Exclusive Interview: Clay Ernst, Executive Director of Financial Planning at Edelman Financial Engines

More strategies to lowering your tax bill this year-end

Ric Edelman: Welcome back. The Truth About Your Future continues. It’s year end, and that means tax planning opportunities. And to help us delve into that, I'm happy to welcome onto the program my good friend Clay Ernst. He's Executive Director of Financial Planning at Edelman Financial Engines. It's good to have you on the show. How are you doing?

Clay Ernst: Doing great, Ric. Happy to be here.

Ric: This has been a really difficult year for the financial markets, the worst year in decades. But there is an opportunity for lowering your taxes as a result of what's been going on in the stock and bond markets. Talk about how that works.

Clay: Sure. So there's a number of different strategies out there. One of which is called tax loss harvesting. So we're at lows of the year. And so this creates an opportunity for investors, especially with those with taxable accounts. And it works like this: if you have a security that's fallen in value below the purchase price, then you have an opportunity to sell that security and capture the loss. The way we think about it as making lemonade out of lemons. You can't own that same security for 30 days, and then you're allowed to repurchase the security that has fallen in value. You've sold it and you recognize that loss on your tax return.

Ric: Are there other considerations you need to be thinking about Clay before you engage in tax loss harvesting?

Clay: Absolutely. There there's a few gotchas that you've really got to be aware of, and you should definitely consult with a financial advisor before you try to do this on your own. Number one is you're not really avoiding capital gains taxes through tax loss harvesting. What you're really doing is just resetting the cost basis at a lower level and deferring the taxes for when you otherwise would sell the securities down the road. Another is that you might not be in any capital gains tax bracket of significance anyways. If you're married filing jointly, for instance, your taxable income is less than $80,000, and the tax year 2022, you're already in the zero capital gains percent tax brackets. So the tax loss harvesting doesn't offer you any type of measurable benefit in that case. Another gotcha is you can't own the security that you sell for that period of time, meaning that you can't sell it in say, a taxable account, and then buy it in your IRA account. The good news is that there's ways to address all of these concerns, and that's one of the things that we do for our clients. We can identify replacement securities that have very similar performance characteristics to what you've sold and allow you to maximize the value of the loss. So it's a very powerful strategy, but you do have to be aware of these gotchas.

Ric: And that's a really important point because a lot of fear that people have is that if I sell this asset, I can't buy it back for 30 days. I'm out of the market and the market might recover in that window, and I'll end up missing that profit. You know, if you sell one ETF, you can't rebuy that ETF. But as you said, there are similar ETFs that you could buy as a proxy, so that you essentially have the same positioning that you had before. And that way you get to have your cake and eat it, too.

Clay: Absolutely. Yeah. I would say definitely consult with a financial advisor that can tell you whether or not the security replacing it with qualifies to maximize that deduction.

Ric: And what about 401Ks, any opportunities there?

Clay: This is one of the most common questions we get in the field, Ric. How can I lower my tax bill? Are you taking full advantage of your 401K? And to maximize your 401K, you're allowed, if you're under the age of 50, to contribute in 2022, $20,500. If you're over the age of 50, you’re allowed to contribute another $6,500. That's called a catch-up contribution. And if you're contributing, say, 3% or 4% of your salary, you might not be taking full advantage of one of the greatest tax shelters.

Ric: Another huge way you can lower your taxes and at the same time be doing something good with your money is charitable donations. This is the time of year people tend to think of making charitable contributions. Talk about how that fits into your year-end tax planning.

Clay: This is the time of year for giving, and we do see a lot of questions coming in from our clients and prospective clients about ways that they can, in a tax efficient manner, make charitable donations. And so three strategies come to mind that I think everybody should be aware of. Number one is the ability to donate appreciated stock in lieu of cash. Maybe it's a position that they inherited from a family member. Maybe it's a stock in your own company that you've accumulated over the years. So let's pretend that you are inclined to make a charitable donation of X amount of dollars, and you have a choice. You can write a check. Well, the money that you would pay if you write a check or give cash to the charitable organization has already been taxed, meaning that you've already paid income taxes on the amount. But let's say that you have securities that have gone up in value. Well, the charitable organization, the 501c3 organization, would love to get your stock just as much as your cash. And they can sell the appreciated stock and pay no capital gains tax. Whereas if you sell the stock, you're on the hook for the capital gains consequences. So donating stock is a very powerful strategy.

Ric: And because of the nature of this, in order to do it, it's paperwork intensive, which means it takes a good couple of weeks to get all the paperwork done. So you need to act on this right now because if you call your advisor on New Year's Eve, you're out of luck.

Clay: So yeah, yeah, definitely. The gift has to be completed before the end of the year. So we all know that processing times, holidays come into play. So definitely I would say November, early December is probably the best time to tackle this one.

Ric: And how about self-employed individuals? Any strategies uniquely available to them?

Clay: Yeah, the pandemic has really shifted the workforce. A lot of folks that were fully employed before now might be working as freelancers or consultants. And so whereas before they had W-2 income, now they might have 1099 income. And so they have options to invest in things like SEP IRAs (SEP: simplified employee pension plan IRAs) or a 401K plan. So if you are self-employed as a consultant or a freelancer, there's a couple of strategies that you might want to consider. Number one is you can delay the billing for your services until, say, mid to late December. That way the payment is not recognized or received until, say, January. It's called payment deferral. Another strategy is the option to open a solo 401K, but there is a deadline here. You don't have to fund the account in 2022 in this example, but you do have to have the account open before December 31. So if you are self-employed or a freelancer, and you're interested in exploring a 401K, the time is now to go ahead and consult your advisor about getting this account open.

Ric: And finally, there's the Roth IRA conversion idea.

Clay: This is something we're looking very carefully at for our clients. It's a very powerful strategy, but you have to be careful about it. Roth IRA conversions do recognize income. But here's the thing: with the market at lower levels, you can actually convert the shares at lower tax impact right now because the price of the shares dropped sharply. So you still have to recognize the income. The key thing to keep in mind here is with market levels at lower levels, convert the same number of shares at lower tax impact right now because the price of the shares dropped sharply. The tax consequences are lower, but I would recommend that you work with a financial advisor and a tax advisor to make sure that you're not converting enough of these shares to boost you on a higher marginal tax bracket. That would probably start to negate the benefits of this.

Ric: And the real key is urgency. You know, we're getting to the year end, we've got the holiday season, everybody's very busy, and they tend to procrastinate and put this off. So the real message beyond all else, which you've conveyed very effectively is: get on with it, get moving, talk with your financial and tax advisor. Do it now before you're inundated with the holidays and New Year's Eve. 

Clay: Absolutely. Yeah, absolutely. And everybody's different. Ric. Some of these things might make sense to some investors, but they might not make sense for others. So definitely seek out professional advice before you jump off the ledge here. These are great strategies for the right situation.

Ric: And you don't need to be an expert in any of this stuff. That's why you go to the advisor. And if somebody wanted to talk with you or your colleagues at Edelman Financial Engines, how would they reach you?

Clay: Sure, the best way to reach us is just go to PlanEFE.com/Ric.

Ric: That's Clay Ernst. He's Executive Director of Financial Planning at Edelman Financial Engines, the number one ranked investment advisory firm in the country by Barron's. Clay and I actually spoke for a lot longer. If you'd like to hear, watch, or read the entire conversation, just visit TheTruthAYF.com. Stay with us for more here on The Truth About Your Future.