Are Your Tax Strategies Like a Good Homemade Soup?
I enjoy making homemade soups. Sometimes I use recipes, and sometimes I try different ingredients not on the recipe. One day, I was making “stone soup” with all my leftovers in the kitchen. I roasted 4 carrots, 1 yam, and 1 baked potato. I them pureed them and added them to my chicken stock. I was so excited when the broth took on the creaminess of those roasted vegetables. I then proceeded to add the other normal ingredients of chicken and orzo. To my delight, the addition of these extra ingredients kicked my soup up on the delicious scale.
Today, I am going to show how you can do the same for your tax strategy soup.
I have eight strategies that help you to maximize your tax savings. Thus far, we have discussed four of those strategies: diversifying your income sources and utilizing IRAs , helping your children fund their own IRAs, charitable giving, and health savings accounts.
Today we continue on by learning about how to utilize municipal bonds and understanding net unrealized appreciation.
Strategy 5: Using Municipal Bonds
If you are a high-income earner, incorporating municipal bonds into your taxable accounts may be a good tax strategy.
When your portfolio construction calls for some fixed income allocation for the purpose of diversification to reduce risks, various bonds, such as high-yield bonds, corporate bonds, and government bonds, can be purchased in your IRA account because the interest income is not reported on tax returns each year. Remember, you only have to report income from an IRA when it is distributed out of an IRA to you.
If you buy the municipal bonds in your resident state, interest is tax-free at both the federal and state level. If you buy municipal bonds in other states, you still receive tax-free income at the federal level.
For example, an investment-grade municipal bond in Minnesota that matures on February 1, 2030, and pays 3 percent annual interest, is equivalent to a corporate bond that pays 5.44 percent. How did I figure this? First, let’s presume you’re a resident of Minnesota, your federal income tax bracket is 35 percent and your Minnesota tax bracket is 9.85 percent. This makes your combined tax bracket 44.85 percent. The calculation for tax equivalent rate is: 3 percent is divided by (1 minus 0.4485) = 5.44 percent.
If you cannot find the similar credit rating and maturity date of corporate bonds that pay as high as 5.44 percent, then consider buying municipal bonds to receive tax-free income inside your taxable account (joint, individual, or revocable trust account).
Strategy 6: Net Unrealized Appreciation Strategy (NUA)
Before the Enron crisis, many employers matched company stock in employees’ 401(k) plans, and employees kept that stock for many years.
As they retired and considered taking distributions from their 401(k), they had to decide what to do with the employer stock. Before deciding to sell the stock inside the plan and rolling over the entire balance to an IRA, an analysis of cost basis and tax situation should be completed.
If the stock’s cost basis (the original purchase price) is low and in the region of 20 percent to 30 percent of the current market value, it may make sense to transfer the shares to a taxable brokerage account (such as joint, individual or revocable trust account, but not an IRA account). You would pay ordinary income tax on the cost basis only in the year of taking the stock out of the 401(k) plan.
Any appreciation above the cost basis is treated as long-term capital gains when you sell the shares inside your taxable brokerage account.
The mutual funds inside your 401(k) could be sold, and the entire balance must be rolled over into an IRA in the same calendar year as you take the stock out of the plan. The benefit is to pay long-term capital gains tax (maximum 20 percent, lower than the ordinary income tax rate) on a substantial portion of the appreciation.
In December 2018, my client Mary’s father passed away suddenly at the age of eighty, and her mother, Susan (age seventy-nine), inherited a large 401(k) plan balance with about 40 percent in employer stock. The cost basis was about 20 percent of market value.
I reviewed the most recent 401(k) statement on December 14 and learned that the required minimum distribution (RMD) for the year 2018 was about $50,000. This needed to be taken out immediately to avoid a 50 percent tax penalty assessed by the IRS.
After analyzing her other assets, Social Security income, and pension income to calculate her projected tax rate in the future along with her estimated living expenses, it became apparent that taking out this employer stock in-kind and paying income taxes on the $75,000 cost basis was the best choice for her because this distribution of stock met the RMD requirement for the year.
She would have over $350,000 worth of stock in a taxable account on which she would potentially pay lower long-term capital gain taxes on the appreciation above $75,000 cost basis when sold at a later time.
This timely action before the end of the year resulted in an immediate savings of $25,000 in IRS penalties and gave her peace of mind.
A lesson for you all: never wait until the second half of the year to take the RMD, as it may take a few months for the beneficiary to figure out how to take the RMD in a timely fashion.
When she passes away, her children will inherit this stock with stepped-up basis so that they don’t pay any taxes if sold.
I know some of you are saying, whew! Again, this is a great example of the need for a financial planner, a quarterback, one who knows what to do, when and how to do it, all in order to save your money.
I will wrap up the last 2 tax strategies our next time together. Until then, I would like to hear about your favorite unexpected ingredient in your soups. Please share below, I’m hungry. (P.S. - If you don’t know the story about stone soup, research it. It is a great teaching story.)
