About this time of year, it’s likely you’re in the middle of it with your accountant or tax preparer, as the return is due inside of a month. It’s likely, I’d say, there are quite a few hands on foreheads, as realization hits that once again some failure of action last year is creating pain, suffering and the payment of excess taxes today.
So, let’s not make the same error again. The fact is this: Now is the time to be thinking about how your investments will be taxed next year. Here’s your checklist:
Am I paying enough in fees? Seems like an odd question, but thanks to a steady tightening of Circular 230 over the years, tax preparers are exposed to the risks of incorrect tax filings via fines and penalties. Further, as the tax code becomes more complex, there are more gray areas requiring time and attention to see if they might offer an advantage. If your tax preparer is paid a fixed fee, or is paid ‘what they are always paid,’ there’s no incentive to delve into these gray areas. In fact, with fines and penalties looming for tax preparers who help file incorrect returns, there’s an incentive to prepare your return in the same way it’s been prepared in the past.
The upshot is that if you want to maximize your tax benefits, you may have to pay for the added value in the form of fees. While you may end up incurring more fees as your accountant works to navigate the ever-evolving tax code, the potential tax savings may be worth it.
Is my current tax advisor up to the job? Remember, almost anyone can sign a return as a preparer. No professional credentials needed. Further, even if your wealth managers are investment experts, they are not, generally, tax code experts. If your taxes are complicated, or you are retiring and considering distributions from tax deferred accounts, or sold a business or other assets, you need tax code expertise on your team. Though there are several options, we recommend having a Certified Public Accountant (CPA), or a tax attorney as your tax code expert.
Is my manager competent at tax loss harvesting? One of the most effective ways to mitigate taxes is so-called tax loss harvesting, a method of limiting the recognition of short-term capital gains that are typically taxed at a higher federal income tax rate. To capture this benefit, you sell a security that has lost value since you purchased it. Then, because of the wash-sale rule, you can immediately invest in a second security in the same sector as the first or wait approximately a month before you repurchase the original investment.
Tax loss harvesting is easier to explain than implement. There are a variety of nuances in the tax code that can trip up taxpayers and/or wealth managers. For instance, if your tax return filing covers more than one taxable account, all of those must be considered together (not separately) to comply with certain IRS regulations. Another wrinkle: If you are not fully exiting an investment, any dividends that are reinvested then sold in a wash sale would likely be flagged as improper, undermining the value and the yield of the harvesting initiative. And finally, any tax loss harvesting needs to be balanced against the transaction costs of buying and selling the securities in question.
So, is your wealth manager competent at tax loss harvesting? If you see all the wash sales occurring near the end of the year, that’s a red flag, as tax loss harvesting is best when it’s carried out over the course of a year. Don’t forget, investment decisions are made on the merits of return first and taxes second. Clustering wash sales near year-end gives tax considerations more emphasis than is appropriate.
Do I have the right team? Remember, your accountant or tax attorney is likely not an expert in investments, and your wealth manager is not an expert in the tax code. If your situation is complex, you likely need both. More importantly, they need to work together, collegially, to get the job done for you.
So while your accountant is up on the latest wrinkle in wash sale rules, your wealth manager needs to maintain a comprehensive understanding of finances and be mindful of changes your CPA or attorney needs to know about before next April. Some examples of these are becoming self-employed, exercising stock options or buying/selling shares in an ESOP. These are all taxable events that can be optimized if they are identified and planned for well in advance.
Nobody likes taxes. But with the right team—with the right skills—in place, who knows, this time next year you may even be smiling.