Tax planning opportunities for funding an IRA.

• Author: Counts, Wayne
• Position: Individual retirement account

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.

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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 S3,000 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.

Three Scenarios

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). (9) 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 nor 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 on p. 125, 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...