out a notable portion from their taxable estate.
It is also worth noting that medical payments made directly to a medical provider do not count as taxable gifts. Furthermore, tuition payments made directly to an educational institution do not constitute taxable gifts. Tuition is narrowly defined as the cost for enrollment; it does not include books, supplies, or room and board.
Forme Financial can help you determine if there is a particular vehicle to use to maximize the benefit of this gifting strategy to you and your beneficiaries.
Utilize the Lifetime Gift Tax Exemption
The Tax Cuts and Jobs Act (TCJA), which was passed in December 2017, approximately doubled the estate exemption from $5.49 million per person in 2017 to $11.18 million per person in 2018. The lifetime gift tax exemption currently stands at $12.06 million per person (and will jump to $12.92 million per person in 2023), with a top federal estate tax rate of 40%.
The increased exemption amounts, under TCJA, are scheduled to run through 2025, after which the basic exclusion amount (BEA) is set to revert to the 2017 level of $5 million per person, plus inflation adjustments.
In recent years, the Biden administration and certain congressional leaders have proposed, albeit unsuccessfully, to lower the exemption amount.
While the elevated exemption is scheduled to remain in place through 2025, high net worth taxpayers should not lose perspective of the unique planning opportunity to get additional assets out of one’s taxable estate.
High net worth physicians should evaluate current assets and assess how much might be needed for their remaining lifetime, with consideration to gift ‘excess assets’ to loved ones. Depending on the size of an outright gift, estate planning which incorporates making gifts to trusts may be advisable to provide parameters or safeguards for the intended beneficiaries.
As a reminder, the Treasury Department and IRS issued final regulations in November 2019 clarifying that taxpayers taking advantage of the increased exemption amounts would not be subject to a future clawback, should the exemption amount decrease from current levels.
Review Estate Plans & Beneficiary Designations
As a matter of best practice, doctors should periodically review estate plans and beneficiary designations to ensure such plans and documentation align with desired intentions, as well as with changing rules and limits. Forme Financial’s estate planning analysis provides you with a visual outline that helps you understand your trust documents and if they align with your wishes.
Physicians who have recently experienced a significant life event (marriage, divorce, birth/adoption) may also need to make updates to existing estate plans and beneficiary designations.
As it relates to retirement account beneficiaries, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, enacted on January 1, 2020, effectively eliminated what was known as “the stretch IRA,” for which a beneficiary could stretch required minimum distributions (RMDs) for an inherited retirement account over their lifetime. Under the SECURE Act, most non-spouse beneficiaries (who inherit a retirement account after 2019) will be required to fully withdraw all inherited retirement assets by the end of the tenth year after the original account holder died.
Evaluate When to Collect Social Security Retirement Benefits
Physicians nearing eligibility for Social Security retirement benefits should give proper consideration for when to start benefits.
A review of 2016’s new Social Security recipients** showed nearly 60% of individuals collected benefits before their full retirement age (FRA), with only 10% waiting beyond full retirement age.
While general guidance is to wait until age 70 (if possible) to collect a higher benefit, there are a number of important factors to consider: anticipated life expectancy, income needs for the interim years when benefits would be delayed, availability of spousal benefits, etc. Forme Financial can help you evaluate the optimal Social Security benefit for you and your spouse.
Consider a Change in State Residency
Changing your primary state of residency is not as simple as spending more than half the year in a new state. With many states more aggressively contesting such residency changes, individuals should take extra precaution to ensure that “facts and circumstances” support the case for changing one’s resident state. Some of the factors that support a new domicile include: days spent in the new state for the year, driver’s license registration, voter registration, medical and dental care providers, country club or social club memberships, official mailing address to which mail and bills are sent, location of family heirlooms and artwork, etc. Additionally, Forme Financial has a compensation benchmarking tool to show you what your expected average salary would be if you changed states
* Source: https://www.cfainstitute.org/en/research/financial-analysts-journal/2020/empirical-evaluation-tax-loss-harvesting-alpha)
** Source: It’s Tempting to Take Social Security at 62. You Should Wait.” By Peter Finch. The New York
As the year comes to a close, we are here to help guide physicians through these considerations. Please contact any of the professionals at Forme Financial with questions.
The information provided herein was prepared for educational purposes only and is not a solicitation to buy or sell any security or insurance product, nor an offer to provide investment advice. All examples are hypothetical and for illustrative purposes only. Nothing contained herein should be construed as legal or tax advice and is not intended to replace the advice of a qualified tax advisor or legal professional. The information contained herein may have been compiled from third-party sources we believe to be reliable but cannot guarantee its accuracy or completeness.
Forme Financial is an SEC-registered investment adviser. Additional information about Forme Financial, including its services and fees, is available online at http://adviserinfo.sec.gov/.
This communication contains past specific securities recommendations for illustrative purpose only. Forme Financial makes no assurances, nor should it be assumed, that recommendations made in the future will be profitable or will equal the performance of the securities included in this presentation. Due to various factors including changing market conditions, such recommendations may no longer be appropriate; nor should any past recommendation be taken as personalized investment advice. You may request from us free of charge a list of all securities recommendation made within the immediately preceding period of at least one year accompanied by the following disclosures: (1) the name of each security recommended; (2) the date and nature of each recommendation; (3) the market price of the security recommended at the time; (4) the price at which the recommendation was to be acted upon; (5) the market price of each such security as of the most recent practicable date. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Any presentation of the performance of such past specific securities recommendation does not reflect the deduction of an investment management fee, or any transaction costs or custodial charges, the incurrence of which would have the effect of decreasing indicated historical performance results. It should not be assumed that your account performance of the volatility of securities held in your account will of will correspond directly to the referenced past securities recommendations.
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