Retirement accounts, and in particular individual retirement arrangements (IRAs), remain one of the few methods that the majority of taxpayers can use to defer tax or to shelter income. Advising clients on starting and contributing to these accounts is one way that tax preparers can provide tax planning advice for their clients. The choice of funding for these accounts is a part of that service the tax professional needs to be cognizant of when advising the client. This article explores various funding choices for IRAs and provides an approach or model by which the tax adviser can optimize the funding choice, given the taxpayer’s tax-related goals. This article specifically discusses redeeming non-IRA mutual fund shares to fund a taxpayer’s IRA contribution for the year.
Stock Transactions and Redemption of Mutual Fund Shares
Regardless of whether the choice is a traditional IRA or a Roth IRA, the source of funding provides the tax professional and client with additional opportunities for tax planning. This article addresses specifically a sale of stock and/or redemption of non-IRA mutual fund shares to fund the current year’s IRA contribution. Because the current value (or selling price) of these investments may differ from the taxpayer’s cost basis for these assets, the taxpayer can, through specified sale or redemption decisions, accomplish specific tax-related objectives in addition to being able to fully fund the taxpayer’s IRA for the year. If the taxpayer has a diverse portfolio of mutual fund and stock holdings, some of these holdings would (if redeemed at the discretion of the taxpayer) trigger a capital gain, while others (if redeemed at the discretion of the taxpayer) would trigger a capital loss. It is this ability to trigger gains or losses (or even achieve a zero tax effect) on the redemption of mutual fund shares and/or the sale of stock that provides tax planning opportunities for the taxpayer.
Taxation of Capital Gains/Losses
In any given tax year, realized capital losses in excess of capital gains are deductible from ordinary income to noncorporate taxpayers up to $3,000. 1 (For purposes of this provision, the character of the losses—short term or long term—does not matter: Any net capital loss can be used to offset up to $3,000 of ordinary income.) A taxpayer can carry forward any excess loss for a given year until he or she can use it, subject to the same rules as in the year of the loss. These rules pertaining to the tax effects of gains and losses provide tax planning opportunities in conjunction with funding the taxpayer’s IRA.
To illustrate planning opportunities, this article discusses three scenarios or taxpayer-specified objectives.
Scenario 1. Current Tax Minimization
The taxpayer’s goal in conjunction with funding his or her IRA is to minimize current taxes. This objective may apply to taxpayers who believe they are currently in a higher tax bracket than they will be in the future, an expectation that could be based on a pending retirement or a windfall in the current year (e.g., the sale of vacation property owned by the taxpayer) that is unlikely to be repeated in the future. It also could apply to taxpayers who are uncertain about future tax rates or income levels.
In this case the strategy is to sell the investment asset (i.e., stock or mutual fund share) that generates the greatest capital loss while generating the needed funds for the desired IRA contribution(s). 2 To minimize current tax liability in conjunction with fully funding the IRA for the current year, the taxpayer would sell shares of stock and/or redeem non-IRA mutual fund shares to generate a net capital loss of $3,000. Where the sale would generate a net loss greater than $3,000, the taxpayer can carry the excess over to future years. If the taxpayer does not desire to have a capital loss carryover, then he or she should sell enough of the investment to generate the $3,000 loss, with the remainder of the contribution coming from a source that does not generate a capital gain or loss effect (e.g., current income or savings).
In general, if tax minimization is the taxpayer’s goal, a traditional IRA would most likely be used, if the client is eligible to make a tax-deductible contribution. However, as indicated by Example 1 below, the judicious sale/redemption of investment assets can still be of value to taxpayers who are making nondeductible contributions to either a traditional or Roth IRA, and who want to minimize current tax liability.
If the client is selling investment assets to recognize a tax loss, the tax adviser should warn the taxpayer not to trigger the wash-sale rules of Sec. 1091, which would cause the taxpayer to be denied loss treatment. This would occur if the taxpayer liquidates capital loss stock or securities to invest in the IRA, and then invests in the same stock or securities within 30 days (or had purchased it within 30 days before selling it).
Scenario 2. Current Tax Maximization
A taxpayer who is currently in a low tax bracket and expects future tax rates to be higher might use this strategy. While the expiration of the 15% capital gain bracket has been postponed through the end of 2012, many clients may believe that future tax rates will be higher. By recognizing income currently, the client hopes to pay taxes now to lower the overall future tax burden. The optimal tactic for these clients would be to sell sufficient investments that qualify for long-term capital gain treatment to generate funds up to the maximum allowed IRA contribution. Because there are no limits on long-term capital gain realization, the only concern about this strategy is to choose the investment that generates the greatest realized long-term capital gain. 3
The tax adviser needs to make sure the client understands that he or she should use long-term capital gain investments (stocks and/or shares of a non-IRA mutual fund) because it will not benefit the client to use short-term capital gain property. Under current law, beginning in 2013 the 15% capital gain rate will rise to 20%, and for clients in the 15% ordinary income tax bracket, the long-term capital gains rate will rise to 10% (from 0%). Short-term capital gains are taxed at ordinary income rates, and short-term capital gain property, after a one-year holding period, will become long-term gain property and be taxed at the more-favorable rates. Therefore, a client should use short-term capital gain property to fund an IRA only as a last resort or when he or she intends to dispose of the investment prior to its obtaining long-term status. A Roth IRA would most likely be the appropriate choice to accomplish this objective, by shifting the timing of the taxation to the present to eliminate future (higher) taxation.
Scenario 3. Achieve a Specific Tax Effect
The third scenario involves a client who wishes to create a current specified tax effect from the asset-disposal transaction; the taxpayer wants to generate a specific tax effect between the two extremes discussed above. For example, the taxpayer may want to both fund the IRA for the year and simultaneously generate from the sale of stock or mutual funds a zero net capital gain/loss, a net capital gain of $2,000, a net capital loss of $1,000, etc. If the client has sufficient funds available either from current income or from savings, the client could sell the appropriate amount of capital gain/loss property to create the desired tax effect and then use the savings or current income for the remainder of the desired IRA contribution. However, if the client lacks disposable funds but has investments with both capital gains and capital losses, using a mix of sales from each investment that yields the desired net capital gain/loss would be the appropriate strategy, as demonstrated by the examples that follow.
Examples for Three Scenarios
Assume a client is single, age 56, with an adjusted gross income (AGI) of $50,000 before considering any potential capital gain/loss or IRA deduction. Assume, further, that for the current tax year the client is covered by a qualified retirement plan but wishes as well to contribute to a traditional IRA. Further assume that the client has two non-IRA mutual fund accounts, each currently worth $20,000. 4 Mutual fund 1 is currently selling for $25 per share, and the client’s basis in these shares is $20 per share. Mutual fund 2 has a cost basis of $17.50 per share and a current market price of $10 per share. Both mutual funds qualify for long-term capital gain/loss treatment. Other data are provided in the table.
In addition, assume that the client does not have discretionary funds to contribute to his or her IRA for 2011 (or chooses not to commit discretionary funds to this purpose), so that the client chooses to redeem shares in one or both of the mutual funds to fund the IRA contribution. Three specific examples are discussed below, based on taxpayer objectives regarding the amount of capital gain/loss or, more generally, the tax effect that the taxpayer would like to generate on the redemption transaction.
Determining how many shares of each mutual fund to redeem requires a two-step process: (1) Calculate the number of shares of one of the mutual funds (or both funds) to achieve the targeted capital gain/loss for the taxpayer, and then (2) calculate the additional shares of the two mutual funds, in a specified mix or ratio, to achieve sufficient proceeds to fully fund the IRA for the current year.
Example 1. Minimize current taxes: The client would like to redeem shares of the two mutual funds simultaneously to generate $6,000 of income (to maximize the annual IRA contribution for a taxpayer age 55 or older) and to realize a net capital loss of approximately, but no more than, $3,000 (the maximum amount currently allowed as an offset to ordinary income). Thus, the taxpayer is looking to have approximately $9,000 of deductions for the year. The question is: How many shares of each mutual fund should be redeemed to accomplish these two objectives?
Assuming sale of partial shares is not allowed, the client should sell 63 shares of mutual fund 1 and 442 shares of mutual fund 2. The redemption of shares from mutual fund 1 will generate $1,575 (63 shares × $25 per share) and a capital gain of $315 (63 shares × [$25 − $20] gain per share). The redemption of shares from mutual fund 2 will generate $4,420 (442 shares × $10 per share) to maximize the client’s IRA contribution. On this redemption the client would generate a long-term capital loss of $3,315 (442 shares × [$17.50 – $10] per share). The client has a combined net capital loss of $3,000 and investment funds of $5,995. 5
As noted above, determining how many shares of each mutual fund to redeem requires a two-step process: first, determine the number of shares of the mutual fund currently selling at a loss (to generate the desired $3,000 net capital loss); second, determine the number of shares of each of the two mutual funds that would achieve the IRA-funding goal of $6,000.
Step 1—Achieving the targeted capital gain/loss: To generate a capital loss of $3,000, the taxpayer should sell $3,000 ÷ ($17.50 – $10) = 400 shares of mutual fund 2. This would generate $4,000 of proceeds that the taxpayer can use to (partially) fund the IRA for the year. This means that the taxpayer needs an additional $2,000 ($6,000 – $4,000) of proceeds from the redemption of mutual fund shares.
Step 2—Generating sufficient proceeds to fully fund the IRA: How many additional shares of mutual fund 2 and how many shares of mutual fund 1 should be redeemed for the taxpayer to have a total of $6,000 to fully fund the IRA for the year? Note that because the taxpayer wants to minimize current tax liability, these additional shares must be redeemed in some combination so that the net result is a zero tax effect (i.e., an additional net long-term gain or loss of $0). Because mutual fund 1 is currently selling at a gain of $5 per share and mutual fund 2 is selling at a loss of $7.50 per share, the only way to redeem additional shares of these funds with a resulting tax effect of $0 is to sell them in a 3-to-2 ratio (that is, redeem three shares of mutual fund 1 for every two shares of mutual fund 2) or 60% to 40%. This results in a weighted-average selling price of $19 per share ([$25 × 0.6] + [$10 × 0.4]).
To generate the required $2,000 of additional proceeds at a weighted-average selling price of $19 per share, the taxpayer needs to sell an additional 105 shares in the previously established 3-to-2 ratio. This means that the taxpayer should redeem 63 shares (0.6 × 105 shares) of mutual fund 1, along with 42 shares (0.4 × 105 shares) of mutual fund 2.
By recognizing the capital loss and investing the funds in a traditional IRA, the client will reduce AGI by $9,000 (capital loss of $3,000 and an above-the-line IRA contribution deduction of $6,000) to $41,000. Assuming a standard deduction and one exemption, this will lower the taxpayer’s taxable income in the 25% bracket by $6,000 and in the 15% bracket by $3,000. Thus, this reduction in taxable income will generate a 2011 tax saving of $1,950 ([$6,000 × 25%] + [$3,000 × 15%]). Using the capital loss provision and deductibility of a traditional IRA, through judicious planning, has reduced the client’s current tax liability by shifting taxation into the future.
Example 2. Maximize current income: This strategy would be used to avoid higher projected future tax rates or for other tax planning reasons. Since the client lacks disposable income to fund the IRA, the client would want to redeem enough mutual fund shares both to fully fund the IRA and to pay the additional taxes on the mutual fund redemptions.
Since long-term capital gains are currently taxed at 15%, the client will need to redeem $7,059 ($6,000 ÷ (1 – 0.15)) or 282 shares (rounded) of mutual fund 1. By investing in a Roth IRA, the client will take advantage of current capital gains rates and provide for tax-free distributions of any future gains, provided the aforementioned withdrawal provisions are met. All other factors being equal, this strategy will increase the taxpayer’s AGI for 2011 to $57,059 and increase taxes by $1,059 ($7,059 × 0.15). 6 Here the client is taking advantage of the capital gain rates to achieve current income recognition and, by changing investment vehicles to a Roth IRA, hoping to achieve lower lifetime taxation. 7
Example 1 assumed the taxpayer’s objective was to achieve current tax minimization or, equivalently, to generate a $3,000 long-term capital loss. This targeted value is a specific example of a more general problem: redeeming non-IRA shares to fund the taxpayer’s IRA (to whatever extent desired) and to achieve a specified long-term capital gain/loss amount (which could be zero). To solve the more general case, apply the same two-step process outlined above in Example 1. The key is to determine the appropriate ratio of shares of the two mutual funds that need to be redeemed and then to use this information to determine how many shares of each fund need to be redeemed to accomplish the taxpayer’s objective.
Example 3. Achieve a specific tax effect: Assume that the objective is to fully fund the taxpayer’s IRA and to simultaneously generate a net long-term capital gain from the redemption of mutual fund shares. Further, assume that to date no contributions have been made to the IRA for the current year.
Step 1—Achieving the targeted capital gain/loss: The client’s goal is to generate a $1,000 long-term capital gain because of an excess current capital loss that the client would rather use than carry forward. The client would need to redeem 200 shares of mutual fund 1 ($1,000 capital gain ÷ [$25 – $20] per share). Alternatively, the taxpayer might want to generate a $2,000 long-term capital loss. In this case, in Step 1 the client would redeem 267 shares of mutual fund 2 ($2,000 capital loss ÷ [$17.50 – $10] per share).
Step 2—Generating sufficient proceeds to fund the IRA: Assume (from Step 1) that the taxpayer desires to generate a long-term capital gain of $1,000 and to generate a total of $6,000 to fully fund the IRA for the year.
Step 1 showed that the 200 shares of mutual fund 1 that are redeemed to generate the targeted gain of $1,000 would generate $5,000 (200 shares × $25 per share) in investment funds. This means the taxpayer must generate an additional $1,000 if he or she wants to fully fund the IRA for the year. So that the redemption of these additional shares would be “tax neutral” (i.e., result in a zero capital gain/loss), they must be sold in the ratio of three shares of mutual fund 1 to every two shares of mutual fund 2, as determined previously. Also as before, the weighted average selling price per share at this mix (60%/40%) is $19.
Thus, to generate $1,000 of investment funds at an average selling price per share of $19, the taxpayer must redeem a total of 53 shares (rounded up) ($1,000 ÷ $19/share ≈ 53 shares). Given the assumed ratio, 60% of these shares (32) would be from mutual fund 1, and the remaining 40% (21) would come from mutual fund 2. Together, the amount of investment funds from redeeming 53 shares would be $1,010 ([32 shares × $25 per share] + [21 shares × $10 per share]).
Combining Step 1 with Step 2 shows that the client would need to redeem 232 shares of mutual fund 1 and 21 shares of mutual fund 2. The capital gain on mutual fund 1 would be $1,160 (232 shares × $5 per share), and the capital loss on mutual fund 2 would be an offsetting $157.50 (21 shares × $7.50 per share) netting $1,002.50.
Selecting the Appropriate IRA
Situations that could affect the choice of IRA include a modified AGI exceeding the contribution limit phaseout ceiling for a Roth IRA. In this case the “contribute then convert” strategy can be used. A contribution to a traditional IRA is always available. The client contributes to a traditional IRA, then converts it to a Roth IRA. If the client does not currently own a traditional IRA and is not a participant in an employer-sponsored plan, the strategy will be tax-neutral if the contribution and conversion are carried out in the same tax year and the value has not changed in the interim.
If the client currently has a traditional IRA where the current value exceeds basis in that IRA (either through earnings or tax deductions), the contribute-and-convert strategy may be only partially effective. If the client is a participant in an employer-sponsored plan, then the only choice would be a nondeductible traditional IRA, which will almost always be less attractive than a Roth IRA. If the client is not a participant, then a fully deductible traditional IRA is available regardless of AGI. This would provide the benefit of no tax liability until withdrawal. The client could also participate in an employer-sponsored plan and have a modified AGI above the traditional IRA deduction threshold, but beneath the Roth IRA threshold. In that case even a client who wishes to minimize taxes would most likely choose a Roth IRA.
Powerful Tools for Every Income Level
Taxpayers and tax advisers alike often view tax planning as a province only for wealthy tax clients. However, as the examples above demonstrate, Congress has provided taxpayers with some powerful tax planning tools through IRAs, capital gain rates, and capital loss deductions. These tools are available to many clients of more modest income levels. By combining the provisions of the Code with existing unrealized gains and losses, taxpayers can go a long way in achieving their investment and tax goals simultaneously. Current tax minimization or long-term tax minimization are common planning goals, which often do not match well with a client’s investment goals. However, by properly combining the characteristics available in existing assets and retirement vehicles, clients can often create specific tax and investment results that match their needs.
Primary questions the tax adviser should consider include:
- Is the taxpayer a participant in an employer-sponsored retirement plan?
- Is the taxpayer eligible for a Roth IRA? A traditional IRA that is deductible? 8
- Does the taxpayer currently own a traditional IRA that would preclude the use of “contribute and convert”?
- Does the taxpayer have current income to fund an IRA or investment assets for which immediate liquidity is not an issue?
- Does the taxpayer have unrealized long-term capital gains and/or unrealized capital losses on these assets?
- What is the taxpayer’s current versus anticipated future marginal tax rate?
Then by using the techniques presented here, taxpayers may be able to achieve their tax and investment objectives concurrently.
1 Sec. 1211.
2 The maximum contribution per individual for 2011 and 2012 is $5,000 (subject to income phaseout), with an additional $1,000 allowed for individuals age 50 or greater. IR-2010-108; IR-2011-103.
3 The authors recognize the trade-off that must be made between selecting the greatest current long-term gain and the appreciation potential for a given investment. Put another way, the ultimate decision rests both on anticipated changes in tax rates and predicted future price movements (and therefore returns on) the securities held by the taxpayer.
4 While the example uses non-IRA mutual funds as the funding vehicle, any capital gain/loss property will provide the same effect.
5 In many mutual funds, fractional shares could have been redeemed so that exactly $6,000 of funds could have been generated. However, the example uses only whole shares and the number of shares that provided the closest result to the targeted redemption proceeds ($6,000) needed by the taxpayer to fully fund the IRA for the year. Further, note that, because of the trading delay associated with traditional mutual funds, the actual selling price (when shares are redeemed) may differ from the price per share on the day the redemption transaction is executed. A more exact calculation could be obtained if the taxpayer’s investment were in an exchange traded fund (ETF) for which proceeds are taxable as capital gain or loss, rather than a traditional mutual fund.
6 The tax adviser must always keep in mind that moving from a taxable investment to a tax-free (Roth IRA) investment can be accomplished if the taxpayer’s AGI is lower than the phaseout threshold or by using a contribute-and-convert strategy (see "Selecting the Appropriate IRA," below).
7 If the client has insufficient capital invested in mutual fund shares to fully fund the Roth IRA, then he or she can accomplish the same general goal, to a lesser degree, by redeeming the available shares and rounding out the Roth IRA contribution from discretionary funds or savings.
8 Even if the client is not eligible for an IRA, the client can achieve the same results by using an employer’s 401(k) or 403(b) by reducing the client’s salary, then creating the desired tax effect with existing investments. In this case, the client would then use the nonqualified investment proceeds to offset the salary reduction.
Wayne Counts and Raymond Shaffer are professors and David Stout is the Andrews Chair in Accounting in the Williamson College of Business Administration at Youngstown State University in Youngstown, OH.