Last December, Republicans in Washington passed the biggest changes to the U.S. tax code in decades, and while most of the really significant alterations were made for businesses (hello, corporate tax cuts!), there are plenty that will directly affect what ordinary Americans will pay to Uncle Sam. Based on analyses done at the time, a large fraction of the middle class will find their annual tax bills shrinking a bit, but another significant share is on course to owe a lot more. As we approach the end of 2018, Motley Fool Answers hosts Alison Southwick and Robert Brokamp want to help you get a jump on tax season, so for this episode of the podcast, they've brought an expert into the studio: Megan Brinsfield of Motley Fool Wealth Management.
In this segment, they get down to brass tacks: The rules have changed, which means that your strategies may need to change, too. They talk 401(k)s, 529 plans, flexible spending accounts, and charitable donations. They also explain why this is the wrong time of year to invest in an actively managed mutual fund, why it's always the wrong time to mess up your tax-loss harvesting moves, and why it may not be too late to adjust your withholding to match your new tax situation.
A full transcript follows the video.
This video was recorded on Oct. 16, 2018.
Robert Brokamp: Let's talk a little bit about what you can do before the end of the year. Here are some things you can do to hopefully lower your taxes by December 31st. I'm just going to tick off a few of these. Probably you're familiar with some of them. Contribute to a traditional 401(k) or a similar employer-sponsored plan you have until the following year's tax deadline to contribute to an IRA, but you have to contribute to your 401(k) by December 31st.
Contributing to a 529, as long as you use it for qualified education expenses, comes out tax-free. You don't get a federal deduction, but depending on your state, you might get a deduction and for some states, you don't even have to contribute to the state plan. You just get a deduction for contributing to the plan. And furthermore, as part of the new tax law, now up to $10,000 a year from a 529 can be used for not just college, but elementary and secondary school expenses. So the tax law has expanded the ways you can use a 529.
Charitable contributions. Megan, maybe you can talk a little bit about that. First of all, you have to itemize, so for a lot of these people, they really won't get much tax benefit from charitable donations. Am I correct on that?
Megan Brinsfield: Yes. If you're on the bubble between itemizing and not, the charitable deductions you're going to see some zone where you're not getting a full benefit. And that's unfortunate, because a lot of people do contribute for the tax benefits.
Brokamp: Now there's one way you can try to get a benefit from that, and that is like lumping or bunching your contributions together in one year.
Brinsfield: Right. I like talking to people about lumping and bunching. It sounds like a really fun party technique.
Brokamp: It's a bonus tax bracket.
Brinsfield: Let's say you're capping out at your $10,000 of deductible state and local taxes and your only other deduction would be charitable contributions. What you might want to do is perhaps not make any charitable contributions one year and then double up the following year so that you are getting benefit from the standard deduction, which is higher in one year and maximizing the use of your charitable deductions in the next year.
We have actually seen this quite a bit with our clients in Wealth Management. That they might utilize this bunching technique by contributing to a donor advise fund, which is kind of frontloading a bunch of charitable contributions in one year and then you can dole out from that fund over time to the charities of your choice.
Brokamp: One thing that you can do, whether you have itemized or not, is to donate appreciated stock. Talk a little bit about the benefits of doing that. We're talking about a stock that is outside of a retirement account.
Brinsfield: So if you hold a stock outside of a retirement account and it is also been held more than one year, you have this long-term capital gain that's built in and when you donate that stock to a charity, you can take the fair market value as a deduction. That is opposed to selling the stock, recognizing the gain, paying the tax on the gain, and donating the net cash.
So a lot of people -- their hang-up with this is if they have a position that they've held onto and they've seen it run -- like seeing that in their brokerage account. I like having Berkshire and being able to see its growth. And what we recommend for those folks is doing a donate-and-replace strategy, where you are donating the stock and getting the deduction at the full market value...
Brokamp: And again, avoiding the capital gain...
Brinsfield: ... avoiding the capital gain and then rebuying the stock at the same price where you donated it. You are basically getting this free step-up in basis when you do that.
Brokamp: Another thing people have to think about for the end of the year is required minimum distributions from traditional retirement accounts by the time you're age 70 and a half. It's something that you should keep in mind. If you have several IRAs, you only have to take the RMD from one IRA, but if you still have 401(k)s or anything like that, you have to take the RMD from each individual account.
Brinsfield: And if you have a Roth 401(k) sitting out there and you're over 70 and a half, that also applies to your RMD.
Brokamp: Right. Then the way to get around that would be just to transfer it to a Roth IRA.
This is just something to avoid, and that is if you're thinking of buying an actively managed mutual fund outside of a retirement account, this is the time of year when mutual funds make their capital gains distributions and you have to pay taxes on those gains whether you've owned the fund for 10 years or 10 days, and you don't want to be paying capital gains taxes on a fund that you've only owned for 10 days.
So if you're going to buy an actively managed fund -- index funds and ETFs probably not so much, but really any fund -- if you're thinking of buying outside a retirement account at this time of year, it's a good idea to contact the fund company to see if they plan. They often will have estimates of what gains distributions are going to make.
Always a popular topic at this time of the year is tax-loss harvesting. It's essentially selling an investment at a capital loss. It could be a stock, but it could be a bond, and definitely for the last year and maybe even two years depending on the bond you own, they could be down. Sell it at a loss. Get that capital loss. It can offset gains or up to $3,000 of ordinary income. That's the basic idea.
You, I'm sure, have seen this in action quite a bit. And one thing that trips people up, of course, is the wash-sale rule, for example.
Brinsfield: Right, the wash-sale rule where you just have to watch out for repurchasing those stocks within a 30-day window before and after.
Brokamp: But the workaround that. You can't sell it in your taxable account and then buy it in your IRA. Or buy an option on it. There are lots of ways that people get around it, but a lot of the time that will trip you up.
Brinsfield: Or even you sell it and then you have your spouse buy it in their account. That's also something that the IRS doesn't like. I think a lot of people probably overestimate the value of tax-loss harvesting. That you could potentially be out of the market for a period of time and essentially what you are doing is you're deferring tax, but it might not be that valuable, depending on your tax rate.
So I think it's important to take a look at the overall picture. If your portfolio needs to be rebalanced and that involves selling some positions at a loss, certainly go ahead and do it. But a lot of the targeted tax-loss harvesting that's being done is lowering your cost basis for the future where tax rates might be higher.
Brokamp: Right. One thing people don't appreciate so much is tax-gain harvesting. What is that?
Brinsfield: I love gain harvesting because there's this window of opportunity in the tax code where you can recognize long-term capital gains at a 0% tax rate, and that's not a very common tax rate. So married couples can have up to $101,400 of total income and still get this 0% long-term capital gains rate. I think people assume that they have to have this low income in order to get this gains-harvesting benefit, but that's not true. You can actually have a pretty substantial income and still reap those benefits.
Brokamp: And there's no wash-sale rule on that. You can sell it for a gain today and rebuy it tomorrow, and you're still realizing that 0% long-term capital gain. That said, the more you sell, the more that does push you up. At some point you could sell so much that some of those gains will be taxable.
Brinsfield: Right. If you go over that threshold, anything over that threshold is going to be subject to the next bracket up, which is 15%.
Brokamp: But the stuff below that threshold is still tax-free, essentially.
Brokamp: Depending on where you work, you might have a December 31st deadline on spending the money in your flexible spending account, so that's definitely something to think about. If you don't have one, this also might be the time of year to consider opening one because this is open enrollment season for a lot of folks.
Brinsfield: Exactly, and I'm a big proponent of the flex spending account, so when fellow Fools come up and ask me about what are benefits that not a lot of people use, I think the flexible spending account is one that is very underrated. People say, "Well, I don't have that much in medical expenses. I don't know if it's worth it. I've got to collect receipts."
And the fact is a lot of people have "medical expenses" that could go through this flexible spending account program. There's a website called FSAstore.com which we have no affiliation with, but it's fun to browse because everything on that website is eligible for purchase via your flexible spending account. So I got some Band-Aids, and a first aid kit, and sunscreen. It's fun to do a little shopping spree on there.
The other thing with flexible spending accounts is that you have to earn a lot more after tax than you think. Let's say you live in a state that has no tax and you're in the 24% bracket. The equivalent of getting $100 in your flexible spending account is earning $150, paying taxes on it, and then going and buying it. So when you multiply that out and see that you can have like $2,500 in your flex spending account, that really adds up quickly.
Brokamp: Well, that does sound like fun looking at that website.
Brinsfield: Have I convinced you?
Brokamp: You convinced me, but maybe not as fun as another fun tax fact.
Alison Southwick: Hey! This time we're going to Sweden. In Sweden, people are required to have their children's name approved by the Swedish tax agency before the child turns five. If the parent doesn't do it, they will be fined $5,000 krone which is about $770. The law was originally put in place in 1982 to prevent citizens from using royal names, but the law states that the rationale is that by approving a name, the tax agency can protect the child from an offensive or confusing name.
So you cannot name your kid Ikea or Allah in Sweden; but they recently approved Google and Lego. So just name away.
Brokamp: Obviously when you do your taxes, a lot will depend on how much you've had withheld throughout the year. That will determine whether you get a refund or whether you have to pay any. A recent GAO study found that so far this year they estimate that only 6% of people are withholding the right amount, and by right amount they were within about $100 of what they should be. Most people are having too much withheld, but a large proportion are not having enough withheld.
So my first question for you, given that we only have about 11 weeks left in this year, do you think it's worthwhile for people to look at their withholdings for this year and try to change anything for these last couple of months?
Brinsfield: I think it could be. People that are going to be most affected by this change that we've seen this year; the TCJA also changed how employers are required to withhold tax and for many people that happened seamlessly. They were just using their old records on file maybe when they started and persisting those deductions into the future, and that can really hurt if you're someone who used to itemize a lot, because that means under the new tax code, we're assuming that you're going to be taking deductions that you don't actually qualify for anymore.
Those are the people who are most likely to need an adjustment, here, at the end of the year in order to get themselves up to speed on the tax that they probably should have been paying throughout the year.
That being said, I think a lot of times it's really just a matter of housekeeping. Checking in on that W4. It's a really fun form, at least for payroll people. Just checking it and making sure it still makes sense. And if you've gotten married. If you've had kids. If you just haven't looked at it in a while, kind of doing a sense check on that.
Brokamp: How much do you have to underpay for you to worry about penalties? No one really wants to underpay because then come April 15th and you have to pay money. But how much does it have to be before you to have to pay penalties on top of that?
Brinsfield: You have to underpay less than 90% of what you should have. So if you owe $10,000 in taxes but you only paid $8,000, then you would be penalized for the $1,000 shortfall that you had over the course of the year.
Brokamp: That brings us to the upcoming year. Whether or not you should look at your withholdings too closely for this year is somewhat debatable, but definitely come December you should be looking at what you're having withheld for 2019.
A couple of things that will probably be changing for 2019 -- they have not been officially announced -- is that the contribution limits on 401(k)s and IRAs will probably go up because they are adjusted in increments based on inflation. We actually saw some inflation this year, so based on some analyses I've seen, we should expect those to go up. That's something to consider and budget for, for the upcoming year.
And those aren't the only things that are adjusted for inflation. The standard deduction is tax brackets. All kinds of things do go up, so that is one thing that will change your taxes. Anything else that's significantly different, though, for 2019?
Brinsfield: One of the big things that was kind of a delayed implementation from the tax plan was removing the mandate for Obamacare. So under the old tax plan, if you did not have adequate health insurance for the year, you had to pay a penalty for that, and going forward that will not be the case. You can live free and easy and assume you're going to be healthy forever and not get insurance and not be penalized for it outside of maybe judgmental stares.