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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The fourth quarter will soon be upon us. Joining me to share some year-end financial planning to-dos is Tim Steffen, he's director of financial planning for Baird.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: So we are hurtling toward the fourth quarter of 2016. Let's talk about some things that investors should have on their radars as they are kind of looking at their portfolios and assessing their tax situations. Let's start out with taxes. For 2016 are there any big changes that people should be aware of?

Steffen: It's been another quiet year overall on the tax law front, not a lot of significant changes. I guess the big thing we've had is we've had some more permanency of some of the things that had in the past had been expiring on an annual basis. So things like charitable giving from IRAs and teacher expenses, out-of-pocket expenses, and some of the other extenders bills that we've always had the last few years. That's all been permanent now. So we are good on those. So if anything there's a little more certainty this year and going forward. But in terms of significant changes it's been pretty quiet.

Benz: OK. But you say that investors should still think about, as they are addressing their financial plans and certainly their tax considerations, they should think about whether there are any changes in their own situation. So let's talk about some big life changes that could prompt you to review your portfolio.

Steffen: Your tax situation might have changed dramatically this year, and it has nothing to do with law, it's just what's happened in your life. So the big one that we see is--one of the big ones--is retirement. Somebody who retired in 2016 after maybe working a full year in 2015 or who is going to retire in 2017, your income is going to change dramatically over the course of that two- to three-year period. And understanding what that means from a tax-rate standpoint and what types of deductions you might claim or would be more valuable to you--you really need to sit down and look at that. One of the recurring themes on tax planning is it's not a one-year thing, it's a multiyear thing. This is a perfect example of that, where what you do this year has an offsetting impact on next year. So you want to make sure you look at that on a multiyear basis, in particular in years when you are retiring.

Benz: So let's home in on that multiyear planning idea. Can you give some examples of how decisions I make in 2016 could have an impact on me in 2017?

Steffen: So the big one is maybe netting of capital gains and losses. So you find that you've got capital gains for this year, and you could sell something at a loss this year to offset that. But you look ahead to next year and maybe that's the year you plan to sell a business, for example, and that loss might be more valuable to you to offset a larger gain next year than maybe a smaller gain this year. Or maybe charitable contributions--if you are going to retire next year and maybe you get a deferred comp payment, or you are going to exercise some stock options connected to it, you may actually see your income spike. In that case charitable contributions might be more valuable to you a year from now when they are offsetting income that taxed at a higher rate. So we encourage people to do a multiyear projection, because any planning you do now is going to have an opposite impact on what you would do in the future. So you want to make sure you know what the cumulative impact of any change is going to be.

Benz: Can you address this idea of bunching deductions, what that means and when that might be appropriate to think about.

Steffen: So when you are talking about deductions and itemized deductions you are usually comparing what are my total itemized deductions, things like mortgage interest, property tax, state income tax, charitable contributions, and some others. How does that number compare to what would be the standard deduction? So if you are somebody who is kind of always right at about break-even in terms of total deductions compared to the standard deduction, it may make sense to in one year try to accelerate a deferred deduction so you can get a higher amount in one year and then a lower amount of itemized deductions the next year, which allows you to then use the standard deduction.

Benz: OK.

Steffen: For many people that's easier said than done. Things like state taxes and mortgage interest, you can't really move those much. Some states allow you to time the payment of your property taxes.

Benz: You could prepay if you wanted to have high deductions.

Steffen: Some states let you pay it in December or January so you can time when you get your deduction. Charitable contributions is probably the one you have the most control over in determining [whether] you want that in this year or next year. So the idea is a great idea if it works. Other things like that may be those that are subject to limitations, like for example medical expenses, which can only be deducted if they exceed a certain percentage of your income. Or miscellaneous deductions, which, again, can only be deducted if they exceed a certain percentage of your income. If you find every year you are just not quite over that hump to get a deduction, maybe you try and time it such that you can get two years' worth in one year to get over that threshold in one particular year.

Benz: OK. So let's talk about the portfolio level as you are thinking about your portfolio as the year winds down and also thinking about the tax implications of that portfolio. What sorts of things should investors have in mind?

Steffen: Well, the big one that people like to look at is gains and losses. So capital gains and losses. If you had a lot of gains during the year, you've realized some capital gains, you may want to take advantage of some losses that may be in your portfolio. Ultimately you'd rather always have gains than losses, but losses do have some value to you from a tax standpoint. If you are in a net gain position maybe realizing some of those losses can help reduce your tax liability this year. Ultimately any tax planning play you do, you implement, should have an overall investment strategy with it, too. You don't want to let the tax tail wag the investment dog, that's the old saying. So you want to make sure that if you are selling something for a gain or loss that it makes sense from an investment standpoint, especially if you are selling for a loss, because of the wash-sale rules. If you sell something for a loss you can't buy it back again for 30 days.

Benz: The very same security.

Steffen: Exactly.

Benz: Or even anything quite like it.

Steffen: A call option or something like that. Right. And that gets a little trickier when you are getting into mutual funds and ETFs, what's substantially identical to another. But you want to make sure from an investment standpoint it's the right thing to do first.

Benz: The sort of last-minute contributions to those retirement accounts. What about Roth conversions? If people have their eyes on doing Roth conversions or maybe they did them earlier this year, what should they be thinking about as they review the status of those accounts?

Steffen: So if you've already done a Roth conversion this year in 2016, you have until Oct. 15, 2017, to change your mind. So what some people will do is just do a big conversion this year and then see where the year shakes out, and then maybe after the first of the year, even late this year, recharacterize some portion of that to true it up to the actual amount they want to convert. You've even got some time in 2016 yet to maybe change a 2015 conversion, you've got until Oct. 15, 2016, to do something. So the whole idea of a Roth conversion is, or of the recharacterization, is finding what's the optimal amount to convert. And you may not know that upfront, but you've got time later on to find that out. 

Now the other side of this is if you did conversion earlier in the year maybe when the markets were struggling a little bit and you found that account is still down in value from the time you converted it, a recharacterization can help you recoup some of that. So rather than paying taxes on a value that's higher than what it's at now, you undo that conversion, wait a little while, and then reconvert again when it's maybe more optimal from a tax standpoint.

Benz: People really have quite a lot of leeway to undo these conversions to recharacterize. So it's something that people should look at.

Steffen: You can't do it over and over again, they stop those rules those serial conversions. But you do have plenty of time to make up your mind on that. So you don't even have to rush into it, you got as I said until next October to make up your mind.

Benz: OK. Another thing that you say investors should have on their radar is this idea of mutual fund capital gains distribution, it's something we keep an eye on here at Morningstar. Let's talk about that, why investors want to look out for these distributions and what sorts of impacts that they can have on those plans.

Steffen: So as mutual fund investors know, you may be a long-term holder of a fund but that doesn't mean you are not going to recognize gains. Because as the funds are realizing gains inside the fund that gets distributed out to you. Or if other investors are selling their shares, the fund has to sell investments inside the fund to pay them out, so you may get stuck with gains thanks to other investors getting out. Frankly there really isn't much you can do to avoid that other than sell the fund yourself.

So maybe you look, from an investment standpoint, you look for funds that aren’t going to have as high a turnover inside maybe, or if you do have one that you are anticipating larger gains from you could sell it yourself before that date comes. You may have to recognize some gains on your own, but it could be less than what the fund is going to send to you; it could be. So, try and get a handle on what that's going to be. In the next couple of months your funds are going to start estimating what their distributions are going to be. You'll have time to decide, do you want to hang in the fund and get that distribution yourself, or do you want to sell it ahead of time and manage that on your own? If you do get a capital gain distribution, again, that can be offset with losses, so all is not lost necessarily. You can still protect yourself from tax standpoint on those.

Benz: I guess a point I always like to make on this front is that you do get credit for those gains that you have paid taxes on, that your basis steps up. So it's not like you are necessarily going to be taxed twice, which I think some investors believe.

Steffen: I would agree. Back in the day before everything was so electronic it was easy to miss those basis adjustments, when you got those distributions, whether it's a capital gain distribution, or a dividend, or anything. That's if you reinvest it that basically adds more basis to your portfolio or to your investment. Now with everything done electronically I think most firms are pretty good about catching it, but it's still something to keep an eye on for the do-it-yourselfers.

Benz: OK. Tim, thank you so much for being here. We always appreciate hearing your insights.

Steffen: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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