It is that time of year again where the holiday season can be distracting from the rapidly approaching December 31 end to the tax year. Tax planning should be a year round endeavor but running through applicable issues with clients as the year comes to a close is an activity that is well received and appreciated by clients. Some elements are perennial but 2011 is unique in many regards for retirees.

They're back. For many, 2011 will mark a return to managing year-end capital gain distributions form mutual funds.

Mutual funds are required by law to pay virtually all net gains to their shareholders in capital gain distributions. For example, a fund share sells at a net asset value of $10, of which $2 a share represents net gains accumulated in the fund during the year from the manager's sales. A capital gains distribution of $2 will be deducted from the NAV on a specified date. On that date, the fund share price will decline to $8. Clients may think they lost 20% in one day. This can shock clients that don't know a distribution is coming.
The holding is still worth $10 but its form has changed. The fund's NAV is $8 and $2 in cash is coming on the pay date. If the dividend is set to automatically reinvest, it buys additional fund shares at the new, lower price of $8. The total value is still $10 but the cost-basis is now $12.

You should be combing your clients' taxable accounts and identifying which funds will be paying distributions. If they own, on the record date, a fund making a distribution, they will receive the distribution and be liable for the tax. Buy the day after the record date, they are in the clear. This means it may be wise to wait to buy certain funds to avoid "buying a distribution."  

Receiving a distribution is not necessarily a disaster. Despite taxes from the distribution in 2011, future taxable amounts will be less by the amount of the distribution.

If selling a fund before the record date would result in a lower gain than what is to be distributed, or a loss, consider getting out. Harvesting a loss may be what you would do even if there were no distributions to be paid.

I think it is wise to look for opportunities to take losses throughout the year but better now than not at all. With that said, loss harvesting is not as impactful as many make it out to be. Only $3,000 of losses can be used against ordinary income and, in the process of harvesting the losses, cost-basis is reset to a lower amount thus increasing future gains.

For simplicity, assume no other trades in a taxable account and ignore dividend and capital gains payouts. We buy $100,000 of a fund. It drops 30%. We sell for $70,000 and buy another similar fund with the proceeds. We have maintained our desired risk profile, avoided a wash sale and have "harvested" a $30,000 loss. We use $3,000 on this year's 1040 and carry forward $27,000. The new fund's basis is $70,000. It eventually grows to $100,000 and is sold. The loss available to offset the gain is $27,000, less $3,000 for each year in the holding period. The remaining gain is taxed at the then prevailing capital gain rate.

So, in our example if you sold the fund for $100,000 after 5 years, the taxpayer has saved tax on $15,000 of ordinary income (in five $3,000 installments), paid no tax on the first $15,000 in gain, but paid tax on the remaining $15,000 long-term capital gain at the rate in effect at that time. If we assume a 40% rate on ordinary income and today's 15% capital gain rate are in effect the entire five years, the total net tax savings on that $30,000 loss harvest is $3,750. Taxes saved minus taxes paid = [(5 x $3,000 x 40%) - ($15,000 x 15%)].

You are probably doing some good by harvesting losses, but for lower tax-bracket clients the benefits are modest over their retirement. Change the ordinary rate above to 25% and use a 20% LTCG rate and the total saved is only $750.  

In the example above, there are actually six rates that impact the math; one rate for ordinary income for each year and the rate for capital gain rates upon the sale. Retirees often experience lower taxable income prior to age 70½ and higher incomes after that due to required minimum distributions (RMD). Couple that with the potential for Congress to impose higher capital-gains rates and it is possible that for some, the savings on the loss harvest may disappear entirely.  

One of the planning opportunities lower tax-bracket clients have is gain harvesting. In 2011 and 2012, the federal income-tax rate on long-term capital gains and qualified dividends is 0% for gains and dividends that fall inside the 10% or 15% rate brackets. For some, this means we can sell and immediately buy back the same security (wash rule does not apply to gains) and effectively step up the basis, causing future gains to be less.

The zero rate only applies to gains to the extent there is still some room under the top end of the 15% bracket. Retirees, that take withdrawals from retirement accounts, for instance, may find the zero rate won't apply to much because there is little or no room within the 15% bracket.

That may be good. Getting retirement money taxed at 10% or 15% could be advantageous, particularly to retirees with large retirement account balances because future RMDs will be less. Clients with heirs in higher tax brackets may wish to take more than required to fill up lower brackets as well. Some clients that were thinking they would not tap their retirement accounts until 70½ might consider this.

Of course, rather than just taking and spending distributions from retirement accounts prior to 70½ or taking distributions in excess of the RMD, converting those amounts to a Roth can be even better for some households. Roths are not subject to RMDs and the ultimate rate paid on distribution will be zero.

Speaking of RMDs, clients who turned 70½ in 2011 are subject to the requirements for the first time in their life. You should consider whether to take that distribution in 2011 rather than wait until the first-year extension date of April 1, 2012. Delaying until then means two distributions in 2012 -- the delayed 2011 RMD and the normally required RMD for 2012.

Part of an RMD can be satisfied with a qualified charitable distribution (QCD) in 2011. For non-itemizers, this is a bigger benefit but even an itemizer gets a break. Just have the IRA send the cash ($100,000 or less) directly to the charity.

Charitably inclined clients should also know about the advantages of non-cash gifts. Explain the pros and cons of donating appreciated securities, for instance. It is easy to do since most charities these days have a brokerage account to receive such gifts. If not, it is an opportunity to open one for the charity and forge a relationship.

For non-charitable gifting, the annual exclusion of $13,000, the $5 million gift tax exclusion, and the zero long-term capital gains rate can all impact a family's gifting. Give appreciated shares to the unemployed son and have him sell for cash for no capital gains tax. Want to give six figures to a daughter and her family for a new house?  The client and spouse can each give $13,000 to the daughter and $13,000 each to the son-in-law before December 31 and another $52,000 after that date because a new tax year starts Jan 1st. In a short period of time, $104,000 can be gifted without using any of the $5 million exclusion. With more family members cooperating, even more can be transferred.

Considering more than one tax year is classic tax planning. It may be advantageous to accelerate or defer income. Consider timing mortgage payments, real estate tax bills, and charitable donations, for instance, to occur in either 2011 or 2012 if doing so provides a better overall outcome when looking at the two years combined.

There are many more methods and nuances and I would love to hear about your favorites. A year-end conversation with your clients about the techniques and opportunities that apply (or don't) to them can be a great opportunity to demonstrate your value as an advisor. Don't waste this chance. The clock is ticking.

Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at [email protected]
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