Look Beyond Tax-Loss Harvesting
Selling stocks that are faltering is only the start for investors.
By Steve Dudash
December 5, 2019
WHEN IT COMES TO end-of-year money saving strategies, many investors appreciate the benefit of tax-loss harvesting, which entails dumping faltering stocks to compensate for or even to eliminate capital gains taxes on better-performing holdings in a portfolio.
Yet, there are a couple of other lesser-known tax strategies worth considering that also have the potential to save money this time of year, including taking advantage of after-tax 401(k) contributions and changing positions to avoid mutual fund capital gains distributions. (Keep in mind these are general strategies. You should meet with your CPA and financial advisor before pursuing either).
Due to an IRS rules change a few years ago, it is now possible to make after-tax 401(k) contributions. This is something that has the potential to give retirement savers a boost, even as most people are unaware that such a move is permissible.
The pre-tax 401(k) contribution cap for this year is $19,000 (plus the $6,000 catch-up allowance if you are older than 50). However, once you have hit that threshold, most plans will now continue to allow after-tax contributions, with the total limit being $56,000 ($62,000 if adding catch-up contributions), including employer matching.
As a result, you can contribute substantially more and let it grow tax deferred. Moreover, if you switch jobs, you can roll those after-tax contributions into a Roth IRA and never again pay taxes on those holdings.
This not only allows high earners to fund a Roth IRA without the standard income restrictions, but it provides the opportunity to make more significant contributions to that tax-free vehicle than the standard annual maximums typically allow.
This matters now, because many workers max out 401(k) contribution limits around Thanksgiving and then stop putting money into those accounts until the calendar turns. And unlike IRAs, 401(k)s do not permit you to make retroactive contributions from Jan. 1 until Tax Day of the next year, so there’s only a limited amount of time to take advantage of this strategy.
Mutual Fund Distributions
If you have taxable accounts, keep an eye on mutual fund capital gains distributions. Most investors – and even some advisors – neither understand how these distributions work nor know when they occur.
In simple terms, mutual funds make annual distributions when they experience gains, which are then distributed back into the fund. Of interest to investors, when you hold a fund during this period, you must pay taxes on that distribution, whether you bought into the fund three days before it happened or have had it in your portfolio for a decade.
To the IRS, you are a fund owner and, therefore, subject to both the advantages and the disadvantages that come with that title. There are, however, ways to avoid these phantom taxes.
The first is that if you are looking to invest in a mutual fund at this time of year, read the disclosures to determine when the fund will conduct its capital gains distributions – and then be sure to invest after that happens.
Secondly, if you already own a mutual fund that is about to make a distribution, consider exchanging it for a similar one that has already done so (If you sell the fund before it makes the distribution, you’re not on the hook for the related taxes).
The one caveat is that you have to be mindful of how the fund you are considering selling has performed. That’s because whatever gains or losses have occurred within that holding is an independent issue, so there could be separate consequences to unloading an investment just to avoid a distribution-related tax.
If you did make the sale, you could always repurchase the original fund. If you choose to do this, though, be careful about wash sale rules. As you can tell, this is starting to get complicated – so remember it’s always a good idea to work with an accountant and get your advisor involved.
Historically, funds making end-of-year capital gains distributions barely caused a ripple. When there were fewer funds, each one continuously added new investors, who then absorbed and, thus, minimized those costs collectively.
But as the mutual fund market has expanded, and with many mutual funds experiencing outflows, that dynamic has changed. Exasperating matters, with the market run-up in the past decade, some funds are essentially ticking tax bombs.
Up Against the Clock
With Jan. 1 fast approaching, you don’t have much time to consult your CPA and financial advisor to make the most of these tax-smart investment strategies. If you need any further incentive to act, remember that the 2017 Tax Cuts and Jobs Act instituted a higher standard deduction on income.
This tax rule change has set higher hurdles for households to qualify for itemized deductions, such as charitable giving. That, in turn, makes the little-known strategies cited here much more important for taxpayers.