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Income Tax Planning Retirement Income Planning

Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions

Last week’s post answered the question, “What is the right mix of retirement vs. nonretirement investments in a retirement income plan?” with a simple, but correct, answer: “It depends.” It pointed out that each scenario is different, requiring a professional analysis by a qualified retirement income planner of the interaction between a host of many variables unique to that situation.

One of the variables mentioned last week was income tax carryover losses. There are limitations on the amount of losses arising from various types of transactions that may be deducted on the tax return for the year in which the loss incurred. The portion of the loss that isn’t deductible in the year of origin of the loss must instead be carried forward to the following year, and potentially to additional future years, until the requisite type and amount of income becomes available to absorb the loss.

An example of a common income tax carryover loss is a capital loss. After netting capital losses against capital gains, to the extent that there is an excess of capital losses over capital gains, you end up with a net capital loss. Under income tax laws that have been in existence since at least 1980 when I started practicing as an accountant, only net capital losses up to $3,000 ($1,500 if married and filing a separate return) are allowed to be deducted in the current tax year. Any net losses in excess of the specified amounts are required be carried forward to the following year.

If you have a sizeable capital loss carryover, as many people do as a result of 2009 securities sales when the stock market plummeted, nondeductible contributions to a nonretirement investment account may be preferable to making deductible retirement plan contributions, including 401(k) plans, SEP-IRA plans, deductible IRA’s, and other retirement plans. This assumes that you’re not planning on selling an asset, such as a piece of real estate or a business that will generate a sizeable capital gain that can be used to absorb your capital loss carryover.

Why is this? Doesn’t it make sense to contribute to a retirement plan where you know that you’re going to receive a current income tax deduction, often sizeable, that will save you a bunch of income taxes today? Keeping in mind that the tradeoff for a current income tax deduction when it comes to retirement plan contributions is deferred income inclusion and associated taxation when the assets are distributed, perhaps at a higher tax rate, the answer to this question isn’t necessarily “yes.”

This is especially true when large capital loss carryovers are present. If you’re in this situation and you don’t realize any capital gains, you will be taking a $3,000 tax deduction on your tax return for many, many years with the possibility, depending upon your age and the amount of your loss, that your carryover loss won’t be used in its entirety during your lifetime. Given this situation, the goal should be to create opportunities for capital gains that can be used to absorb chunks of your capital loss carryover each year without incurring any income tax liability until such time as there is no further available capital loss.

How do you do this assuming limited financial resources? One option that can make sense in many situations is to divert funds that would otherwise be used for making deductible retirement plan contributions into nonretirement equity investment accounts that have the potential to generate capital gains. To the extent that the equities appreciate in value, they can be sold, with the gains generated by the sales used to offset a portion of your capital loss carryover without incurring any income tax liability. Furthermore, unlike other situations where capital losses aren’t present and your goal may be to hold onto investments for longer than a year in order to obtain the benefit of favorable long-term capital gains tax treatment, this isn’t necessary. Capital loss carry forwards can be offset again any capital gains, whether short- (i.e., one year or less) or long- (i.e., greater than one year) term.

Using this strategy, you won’t receive an income tax deduction for investing in your nonretirement investment account. You will, however, create an opportunity to potentially increase the value of your nonretirement account up to the amount of your capital loss carryover plus $3,000 without incurring any income tax liability that you might not otherwise do. In addition, once your capital loss carryover has been used in its entirety, subsequent sales of assets can create additional losses or capital gains that can be taxed at favorable long-term capital gains rates. All of this can occur without exposing yourself to guaranteed ordinary income taxation at potentially higher tax rates down the road when you take distributions from your retirement plans had you instead invested the same funds in retirement plans.

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Retirement Income Planning

Nonretirement Investments – The Key to a Successful Retirement Income Plan

When was the last time someone asked you, “Hey, did you make your nonretirement investment plan contribution this year?” When we think of a retirement income plan, the first thing that typically comes to mind is retirement investments. This includes 401(k), 403(b), SEP-IRA, traditional IRA, Roth IRA, SIMPLE IRA, defined contribution, defined benefit, and other retirement plans. While the maximum allowable contribution varies by plan, the inherent goal of each of them is to provide a source of retirement funds.

With the exception of the Roth and nondeductible traditional IRA’s, both of which receive nondeductible contributions that grow tax-free provided certain rules are followed, all of the other plans enjoy tax-deferred growth. The reason that the growth isn’t nontaxable, and is instead tax-deferred, is because the source of funds for each of these plans is tax-deductible contributions. Whenever this is the case, although plan income, including interest and dividend income and capital gains aren’t taxed, plan distributions are taxable as ordinary income.

While it’s great that Congress has authorized the use of these various types of retirement plans and there are indisputable tax and other advantages associated with each of them, they generally aren’t sufficient for meeting most people’s retirement needs by themselves. Aside from the defined benefit plan, the contribution ceilings, especially those associated with traditional and Roth IRA plans, are inadequate in most cases for building a sizeable nest egg.

Recognizing this fact of life, it’s important to include nonretirement investments in most retirement income plans. What are nonretirement investments? These are simply the same types of investments that you find in retirement plans, i.e., stocks, bonds, mutual funds, exchange traded funds, annuities, CD’s, etc., however, ownership is different. Instead of these assets being owned by a 401(k) , SEP-IRA, Roth IRA, etc., they are owned by you, you and your spouse if married, or perhaps your living trust.

Nonretirement investments enjoy several advantages over retirement investments that make them attractive for funding retirement income plans. For one thing, although contributions to nonretirement investments aren’t tax-deductible, there also aren’t any annual limitations on the amount of contributions that can be made to them. Secondly, investments can be selected that have the potential to match the tax-deferred growth enjoyed by most retirement plans.

Nonretirement investments also offer tax advantages over their retirement plan counterparts when it comes to sales of assets. While gains from sales of assets in retirement plans are nontaxable, they are ultimately taxed as ordinary income at federal tax rates as high as 35% when distributions are taken from a plan. The same gains from sales of nonretirement assets, while they are immediately taxable, have the potential to enjoy favorable long-term capital gains rates of 15% in most cases assuming that the assets that have been sold have been held for more than one year. In addition, unlike losses resulting from sales of investments held within retirement plans that are non-deductible, the same losses in nonretirement plans are considered deductible capital losses.

One of the biggest advantages of nonretirement investments is the ability to control the timing of distributions and the associated exposure to income tax liability. This includes avoidance of required minimum distribution (“RMD”) rules. Beginning at age 70-1/2, with the exception of Roth IRA’s, you’re required to take minimum distributions from your retirement plans each year based on the value of each plan on December 31st of the previous year using an IRS table life expectancy factor, resulting in forced taxation. No such rules exist when it comes to nonretirement investments. In addition, unlike pre-age 59-1/2 distributions from retirement plans that are subject to a federal premature distribution penalty of 10% of the amount of the distribution, there are no such restrictions when it comes to nonretirement investments.

So what is the right mix of retirement vs. nonretirement investments? Read next week’s post to find out.