Federal tax reform may or may not happen this year, but in the interim, investors may benefit from planning strategies that can reduce their tax liability for 2017.
1. Consider municipal bonds to generate tax-free income
Municipal bonds may be more attractive on a relative basis, particularly for taxpayers who are subject to the 3.8% investment surtax and who also may be subject to the highest (39.6%) marginal tax rate. These taxpayers have a higher tax equivalent yield, which is the yield an investor should require in a taxable bond investment to equal the yield of a comparable tax-free municipal bond.
2. Utilize strategies to reduce taxable income
Consider ways to reduce taxable income and to keep a taxpayer from reaching key income thresholds that could result in a higher tax bill. Strategies include contributing to a retirement plan or IRA, funding a flexible spending account (FSA), or deferring compensation income. Maximizing the use of tax deductions such as charitable contributions or mortgage interest can offset income as well. Investors also need to be mindful of transactions, such as the sale of a highly appreciated asset, which may increase overall income above the threshold for the 3.8% surtax, the income phase-out of itemized deductions, or the highest marginal tax rates.
3. Employ strategies with Roth IRA/401(k) contributions or conversions
In light of the ongoing federal budget deficit challenge, it may be helpful to use strategies to hedge against the direction of future tax rates. Younger investors or taxpayers in lower tax brackets may consider using a Roth IRA account to create a source of tax-free income in retirement. Like all income from retirement accounts, Roth income is not subject to the 3.8% surtax and is also not included in the calculation for the $200,000 income threshold ($250,000 for couples) to determine if the surtax applies.
4. Explore asset “location”: Allocate assets by tax status
Consider placing a larger percentage of stock holdings outside of retirement accounts and a larger percentage of fixed-income holdings inside of retirement accounts. Allocating a greater proportion of your buy-and-hold or dividend-paying investments to taxable (i.e., non-retirement) accounts may increase your ability to benefit from a lower tax rate on qualified dividends and long-term capital gains.
5. Be mindful of irrevocable trusts and taxes
Because of the low income threshold ($12,500 for 2017), income retained within an irrevocable trust will be subject to the highest marginal tax rates as well as the 3.8% Medicare surtax. Trustees may want to consider tax-advantaged investment choices inside of the trust (municipal bonds, life insurance). In addition, trustees may consider distributing more income out of the trust to beneficiaries who may be in lower income tax brackets.
When considering any tax planning strategies or new investments that could have an impact on your overall financial plan, it’s important to consult with a tax expert or financial advisor who understands your investment goals and financial situation. For more detail on these and additional ideas, read Putnam's article, “Ten income and estate tax planning strategies for 2017.”