Tax Efficient Investing

Well-Traveled? Don’t Get Tripped Up on Tax Day

Cross-border issues to remember while filing U.S. taxes (first in a series)


Key Takeaways:

  • The IRS takes the definition of “global” seriously. All global income, including employee stock option plans, must be reported.

  • There is an increased focus on offshore income tax compliance.

  • The IRS also expects to hear from all U.S. citizens and green card holders living overseas.

  • Taxpayers might be failing this compliance simply because they are not aware of the rules.

  • Make sure your advisors are staying up to date on offshore income rules. 

 

As you get ready to put the final touches on your tax return, here are some important things that you and your financial advisors should remember with respect to global income compliance.

All global income must be reported

If you are a U.S. resident or U.S. citizens (whether NRI, PIO or OCI), you must pay taxes in the U.S. on all global income. A U.S. resident is a green card holder and/or someone who has been physically present in the United States for at least 31 days during the current year and for at least 183 days during the three-year period that includes the current year and the two preceding years. To satisfy the 183-day requirement, count all the days that you were present in the current year, add one-third of the days you were present in the first year before the current year, and then add one-sixth of the days you were present in the second year before the current year.

Global income will include:

  • Any salary partly received in another country.

  • Any income received overseas for freelance or consulting work.

  • Interest on bank deposits and other securities held overseas.

  • Dividends from shares and mutual funds.

  • Capital gains from sale of assets.

  • Rent from property.

Remember, your global income will be taxed in the U.S. as per rules that apply to similar income in the U.S. For instance, while dividends may be tax-free in India, they are taxed in the U.S., and hence your dividends from India will be taxed in the U.S. The same goes for capital gains. According to U.S. law, the definition of “long term” is one year for all assets, but it may be different in other countries. When you file tax returns in the U.S., you must take into account this difference and treat overseas capital gains as per the time period specified in U.S. law.

If you have paid tax in the overseas country from which the income described above is derived, you must check the Double Taxation Avoidance Agreement to see if you are eligible to claim a foreign tax credit.

Tip: When you fill in Schedule B of your tax return Form 1040, pay close attention to line 7. Line 7 asks if the taxpayer had, during the tax year, held any financial interest in or signature authority over a foreign financial account (such as a bank account, securities account or brokerage account). Make sure you confirm that you indeed had overseas investments.

ESOP taxation

Did you exercise an employee stock option plan (ESOP) in 2017? If so, that’s one more thing you must declare on your U.S. tax return. In the U.S., the value of ESOPs granted is taxed at the time when the employee exercises the option.

You must add the total value of their ESOP compensation to your total income in the U.S. Since you may have also paid tax in the country where the ESOP originated, you will be eligible to claim a tax credit in their U.S. tax returns. You must refer to the Double Taxation Avoidance Agreement.

Tip: You can disclose this as other income in Form 1040. You can claim foreign tax credit using Form 1116.

U.S. citizens and green card holders living overseas

In this connected world, you may be constantly on the move. This is a red flag.

Regardless of where you live, all U.S. citizens and green card holders must file tax returns in the U.S. based on their total global income. You must pay taxes on such foreign income unless a treaty or statutory exclusion or foreign tax credit applies to reduce your U.S. tax liability to zero.

In such cases, if you are a U.S. citizen or a green card holder residing overseas, on the regular due date of your return, you are allowed an automatic two-month extension to file your return and to pay any amount due without requesting an extension. So this year, the automatic two-month extension goes to June 15. But remember, while no penalty is charged, interest is still charged on the balance due between April 15 and June 15.

If you are unable to file a return by the automatic two-month extension date, you can request an additional extension to October 15 by filing Form 4868 before the automatic two-month extension date. However, any tax due payments made after June 15 will be subject to both interest charges and failure-to-pay penalties.

Tip: Filing U.S. tax returns from overseas can be quite a challenge. Not all software is equipped to handle foreign tax issues such as earned income exclusions—Form 2555, foreign tax credit—Form 1116, Form 8938, Form 8833 and so on. In such cases, you and your advisors will need to file a paper return.

Conclusion

Foreign income compliance is becoming increasingly important to the IRS. As the Foreign Account Tax Compliance Act (FATCA) gathers steam, opportunities to come into compliance without harsh penalties will diminish. The sooner you act the better.

In the next installment of this article series, we’ll look at the various additional forms that must be included with the 1040 to be compliant with global income reporting.



DISCLAIMER: The views expressed in this article do not necessarily express the views of our firm and should not be construed as professional tax advice.

 

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Withdrawal Strategies: Tax-Efficient Withdrawal Sequence

Key Takeaways:

  • Retirees’ portfolios may last longer if they incur the least amount of income tax possible over their retirement period.

  • Retirees should focus on minimizing the government’s share of their tax-deferred accounts.

  • Make sure your advisor is helping you select the appropriate dollar amount and the appropriate assets to liquidate in order to fund your retirement lifestyle.

Asset Placement Decision

A winning investment strategy is about much more than choosing the asset allocation that will provide the greatest chance of achieving one’s financial goals. It also involves what is called the asset location decision. Academic literature on asset location commonly suggests that investors should place their highly taxed assets, such as bonds and REITs, in tax-deferred accounts and place their tax-preferred assets, such as stocks, in taxable accounts.

In general, your most tax-efficient equities should be held in taxable accounts whenever possible. Holding them in tax-deferred accounts can result in the following disadvantages:

  • The potential for favorable capital gains treatment is lost.

  • The possibility of a step-up in basis at death for income tax purposes is lost.

  • For foreign equities, foreign tax credit is lost.

  • The potential to perform tax-loss harvesting is lost.

  • The potential to donate appreciated shares to charities and avoid taxation is lost.

Asset location decisions can benefit both your asset accumulation phase and retirement withdrawal phase. During the withdrawal phase, the decision about where to remove assets in order to fund your lifestyle should be combined with a plan to avoid income-tax-bracket creeping. This will ensure that your financial portfolio can last as long as possible.

Tax-Efficient Withdrawal Sequence

Baylor University Professor, William Reichenstein, PhD, CFA wrote a landmark paper in 2008 that’s still highly relevant today. It’s called: Tax-Efficient Sequencing of Accounts to Tap in Retirement. It’s fairly technical, but it provides some answers about the most income-tax-efficient withdrawal sequence to fund retirement that are still valid today. According to Reichenstein, “Returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at a positive effective tax rate.”

Reichenstein also noted that only part of a traditional IRA’s principal belongs to the investor. The IRS “owns” the remaining portion, so the goal is to minimize the government’s share, he argued.

Tax-Efficient Withdrawal Sequence Checklist

In our experience, retirees should combine the goal of preventing income-tax-bracket creeping over their retirement years with the goal of minimizing the government’s share of tax-deferred accounts.

To achieve this goal, the dollar amount of non-portfolio sources of income that are required to be reported in the retiree’s income tax return must be understood. These income sources can include defined-benefit plan proceeds, employee deferred income, rental income, business income and required minimum distribution from tax-deferred accounts. Reporting this income, less income tax deductions, is the starting point of the retiree’s income tax bracket before withdrawal-strategy planning.

The balance of the retiree’s lifestyle should be funded from his or her portfolio assets by managing tax-bracket creeping and by lowering the government ownership of the tax-deferred accounts. The following checklist can assist the retiree in achieving this goal:

  1. Avoid future bracket creeping by filling up the lower (10% and 12%) income tax brackets by adding income from the retiree’s tax-deferred accounts.

  2. If the retiree has sufficient cash flow to fund lifestyle expenses but needs additional income, convert traditional IRAs into Roth IRAs to avoid tax-bracket creeping in the future. This will also allow heirs to avoid income taxes on the inherited account balance.

  3. Locate bonds in traditional IRAs rather than in taxable accounts. This will reduce the annual reporting of taxable interest income on the tax return.

  4. Manage the income taxation of Social Security benefits by understanding the amount of reportable income based on the retiree’s adjusted gross income level.

  5. Liquidate high-basis securities rather than low-basis securities to fund the lifestyle for a retiree who needs cash but is sensitive to additional taxable income.

  6. Aggressively create capital losses when the opportunity occurs to carry forward to future years to offset future capital gains.

  7. Allow the compounding of tax-free growth in Roth IRAs by deferring distributions from these accounts.

  8. Consider a distribution from a Roth for a year in which cash is needed but the retiree is in a high income tax bracket.

  9. Consider funding charitable gifts by transferring assets from a traditional IRA directly to the charity. This avoids the ordinary income on the IRA growth.

  10. Consider funding charitable gifts by selecting low-basis securities out of the taxable accounts in lieu of cash. This avoids capital gains on the growth.

  11. Manage capital gains in taxable accounts by avoiding short-term gains.

Conclusion

You and your advisor should work together closely to make prudent, tax-efficient withdrawal decisions to ensure your money lasts throughout your retirement years. Contact us any time if you have questions about your retirement funding plans or important changes in your life circumstances.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.