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Harvest Your Wealth: Tax harvesting, estate planning, and income strategies to consider for 2017 and beyond

Feb 06, 2017 10:35AM ● By James Houck
By James Houck

By the time this sentence is read, our nation will have sworn in its new President and with him, ushered in a short-term era of uncertainty with regards to the economic molding of our country and, specifically, tax law. Even more specifically, how will income tax brackets and what you owe change?

For better or worse (and we most certainly are hoping for the better), there are fundamental rules to the taxation game that we abide by no matter who’s in the Oval Office or Governor’s House.

“People love to speculate about future tax changes based on expectations about a new administration. What they seldom recognize is that our tax system is not that easy to maneuver or change,” suggests professional fiduciary and investment manager Carlos Sera. “Furthermore, there is no clear indication from this administration as to where they will even attempt to go with regards to tax policy. The president has his ideas about taxes that don’t seem to align with the ideas of the Republican Congress. It remains to be seen what will happen. [But] they will not surprise the taxpayer…therefore, our advice is the individual investor should do nothing and wait until things become clear.”

Yet there are strategies worth considering that can help offset any financial discomfort that, otherwise, arises from fluctuations in a myriad of other variables (capital gains/losses, retirement, death) that influence our taxes. How best to mold your own money when the government comes calling? Here are several financial considerations with which you should familiarize.

Capital Gains/Losses & Tax Harvesting

For those playing the long game—that is, investing long term for retirement—consider tax harvesting.

What is it? In simplest terms, and quoting Investopedia, “Tax gain/loss harvesting is a strategy of selling securities at a loss to offset a capital gains tax liability. It is typically used to limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates than long-term capital gains, though it is also used for long-term capital gains.”

For example, let’s suppose that you hold two separate mutual funds (or any security for that matter): Fund A and Fund B.

You’ve held Fund A for 400 days and it has performed quite well with an unrealized gain of $200,000.

You’ve held Fund B for a similar amount of time, yet it has an unrealized loss of $100,000.

Suppose you’d like to sell Fund A for a realized gain of $200,000, yet hold onto Fund B in hope that it’ll perform better with time. Well the federal tax on that gain would be 20 percent, or $40,000.

But with a tax harvesting strategy, you would sell both Funds to offset the tax on the gain and use the savings to reinvest in similar funds to maintain a balanced portfolio.

Fund A and Fund B would both be sold for a realized gain of $200,000 and a realized loss of $100,000. The tax on that activity would thus be:

($200,000 – $100,000) x 20 percent = $20,000

The harvested tax savings of $20,000 could then be used to reinvest in similar funds to maintain a balanced portfolio. This example is simple and assumes the investor is within the highest marginal tax rate bracket of 39.6 percent, in which this investor’s long term capital gains (sold investments held for more than 365 days) are taxed at 20 percent. (Short term capital gains by comparison—sold investments held for less than 365 days—are taxed at the investor’s ordinary income tax rate.)

This strategy, if employed year over year, can dramatically save on taxes and help a portfolio still maintain diversification and risk/return levels.

Estate Planning & Inheritance

Local CPA Dirk Rinehart suggests a breakdown of estate planning in 2017. “For tax year 2017, an estate of $5.49 million or less will not be subject to federal estate taxation. For a married couple, a surviving spouse may also use his/her spouses unused exemption amount (DSUE) and increase his/her exemption to $10.98 million. A surviving spouse is required to file a federal estate tax return; Form 706, to claim the transfer of his/her deceased spouse’s unused exemption. Estates in excess of the $5.49 million exclusion are taxed marginally at rates ranging from zero percent for a taxable estate of $10,000 or less to 40 percent for a taxable estate of greater than $1 million.”

It’s important to note that estate beneficiaries are not taxed on any estate assets received. “Any assets received have the tax basis determined by the decedent’s estate; a ‘step-up’ in basis to the fair market value as of the decedent’s date of death adjusted for any income recognized and retained by the decedent’s estate. In addition the holding period for any estate assets received by a beneficiary is classified as long-term regardless of the time actually held by the beneficiary.”

 The incoming Trump administration has proposed elimination of the federal estate tax.    

In addition to the federal estate tax, Maryland has a separate estate tax requirement. For 2017, an estate valued at more than $3 million would be required to prepare and file a Maryland Form MET-1 to report the Maryland taxable estate. The Maryland estate tax rates range from zero percent to 16 percent based on the amount of the estate in excess of $3 million.   

Maryland also imposes an inheritance tax that is collected by the Register of Wills located in the county where the decedent either lived or owned property. The tax is imposed on the clear value of property that passes from a decedent to certain non-lineal descendants. The tax rate for this tax is 10 percent. The inheritance tax paid to the Register of Wills is subtracted from the gross Maryland estate tax liability and the difference is the Maryland estate tax due.

And, although technically not a tax, the fees assessed to probate assets will reduce the net estate to be paid to a decedent’s beneficiaries. Probate is the legal process by which the assets of a deceased person are properly distributed (if he or she had a will) to the beneficiaries or heirs through an executor named in the will, or (if he or she died without a will) according to the local law by a court appointed administrator. Certain assets such as jointly held assets; assets passing to a beneficiary by a valid beneficiary designation; and assets held in a trust avoid the probate process. Probate fees are commonly computed based on the value of the probate estate. In addition, the probate process may result in additional fees for a surety bond, attorneys, and accountants. 

“Effective estate planning can serve multiple functions,” Rinehart continues. “Assets can be transferred and, in some cases, managed after the decedent dies consistent with the decedent’s wishes and intents. The only way to effectively manage this process is through various legal instruments such as a valid designation of a beneficiary or beneficiaries; a will; or a trust. Persons dying with no estate planning documents are subject to the laws of the state where they die, or the state where certain assets such as real estate is located, for the transfer of their assets.”  

Because of the “step-up” in basis that occurs at death most non-retirement assets are distributed to the recipient beneficiary at the fair market value on the date of the decedent’s death. Effectively, any deferred income inherent in most real estate owned and used personally by a decedent; or in stocks, bonds, exchange traded funds (ETF), or mutual funds held in any after-tax account would avoid recognition. This income is never taxed. “Beneficiaries should know or research the fair market value of any real estate or investments received from a decedent’s estate. For real estate, an appraisal performed by an independent certified appraiser not long after a decedent’s death is strongly urged. Most publically traded investment instruments can be readily valued at the market price on the date the decedent died.”

For most individuals there are certain easy and relatively inexpensive steps that can be taken to protect their assets and assure that these assets are transferred consistent with their wishes. First, individuals should consider preparing a Last Will and Testament. A will expresses a decedent’s wishes including the management and distributions of any assets held at death. Continuing, it is a sound practice for anyone owning a retirement account to confirm that his/her beneficiary designations are completed and up to date. Designated beneficiary can “stretch” an inherited retirement account beyond five years. This strategy provides the opportunity for greater tax deferred growth over a longer period. Additionally, tax deferred retirement accounts that designate beneficiaries to the account avoid the probate process. For some individuals more elaborate estate planning may be warranted.  Generally these plans entail the use of various trust instruments to manage and control their assets.