NEW YORK (TheStreet) -- As 2014 comes to a close, proper tax planning will help savvy investors reduce what they pay on investment gains, as well as take advantage of tactics that might not be available in the future.
Here are three tips investors should consider when filing their 2014 tax returns.
1. Tax Loss Harvesting and Selling in Lower Tax Brackets
The idea of selling securities (such as stocks or mutual funds) that have gained significant value may seem foolish. But for individuals wanting to take advantage of current tax loopholes, selling may not be such a bad idea. Tax loss harvesting is essentially offsetting the gains on a well-performing stock or mutual fund account by selling an underperforming asset.
An investor in the 25% federal tax bracket invests $25,000 each in 4 different stocks, for a total of $100,000. The stocks are held for a year or more. The current status of each stock is as follows:
- Her stake in stock A has increased $2,000;
- Her stake in stock B has decreased $6,000;
- Her stake in stock C has increased $3,000;
- Her stake in stock D has decreased $9,000.
The total investment at this point is down $10,000, yet the investor could be required to pay taxes on the investments that gained value.
By selling now, the investor can offset the long-term capital gains in stocks A and C (which increased a total of $5,000) with the losses from stocks B and D (which decreased a total of $15,000). That's a total capital loss of $10,000. She can use up to $3,000 of this loss to offset her ordinary income for the current year, resulting in a tax savings of $750 ($3,000 in capital loss x 25% tax bracket = $750).
On top of that, she can carry the remaining $7,000 loss onto her future tax returns, offsetting future gains or repeating the same $3,000 offset to her ordinary income for the next couple of years.
For those in a tax bracket above 15%, selling securities with significant losses to offset taxes on gains of appreciated assets can save up to 23.8% in taxes on long-term capital gains. Why? There's now a 3.8% surtax on individuals earning more than $200,000 and married couples earning more than $250,000. And capital gains taxes are at 20% for those who earn taxable income over $406,751 filing as a single person and $457,601 for married couples. So offsetting those gains with losses is a good idea.
Those in the 15% tax bracket or lower -- with $36,900 or less in taxable income if you're filing single; $73,800 for married couples -- will pay 0% on long-term capital gains (capped to a certain dollar amount).
Note: IRS wash-sale rules disallow you to claim a loss if you purchase a similar investment within 30 days.
2. Preparing for Potential Higher Taxes With a Roth IRA
Contributing to your tax-deductible employer-sponsored plan or IRA might make sense for now, but does it make sense for the future? That depends on whether you believe taxes will decrease, increase, or stay the same.
If investors think they will increase, then a Roth IRA will be in their best interest.
If taxes decrease or stay the same, then contributing to a tax-deductible plan makes the most sense, especially when in the top tax bracket.
For those in a lower tax bracket, a Roth is typically best because the long-term reward of tax-free gains outweighs the short-term gain of a small tax deduction.
Converting to a Roth IRA
Years ago, only individuals with an adjusted gross income of under $100,000 were eligible to convert a traditional Individual Retirement Account into a Roth IRA. Today, anyone can convert, and if you have the money to pay the tax now, it might be worth it.
With a Roth IRA, individuals pay taxes on their contributions now and make tax-free withdrawals later on. A traditional IRA works the other way around -- you save in the account without paying taxes now but pay them later on the full amount.
Also, if tax rates are lower today than they will be tomorrow, it is better to get them out of the way now, which is the purpose of the Roth.
All in all, the Roth is the solution for most.
3. Giving to a Charity
The rules for giving to charity and deducting it from your taxes have recently changed. Here's what you need to know.
Donating funds to charity helps investors save on their tax bills. Charitable trusts are one of the best ways. There are certain types of charitable trusts that allow their benefactors to extract income from donated investments, while still booking the tax deduction for the donation.
Tax benefits include that trust assets are not counted for estate tax purposes; appreciated assets are exempt from current capital gains tax; and assets qualify for an income tax deduction on the estimated present value of the interest going to the charity.
Note: Charitable trusts are irrevocable and assets cannot be withdrawn once either trust is formed.
For gifts over $1 million, you may want to set up a private foundation.
Deductions for charitable giving are based on adjusted gross income and depend on the organizations to which the contributions were made.
Usually, the deduction is up to 50% of the individual's adjusted gross income, but 20% and 30% limitations apply in some cases (refer to IRS Charitable Contribution Deductions for a detailed explanation).
And overall, lower income means lower taxes.