1. Tax Alpha: How Tax Planning Can Add Risk Free Investment Returns
Presented By Dan Olson, CFA, CFP®, Registered Tax Return Preparer
Olson Tax & Financial Planning LLC
September 27, 2014
5/31/2019

2. Presentation Goals Understand the concept of “tax alpha”
Identify areas where you can increase investment return by reducing taxes
Provide tax update
Clarify some frequently asked questions
5/31/2019

3. Agenda What is Alpha and Tax Alpha? Tax Planning to increase Alpha
Tax exempt investment income
Tax deferred income
Shifting investment income to optimize taxes
tax update
Frequently asked questions
Self help – on your own with the IRS
5/31/2019

4. What is Alpha? Definition Example
Hot topic: What is the value of active management?
Alpha = Actual Return – Total Expected Return
Total Expected Return = Risk Free Rate + Beta (Market Return – Risk Free Rate)
If Total Return is greater than Expected Return, that is value a manager adds, that is positive Alpha
Example
Total Return US Stock Market: 6% = 2.5% + 1 (6% -2.5%)
If portfolio return is 7%, then Alpha is 1% (7% - 6%)
Alpha is generally a “before taxes” return
5/31/2019

5. What is “Tax Alpha”
Definition: Tax Alpha is the value an advisor adds by implementing investment strategies that reduce taxes
Tax Alpha = Actual Portfolio Return – taxes paid
Key drivers of Tax Alpha
Asset location (create 0 to 0.75% annual value*)
Placement of assets between taxable and tax advantaged accounts
Withdrawal order during retirement (create 0-0.7% annual value*)
Where you invest during the accumulation phase?
From which accounts do you withdraw during spending phase?
* Research from Vanguard. Reference available on request
5/31/2019

6. Tax Alpha: Example of Benefits
Assume $100,000 investment, and
Earnings of 3% or $3,000 per annum
Tax Bracket (%)
Tax Bracket Taxable Income, MFJ ($k) for 2014
Ordinary Income, e.g. Interest ($)
Qualified Dividends or LTCGs ($)
Savings per annum ($)
Yield Equivalent of Savings, p.a. 10
0-18
300
0.30% 15
18-74
450
0.45% 25
74-149
750 28
840
390
0.39% 33
990
540
0.54% 35
1050
600
0.60% %
457+
1302
702
0.72%
5/31/2019

7. Creating Tax Alpha with Tax Planning: Definitions
Marginal rate vs Tax Bracket rate
Marginal: impact on taxable income including state
Bracket: impact of tax tables on taxable income
Alternative Minimum Tax (AMT) changes most of the rules
Adjusted Gross Income (AGI) vs Taxable Income
Deductions or adjustments before AGI or after AGI
Phaseouts impact deductions, credits and exemptions
Investment vs Account vs Product
Investment is an asset; it can be held in a variety of accounts (e.g. stock in an IRA
Product can hold an investment; products can be in accounts (e.g. variable annuity)
Know your cost basis
Specific Selection vs FIFO vs LIFO
Use Specific Selection in taxable accounts
5/31/2019

8. Tax Planning: Some Investment Income is Better than Other?
Exempt better than deferral – never pay tax
Deferral better than current period – pay tax later
Qualified dividends better than interest or non-qualified dividends – 15% vs Marginal Rate
Long term capital gains better than short term capital gains – 15% vs Marginal Rate
Specific identification for investment basis better than average cost or first in first out (FIFO) – smooth taxable income
Passive investing better than active
Asset location determines how income is taxed
5/31/2019

9. Tax Planning: Hedge Your Bets
Some strategies depend on knowing the tax rate today versus the tax rate in a future period
E.g. Conversion of traditional IRA to a Roth IRA
But we don’t know future
Tax rates
Congressional action on IRA
Hedge: use a variety of accounts
Tax deferred
Tax exempt
5/31/2019

10. Sources of Tax Savings: Asset Location
General proposition
Locate investments with high current income in tax deferred accounts
Investments such as taxable bonds, HY bonds, active (high turnover) mutual funds, high dividend stock strategies
Locate investments with low or deferrable gains in taxable accounts
Individual stocks, tax aware funds, stock ETFs that only pay dividend distributions
Two kinds of accounts and two kinds of investments
Tax exempt
Tax deferred
5/31/2019

11. Sources of Tax Savings: Asset Location
“Account Location” means put the investment in the best account
Ordinary income in deferred accounts, e.g. Traditional IRA
Defer taxation until in a lower tax bracket
Qualified income in taxable accounts, e.g. long term capital gains from stocks
Reduce trading turnover
Tax long term gains less than short term gains
Offset capital gains with capital losses
Know investment basis!
Fast growing income in tax exempt accounts, e.g. Roth IRA
No tax paid on the increase in value
5/31/2019

12. Tax Exempt: Muni Bonds
Typically, people put munis in taxable accounts, but
Historically taxable bonds outperform munis before tax by 1.0%
Action: Don’t load up on low yielding munis
Put high returning taxable bonds in tax exempt or tax deferred accounts
5/31/2019

13. Tax Exempt: 0% Tax Bracket
If your taxable income is in the 10 or 15% federal income tax bracket, the tax bracket is 0%
Up to $73.8k MFJ or 36.9k Single or MFS
Only qualified dividends and long term capital gains are taxed a 0%
Take non taxable capital gains to “reset basis”
Note: all NY income taxed at same rate except for excluded items, e.g. NY muni bonds
5/31/2019

14. Tax Exempt: Healthcare Savings Accounts (HSAs)
Recent trend toward high deductible health plans (HDHP)
If HDHP, then set up Healthcare Savings Account (HSA)
Plan should tell you if HDHP, but generally:
Deductibles not less than $1,250 individual/2,500 family
Out of pockets do not exceed $6,250/12,500
Benefit: IRA on steroids! Employee contributions to HSA are deductible before AGI for all income levels AND distributions for eligible expenses not taxed AND you can carry balance forward
Action: Contribute!
5/31/2019

15. Tax Exempt: Donor Advised Funds
If you have charitable intent, extra cash, low basis stock
Consider a Donor Advised Fund (DAF)
Multiple benefits:
Donate investments with high unrealized gains and get deduction for charitable contribution
Avoid paying tax on unrealized gains
Let gains in the DAF grow tax free
Action: Donate when taxable income is high; use funds when income is low
5/31/2019

16. Tax Exempt: Capital Loss Carry Forwards
Use sooner than later – time value of the benefit
Use losses to offset short and long term capital gains
Use the loss to offset gain and reset basis at higher level on the investments you want to keep
Maximum deductible loss is $3,000 per year as ordinary
Takes a long time to fully use this up
Action: Use Specific Identification for investment “tax lots.” Reset basis on investments with gains
5/31/2019

17. Tax Deferred: Exchange Traded Funds, Not Mutual Funds
Mutual funds must distribute any dividends received or capital gains realized
ETFs allow investor to defer capital
ETFs also usually lower expense ratios
5/31/2019

18. Tax Deferred: Passive Rather than Active Investing
Active investments have higher turnover than passive investments (greater than 50% of portfolio annually)
Higher turnover usually mean realized gains
Passive or tax sensitive investing means realization of taxable income is deferred to a future period or offset by capital losses
5/31/2019

19. Tax Alpha: Withdrawal Order
Good tax planning means you will have a variety of investments and investment accounts in retirement
Withdrawals can be timed to minimize taxes over your lifetime – see Tax Shifting
General Rule: Let investments grow tax deferred as long as possible
Better to withdraw in this order, if no penalty,
Taxable
Tax free
Tax deferred
Inherited Roth IRA
Roth IRA
Inherited IRA
Any qualified plan
5/31/2019

20. Tax Alpha: Withdrawal Strategy
Smooth Taxable Income Over Your Lifetime
Realize investment income when earned income is below your long run average:
Early in career
Between jobs
Before you begin Social Security or Required Minimum Distribution (RMD)
How do you shift income?
Contribute to a Roth rather than a Traditional IRA
Convert Traditional IRA to a Roth IRA
Withdraw from qualified plans (IRAs or 401ks)
Reset basis on low basis stock
5/31/2019

21. Case Study: Back Door Roth IRA
Tax benefits of Roth
Investment income is tax exempt
Reduces future income since no forced RMD
Tax diversification regardless of future tax rates
Estate planning
If you can’t contribute directly to a Roth, then
Roth contribution phase out begins at $178/112k
Evaluate basis in Traditional IRA
Contribute to Traditional IRA
Convert Traditional to Roth IRA
BEWARE: tax basis in existing traditional IRA
IMPORTANT! Track basis in your traditional IRAs
File Form 8606 to track non deductible IRA contributions
5/31/2019

22. Update: Federal and NY Estate Taxes
Federal exemption increased to $5.25 million per person from $1 mil
Tax rate lowered
Top rate falls to 40% from 55%
Unified gift and estate
Gift and exemption amounts now same; give more during lifetime
New: Portable exemption between spouses
Full exemption for each spouse available even after death of first spouse (use tax return to elect)
Permanent, no sunset, eliminates uncertainty, indexes to inflation
Planning: Keep low basis assets in the estate
Examples include house, long held stock, raw land
New York amended April 1, 2014; if you die after this date, then
Estate tax exclusion will match IRS by January 1, 2019; currently $2,062k
No portability so you’ll to plan your estate
E.g. For a taxable estate of $1 million, rate is 5.5% rises to 16%
5/31/2019

23. Update: Modernized eFiling
IRS Modernized eFiling
Biggest technology update in decades
Faster refunds; faster rejections; faster identification of fraud
Use of business validation rules to screen
SSN mismatches one of biggest problems, e.g. EITC
Schedule A items esp. contributions, miscellaneous
1099 matching
New York State completed a similar award winning update
Automates review of tax return before refunds
Compares tax data with other data
Summer: Crackdown on tax preparers who don’t pay own taxes
March: suspended 8,900 NY drivers licenses for failing to pay taxes
Last fall: Renew STAR credit
5/31/2019

24. Update: Annual Filing Season Program (AFSP)
New program from IRS effective immediately for tax preparers
Voluntary – “AFSP - Record of Completion”
Focused on education – pass a test plus 18 hours of continuing education
Weeds out bad preparers. NY also using data to eliminate bad preparers
Benefits for taxpayers
Know that tax preparer meets continuing education – higher quality
Tax preparer can help with more problems based on the tax return they prepared
Easier to find more qualified tax preparers; directory coming January 2015
Unless you are part of this program, you can’t represent a tax payer for any matters. This enforced in 2016 for all tax years
New York State implementing a similar program
5/31/2019

25. Update: Nonprofit Organizations
Federal new short Form 1023-EZ
Streamlined Application for Recognition of Exemption Under Section 501(c)(3)
File electronically, only three pages!
New York Nonprofit Revitalization Act
Biggest change in governance of nonprofits in decades
Eliminate conflicts of interest and strengthen boards and financial reporting
5/31/2019

26. Update: Health Insurance Premium Tax Credit
Insurance must be purchased through an Insurance Exchange
Not all insurance policies will qualify for tax benefits
Tax credit is refundable and can be paid in advance to Exchange
Taxpayers will receive new forms from insurance providers
Notify Insurance Marketplace and qualify for new enrollment period
Move, marriage/divorce, change in dependents, new/lost job, income changes
Reconcile tax credit received with credit allowed
5/31/2019

27. Update: Shared Responsibility Penalty
“Shared Responsibility” is effective January 1, 2014
Either “minimum essential coverage” OR “exemption” OR “penalty”
Essential coverage
Numerous exemptions
Medicare, some clergy, etc., etc.
Shared Responsibility Penalty
Individual mandate covers everyone
Begins when uninsured for more than 3 months
Greater of 1% of income or $95 per adult family member and $47.50 per child (max $285 for 2014)
Increases in subsequent years (e.g. greater of 2% of income or $325/975 for 2015)
Example: Family income is $80k then 2014 fine is $1,600 (>$285)
Implemented via federal tax collection system Form 1040
Without documentation, IRS will add penalty to tax bill
Penalty will offset refunds
IRS can’t set liens, garnishee wages or do other things to collect
5/31/2019

28. Update: Taxation of Global Income
US one of few countries that taxes income regardless where earned
US has major initiatives to find income “hidden” outside the US
Going after fat cats and kitty cats alike
Penalties are punitive and onerous
No 3 year statute of limitations
IRS voluntary program
US Treasury has two programs
FATCA – Foreign Account Tax Compliance Act (effective March 2010)
Form 114 Report of Foreign Bank and Financial Accounts (FBAR)
Reporting required if ownership interest in a financial account domiciled outside the US if value of the account(s) greater than $10k at any one time during the year
File Form 114 with US Treasury Department, not with IRS
Form 8938 Statement of Specified Foreign Financial Assets (Dec 2011)
If value of accounts were $50/100k on last day of year or $75/150k at any time during the year
Many countries now or soon reporting account data to IRS. Treaty countries include: UK, Germany, Switzerland, Bermuda, BVI. Talks far along with Israel
File with the IRS Form 1040
5/31/2019

29. Frequently Asked Questions
Should I file MFS (married filing separately)?
Do I owe self employment taxes?
Why did I get this letter from the IRS or NY?
Can I use a credit card statement to support a tax deduction?
If I give more than $14k to my daughter, is that taxable?
Do I need to report income from an overseas account?
5/31/2019

30. Self Help Tax Sources IRS phone service: forget about it!
Go to website:
YouTube or
Begin Google searches with “IRS” or “New York Department of Taxation”
File free if you meet income requirements
Google “IRS free file”
Pay online or set up periodic payments
Google “IRS direct pay”
5/31/2019

31. Daniel Olson, CFA, CFP®, Registered Tax Return Preparer
Olson Tax and Financial Planning LLC
Metropolitan Avenue
Forest Hills, NY 11375
5/31/2019