Avoid Tax Mistakes
Taxes Become Strategic for Financial Planning in 2013

We believe tax strategies for financial and investment advice will be resurgent in 2013. With domestic and international markets still weighing global risks to economic growth, investors will increasingly want to take taxes into account in their financial planning strategies. They will need to be mindful of both transactional and longer-term tax planning, and they need to be wary of certain tax “rules of thumb” that often are inappropriate or (worse) just plain error.

Notwithstanding the progress Capitol Hill is (or isn’t) making regarding deficit reduction, investors should not assume that all is settled on the tax front. Even if revenue-neutral changes are all we see for the next few years, many so-called “loopholes” may be closed, or the tax laws “simplified”, on the rocky road to fiscal responsibility. These changes, while not clearly visible today, must be anticipated to some extent in structuring one’s financial affairs.

Integrating tax considerations into one’s financial affairs involves two broad types of tax strategies, transactional and long-term.

  • Transactional tax strategies cover the immediate tax implications of a proposed investment or transaction. Structuring a transaction requires an understanding not only of the tax laws and rates, but of the specifics of all aspects of the investor’s tax situation.
  • Long-range tax strategies address the long-range tax considerations that will affect the investor – varying income levels over time and with phase of life, asset withdrawal years and amounts, and general tax principles and structures. Structuring tax flexibility into one’s affairs must be considered, to adapt to possible law changes. Even though long-range tax forecasts are necessarily inexact, they often can alert the investor about the likelihood of facing differing tax environments over time, and suggest how to take advantage of these differences.

Both kinds of strategies may, over the long run, contribute significantly to an investor’s after-tax returns and, ultimately, to their net worth – even if hard to measure precisely.

Common tax errors

Sometimes it’s easier to learn from mistakes than from perfection. Below we’ve outlined eight categories of misguided tax thinking that we believe could be costly. Skim the key headings for the top-level points, and know that income tax planning guided by a competent advisor can reduce the odds of tripping over these potential pitfalls.

Focusing excessively on tax minimization or avoidance: It’s not what taxes you pay, but what you keep after taxes. Considerations of both risk and return can illustrate this:

  • Similar risk, different taxation of return: Sometimes it can make sense, for example, to hold high-grade taxable corporate bonds instead of tax-free municipal bonds, if the after-tax return is higher. Tax aversion for its own sake can be costly here.
  • Incurring increased risk to lower taxes: Waiting for long-term capital gains rates on concentrated positions (such as employer stock or options) can save on taxes, but requires holding the undiversified asset longer than desired. The extra risk may not be worth the tax savings.

Confusing your marginal, effective or average, and situational rates: Being unclear on how exactly you are taxed can lead to poor decision-making. Phil Michelson, for example, recently made news (and noise) about leaving California because he thought (incorrectly) that he was paying over 62% in taxes.

    Many flavors of confusion exist regarding tax rates.

  • Top stated “marginal” rate: Investors often err in understanding the tax rates they face. Often they believe that everything they earn is subject to the top marginal rates – ignoring the benefits of the lower brackets. Crossing into a higher bracket does not cause every dollar to be taxed at the higher bracket – only the excess over the bracket limit.

    So – that last dollar of income won’t cause a dramatic increase in your total taxes. Don’t avoid earning it.

  • Average or effective rate: This concept combines the benefits of lower brackets, plus the impact of deductions. It divides total tax bill by gross income, and it is a much more sensible rate to think of when looking at total tax bite – for example, in gauging pre-tax retirement income needs. Focusing upon marginal rates would overstate your required income and distort your retirement planning.
  • Situational rates: Knowing the exact incremental tax from a proposed tax event requires knowing about virtually every aspect of your tax situation. There are many eccentricities in the tax law. Do not make assumptions, or you may face an April surprise – complete with interest and penalties.

Below are a few examples of situational rates that might influence your financial decision-making – or at least your tax payments:

  • Itemized deduction phase-outs: Essentially a surtax on income, capped at times by the level of certain deductions. Don’t decrease your deductions to avoid this – it won’t generally work, especially if your state has an income tax or you own property.

  • Multiple states: If you are subject to taxes in more than one state, ignoring income allocation rules could cause your state income taxes to be higher than necessary.

  • Kiddie tax and related: Gifting investment assets to children may not spare them being taxed at your rates. Similarly, trust tax brackets (steeper than individual brackets) may make holding back distributions tax-disadvantaged (more below under “tax location”).

Creating capital gains or losses without a non-tax purpose: Investors with losses often ask whether they should create gains to consume carry-forward losses. The general answer is “no” (there are exceptions for, e.g., grantor trusts and surviving spouses). Even if tax rates are rising a bit, at least four factors mitigate against this – 1) the losses might well be used to shelter gains caused by ordinary investment activity in a few years, 2) the gains might never otherwise be realized – either through step-up in basis, gift to charity, or other circumstances, 3) selling and then buying back restarts the holding period (you’re short-term for another year), 4) selling and repurchasing can cause transaction costs and fees, and (5) it doesn’t reduce your taxes by even a single dollar.

The opposite strategy, creating losses by selling and then repurchasing different investments (to avoid the wash-sale rule), can be beneficial but similarly is not universally appropriate. You may be forced to repurchase investments that are your second choice, simply because you sold during a dip; you will restart the holding period, and may create transaction costs; and you may be temporarily uninvested during the transaction, thus missing market participation.

Failing to adequately consider tax location in funding or withdrawing from accounts: Look at your whole tax structure, over time, in managing your portfolio – taxable accounts, IRAs and qualified plans, and Roth IRAs. Consider creating new tax-advantaged investment locations, such as cost-efficient variable annuities or charitable remainder trusts if they fit with your goals, liquidity requirements, and resource levels. Some examples:

  • Should growth assets always be placed in IRAs and 401(k)’s? These are long-term accounts, and so the thinking is that long-term assets such as equities are appropriate. But they convert all forms of income to ordinary income, taxed at higher rates - eventually. So, if you have the ability to hold some of your growth assets in a taxable account (where only the dividends are taxed, until sale) and your income-oriented investments in the taxdeferred vehicle, year-to-year you may be keeping more of your portfolio. Again, this is situational and depends upon your exact circumstances.
  • Should you always delay IRA withdrawals in favor of drawing down taxable accounts? You may experiencelow-income years that would result in low-tax withdrawals from IRAs and the like. For example, in the years immediately after retirement but before you start taking Social Security, it might be worth drawing on a large IRA – to avoid higher taxation later.
  • Should income from trusts be accumulated? Trusts allocate the taxation of income between the trust and the beneficiary. They reach the highest brackets in 2013 at $11,950 of income, at which point the 39.6% rate, plus the 3.8% for net investment income, are triggered.
    Some trusts allow for income to be accumulated, instead of distributed. While this may at times seem wise in order to prevent the beneficiary from “squandering” the distribution, it costs the beneficiary in the long run, if the beneficiary is in a lower tax bracket, as it may “squander” tax dollars. Consider alternative methods of regulating trust income.

Failing to look at taxes over multiple years: This question pertains to the timing of income recognition, the creation of deductions, and the timing of payments. Generally you’ll want to minimize total tax over the multi-year period, not\ simply the current year’s taxes.

  • Deferring income and its taxation isn’t always best. Sure, if receipt of income is delayed (e.g. from an IRA distribution or sale of an asset), your taxes on the current year are also delayed. But – will it cost you less in that later year? Taxation now may be cheaper.
  • Accelerating deductions isn’t always best, either. Accelerating deductions will generally lower your taxes for the current year. But those deductions, if they can be delayed, may prove more valuable in a later year. In particular, if the deduction in question isn’t allowed for the alternative minimum tax (e.g. state estimated income tax payments), and you are subject to the alternative minimum tax in the current year, generally you should delay payment of that item.
  • Permanent or timing difference: Some tax impacts (such as the adjustment for incentive stock option premium) go away over time. Thus, a current-year increase may be more than offset by decreases in later years, or at the point of sale.
  • Estimated taxes and safe harbor rules: Your minimum tax payment requirements are based upon your taxes for either the current year or the prior year – whichever is lower. While not technically changing the amount of tax due, paying too fast means you lose income on the prepayment – while paying too slowly costs you “interest” (technically called penalties) on the tardy payments.

Coordinate your tax payments with these requirements – and with considerations relating to timing of taking deductions, as discussed above.

Failing to keep current on tax laws: It’s hard to keep current on every new law, and then to know if it’s going to apply to you. Take for example, the new tax on net investment income (NII) of 3.8% when NII causes modified adjusted gross income to exceed $250,000 for a couple filing jointly. You may think this doesn’t apply to you generally, but there could be years where, due to special events such as sale of a rental property, or large severance pay, or big bonus, that you suddenly find you are over that line – and the NII tax kicks in.

If you can’t keep up with it all – hire an advisor who can do it for you.

Failure to perform enough detailed record-keeping and tracking: While not very exciting, there are some areas where taxpayers can easily leave money on the table if they don’t track some key details. Two examples: 

  • Non-deductible IRA contributions: Improper tracking exposes the taxpayer to higher federal and state taxes later on.
  • Alternative minimum tax basis: Most commonly missed relating to incentive stock options, ignoring this can cost the taxpayer when the stock acquired is finally sold.

Pursuing one enticing tax planning idea when other strategies may be superior: Sometimes the latest device or rule, or one that’s about to go away (pressure to use it while it lasts!), isn’t your best approach. Take, for example, direct IRA charitable rollovers for individuals subject to required minimum distributions (i.e. over age 70 ½). These rollovers allow (through the end of 2013) a direct payment from your IRA to charities, without the payment counting as either income or deduction. Sometimes this direct charitable rollover is best, but sometimes other strategies (e.g. contribution of appreciated property) are superior, because you get to give away the unrealized gain while keeping the deduction. Check out the differing approaches and find the one that maximizes your tax benefits in your specific situation.

Tax planning, over multiple years, working with an experienced tax advisor, can help avoid these mistakes. Do not let the complexity paralyze you – there are benefits to acting, even under uncertainty. The interactions of these different changes are complicated, and the exact impact is difficult to estimate. Planning now can only open up possibilities.


Please note that the strategies discussed herein can be complicated and Weston Financial Group, Inc. (“Weston”) does not recommend trying to assess and/or implement them yourself. This piece is a very high level summary and is not intended to cover every aspect of the changes to the tax laws.

We recommend contacting your tax advisor and your Weston financial counselor with any questions you may have regarding these strategies and questions concerning your specific situation.

This information is for educational purposes only and is not intended to serve as investment, legal or tax advice. The opinions expressed herein are those of Weston as of the time of the articles issuance. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is neither representation nor warranty as to the current accuracy of such information, nor liability for decisions based on such information.

Tax Advice Disclosure: To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for purposes of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.

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