Advisors have a timely opportunity coming up to help clients plan for a financially successful 2016. Tax optimization in particular can be tied to the calendar months.
Here are some action items advisors can keep in mind as soon as January starts that may make a big difference in clients’ after-tax returns.
1. Fund Early
Contributions can be made to a tax-favored retirement account as early as Jan. 1 this year, or as late as April 15 next year. It seems obvious that, the sooner you get your clients’ money behind the tax shield, the more money there will be for them to use in retirement.
However, research from Vanguard shows that many people are inefficient at funding their retirement plans. Vanguard examined the IRA contributions of its clients for the years 2007 to 2012. Only 10% of the contributions were made at the optimum point in January; over 20% were funded in the very last month possible.
Clients can significantly improve their after-tax returns by being more diligent when putting money away for retirement. Vanguard modeled the “procrastination penalty” to be over 10% of the ending value of the investment when comparing one who funds on Jan. 1 to one who waits until the last moment to make a contribution for the previous calendar year.
- Read more: Advisors' Exclusive Year-End Tax Tips
Sure, many of us make New Year’s resolutions to exercise. For clients holding incentive stock options, following through with that pledge can be critical in managing their possible Alternative Minimum Tax liability.
When clients exercise such options, there are AMT implications only if they continue to hold the shares they received past year’s end. The AMT is levied on the difference between the option exercise price and the market price at the time of exercise.
If the shares are at $100 and the option lets clients buy the shares at $20, there is $80 of income subject to the AMT, no matter what price the shares are sold for. Many ISO holders keep their shares after exercising, hoping to age them to long-term holding status. If the shares are sold for $100 after more than one year has elapsed, the $80 would be taxed as a long-term capital gain.
If the shares are disposed of in less than one year, then any gain above $20 is taxed as ordinary income. Unfortunately, many employees have watched their shares plunge in price and wound up paying an AMT on these near worthless shares. This is why the rules allow employees to avoid the AMT hit as long as they dispose of the shares before the year of exercise ends.
The rules do not grant clients 12 months to see how the stock does; they give the employee only until the end of the year of exercise to sell the shares and have no AMT implications. The government gave clients this option; it is up to them to make the most of this gift. If a client exercises on Jan. 1, he has 12 months to see how the shares perform; if he exercises in November, there are only two months to act.
The optimal plan is to exercise ISOs on Jan. 1; then, on Dec. 30, see if the stock is still trading considerably above the option’s exercise price. If the shares still have a lot of unrealized gain, it is probably worthwhile to hold on for two more days to get to long-term capital gains, remembering this choice comes with AMT implications. If the shares have declined, however, it may well not be worth paying the AMT, and the shares can be sold before year end.
3. Convert Now
Another area in which clients are granted a tax option tied to the calendar is in the Roth recharacterization rules.
The government again allows an escape hatch for clients who have made a poor timing decision that has financially punishing tax consequences. When clients convert taxable IRAs into Roth IRAs, they must pay a tax on their deferred income to earn the right to withdraw the funds later without future tax consequences. Ultimately, they are paying a tax now in order to not pay any taxes on the money going forward.
Within specific time limits, Roth converters can undo a transaction by recharacterizing, with the money reverting to the taxable IRA without triggering the conversion tax. They can do this until the last minute a tax return is due; taxpayers are allowed to seek a filing extension, so the final deadline to submit a tax return is on Oct. 15 of the calendar year after the conversion.
If a client executes a Roth conversion on Jan. 1, 2016, she would have until Oct. 15, 2017, to change her mind and recharacterize. If the client waited until November 2016 to do the Roth conversion, the time limit for unconverting would be half of that. Another factor, of course, which is unknowable, is the value of the investments on any particular date, so consider that, as well, when making or recommending such a move.
Robert Gordon is a contributing writer for On Wall Street, adjunct professor at New York University Stern School of Business and president of Twenty-First Securities.