The new year brings a new tax season and the opportunity to advise clients on ways to save money on their taxes.
Roth IRA conversions have long been a recommended strategy, and clients' investment losses last year could provide fresh impetus for converting individual retirement accounts.
"We're seeing that quite a bit as we have in prior years as well, that strategy of really creating another bucket of assets that can be utilized for cash distributions in retirement," said Michael Prinzo, managing principal of tax at Top 10 Firm CliftonLarsonAllen. "This year is a little bit unique as well, given some of the market downturns that we've experienced, as well as for some taxpayers who might have experienced a decline in income in 2022. They can take a silver lining from the challenging year of 2022 for many individuals, and convert a portion of a traditional IRA, pay tax at maybe a lower marginal tax rate if one's income has declined in 2022, and then create that tax-free asset that can either be used in retirement as a mechanism for tax redistribution, or potentially even as a legacy asset for beneficiaries in the future that you desire to pass assets onto."
Tax loss harvesting is another tried-and-true approach for investors during a market downturn.
"One of the common strategies a lot of taxpayers employed in 2022 is to take a harvesting approach with respect to capital losses in taxable portfolio accounts," said Prinzo. "As we've seen significant volatility in the markets, they're really looking at the opportunity to capture a capital loss, even for taxpayers that may not have a current use for that capital loss. One might not have capital gain income that they're looking to shelter with some of that capital loss, but to create a tax asset to be used in the future."
Capital losses can be used to offset capital gains, he noted. "If they exceed capital gains, then you can use capital losses to offset up to $3,000 of other income for married taxpayers filing jointly, and then beyond that, if there's still capital losses remaining, and that carries forward to the future year," said Prinzo. "We've seen a proactive approach to using that volatility to say, 'OK, I'm going to capture that loss and harvest it because I might need it in 2023 or future years to offset maybe capital gains that might come from the sale of a business or other assets that would be liquidated that would produce a capital gain in the future.'"
Investors who have been stung by steep declines in the cryptocurrency market and other assets can take advantage of such a strategy. "We see that aside from crypto, just capital losses in general, because the markets have obviously experienced a significant downturn broadly in 2022," said Prinzo. "It's creating that window of opportunity for folks to really think a little bit differently about how to leverage some of that downturn into a future tax asset by capturing that loss before the end of the year."
Those investment losses can be applied in future years and function as a kind of asset. They can be paired with qualified opportunity zones, a tax break from the Tax Cuts and Jobs Act of 2017 in which investors helped fund real estate projects in distressed communities.
"Capital losses that aren't used against current-year capital gains can carry forward and offset those future capital gains," said Prinzo. "We've often seen that strategy coupled with qualified opportunity zones. A couple of benefits from qualified opportunity zones is that one can defer a capital gain that they've incurred if they make a contribution into a qualified opportunity zone fund and then push that gain out until 2026 to be recognized in the 2026 tax year. Well, if I can push a capital gain out into the future, and then in the intervening time period, maybe take a proactive approach with the portfolio and harvest some of those capital losses, then I can accentuate my after-tax rate of return, because those capital losses can offset that capital gain that's coming in the future."
"We've seen quite a bit of interest in qualified opportunity zone funds because it also comes with a second tax benefit," he added. "That is, if an investor holds a qualified opportunity zone for at least 10 years, then any new gains that come from that asset are tax-free after that 10-year holding period. You can't do anything to manage that current capital gain that's contributed into an opportunity zone but any new gain that comes with that can be tax-free if you meet that holding period."
Qualified opportunity zones have attracted criticism since many of them have been in areas that were already gentrifying and attracting real estate investment, as opposed to the distressed communities they were supposed to help. The slow pace of development has also deterred some investors. However, the downturn in the stock and crypto markets last year could be bringing more investors back to opportunity zone funds.
"In part, the market conditions certainly impact the desirability of that," said Prinzo. "In the years prior to 2022, I think taxpayers in general experienced more capital gains, and you really need that capital gain in order to fund into a qualified opportunity zone. I think they were more common in prior years. There was also another tax attribute associated with those that expired a few years ago, where you actually got to decrease that gain that you were going to recognize. That has since expired and there are only two tax benefits instead of three. I think that mitigated somewhat the interest in opportunity zones, but we're still seeing that strategy employed regularly because of that tax deferral and that creation of a tax-free asset that can be utilized in the future."
Many taxpayers were making their end-of-year charitable contributions recently to qualify for tax deductions, but probably should be looking at charitable giving year round, perhaps in conjunction with their investments.
"Another great strategy is to look at how to fund those philanthropic goals," said Prinzo. "Oftentimes, we'll see that's done via cash or check, but for those investors who have appreciated securities in a taxable account, often we'll see a donation of securities and be able to realize that same fair market value deduction, and also not having to pay tax on that capital gain inherent in that security. It's a very common strategy to look at using appreciated securities to fulfill those philanthropic goals."
Bunching charitable donations can also be wise. "One other aspect to charitable giving that we've seen increase over the last several years, since the standard deduction increased significantly as a result of the 2017 Tax Cuts and Jobs Act, is we find that many more such taxpayers might be taking that standard deduction in lieu of itemizing deductions," said Prinzo. "One strategy that taxpayers can look at is maybe bunching of charitable contributions. One might make contributions for the current year and what they anticipate to make for the next year so they can itemize in the current year, and then they would take the standard deduction in the following year to take some of that benefit. In an almost every other year strategy, they bunch charitable contributions along with other itemized deductions, and then take the standard deduction in the off year."
Charitable remainder trusts are another way to donate to worthwhile causes, but also take advantage of tax breaks. "I think one strategy that will become more common as we look to 2023 is utilizing charitable remainder trusts," said Prinzo. "Charitable remainder trusts allow an individual to obtain a current charitable deduction, to retain an income stream of payments, and also to create a charitable legacy by using a vehicle like that. We've seen less charitable remainder trusts over the last several years because they are impacted by interest rates and, when interest rates are low, there's less of a benefit of using a charitable remainder trust. As we've seen interest rates increase, that planning strategy I think will be utilized much more in 2023 than we've seen it in prior years."
Other suggestions for clients can be pointing out the opportunity to maximize retirement contributions and funding of education accounts and health savings accounts. "Those vehicles, while they've been around for quite some time, are certainly tried-and-true strategies to help manage taxable income and create some baskets of assets that can be used to fund those various types of expenses," said Prinzo. "Although that's a common strategy that's been around for a number of years, we do see that as an effective one to help manage taxable income for individual taxpayers."
