Hard to believe we’re approaching the end of 2016, right? Terms like year-end tax planning and loss harvesting get thrown around. Here’s a look at some of the technical considerations for year-end planning. They apply to taxable (non-retirement) accounts only and are often geared towards families with significant investable assets.
Take Advantage of Tax-Loss Harvesting
You can deduct up to $3,000 annually through tax-loss harvesting; any overall loss above this amount can be carried forward to future tax years. Tax-loss harvesting involves selling one position with a tax loss—where the value is less than the cost basis—and purchasing another position that will hopefully increase in value. Be careful to avoid wash sale rules: you cannot purchase the same or substantially identical position within 30 days of the other position’s sale.
So what does substantially identical mean? If you're trading individual stocks, make sure it is not the same company. If you sell Dell at a loss and repurchase Apple in the same taxable account, you have successfully avoided wash sale rules although they are related industries. If, however, you sell Monsanto stock in a taxable account and immediately repurchase Monsanto stock in an IRA, you will trigger wash sale rules. Bottom line? If it is the same stock, you cannot repurchase it within the 30-day window—even in a different account. (For related reading, see: Tax-Loss Harvesting: Reduce Investment Losses.)
Moving beyond stocks, you could sell a large cap blend exchange traded fund (ETF), such as Vanguard’s Total Stock Market ETF (ticker VTI), at a loss and immediately repurchase a large cap growth mutual fund like Vanguard Growth Index Fund (ticker VIGAX) without running afoul of the wash sale rules. If you are strictly buying and selling ETFs, I suggest shifting into a different asset class. For instance, invest the proceeds of a domestic mid-cap ETF into an international or domestic large-cap ETF.
Consider Creative Charitable Giving Strategies
Most people will make year-end cash gifts to charitable organizations. But if you intend to give over $1,000 to a particular charity, consider gifting appreciated stock instead. Appreciated means it has a significant value above the cost basis—the price at which you purchased or inherited the position. Contact the charitable organization to ensure they accept the position, and avoid capital gains tax by sending it directly to the charity. (For related reading, see: Tips on Charitable Contributions: Limits and Taxes.)
Another option for philanthropic families is a donor advised fund (DAF). Under the DAF, you get an immediate tax deduction in the current tax year even if your proposed charitable grants are pushed into a later tax year. Fidelity and Schwab are known leaders for donor advised funds, but minimum account sizes apply (i.e., $5,000). DAFs are also great mechanisms to involve children in charitable decision-making.
Pre-Fund Education Costs
Do you want to start saving for your children or grandchildren’s education costs? There are separate guidelines for 529 education plan contributions and gift tax rules. Gift tax regulations allow you to gift up to $14,000 to a single beneficiary, and your spouse (if you are married) can gift up to $14,000 to the same beneficiary. Combined, the two of you can gift up to $28,000 to one person in 2016.
529 plans have a special “superfunding” gift tax rule whereby you can make five years worth of contributions in a single tax year. However, if you take advantage of this strategy you cannot make any subsequent 529 plan contributions until six years later. Each state has its own guidelines on the maximum 529 account value and state income tax deductions for 529 plan contributions, so read the fine print.
One other potential downside to 529 plan “superfunding” involves asset allocation. Let’s suppose you are single and make a lump-sum contribution of $70,000 this year to a 529 plan for a six year old. If you choose an age-based fund (typically a default), the six year old's account will be heavily invested in equities for the next four years. Common practice is for any new contribution to be 100% invested. So if instead, you fund $14,000 each year for the next five years, you can put fresh cash to work in each of the tax years. If the stock market declines within the next few years, you'll have a smaller setback with this strategy.
These are just a handful of the year-end planning techniques available to affluent investors. I could not cover all technical details of the strategies within this article but hope this provides a nice overview. (For more from this author, see: How to Achieve Financial Success in Your Marriage.)