Jason Method: The leaves have turned color and started to fall. Thanksgiving is around the corner, and the calendar will soon change to another year. At this time, some of our thoughts can turn to planning for the future, both the immediate and the longer term. What does the year end hold for us?

Hello, and welcome to Vanguard’s Investment Commentary Podcast series. I’m Jason Method. In this month’s episode, which we’re taping on October 26, 2017, we’re going to discuss planning that centers on, but is not necessarily limited to, the year end. Maria Bruno of Vanguard Investment Strategy Group, one of our financial planning experts, is here to offer some tips for just about everyone, including investors and advisors. Hello, Maria, and thanks for joining us.

Maria Bruno: Thanks, Jason. It’s good to be here.

Jason Method: Maria, what is important about year end?

Maria Bruno: Year end is a really good opportunity. When you think about it from a financial planning standpoint, most investors at this point should have a pretty good handle on what their income will look like for the year. And what they can do is they can look at their portfolio and make any changes with an eye toward tax efficiency.

Jason Method: Let’s start with retirees who face some annual decisions themselves. What do they need to consider?

Maria Bruno: The big one for retirees is required minimum distributions. For many, they’ve deferred their savings in tax-deferred accounts through their working years. Once they reach age 70½, these accounts are subject to required distributions. And these have to be taken by the end of the year. If not, there’s a pretty stiff penalty. It’s 50% of the amount that you should have taken.

Jason Method: And this applies to any type of account, correct, whether it’s an IRA or something else?

Maria Bruno: These are tax-deferred accounts, so these are things like employer-sponsored plans like 401(k)s. They’re also traditional IRAs.

The one thing I will add is for those that have Roth 401(k)s, distributions are mandatory beginning at age 70½ for those that have employer-sponsored Roth plans. But they won’t be taxed.

The main question from retirees is, well, how do I take this RMD since I have to take this distribution anyway? The first piece of guidance that I typically give is to use it as a rebalancing opportunity. Look at your portfolio, see where you’re overweighted, and pare back on those holdings. Since you have to take the distribution anyway, doing so with an eye toward rebalancing is prudent.

Jason Method: There [are] some significant tax implications here for these RMDs, correct? Most of these people are taking Social Security at this time, so many of those benefits may be taxed. They may have some other income, like a pension or rental income. And now come the distributions. Can you help us think that through a little bit?

Maria Bruno: Absolutely. Once you reach age 70½, you have to take these distributions. It’s just really how can you be mindful to minimize the tax implications.

So one good example is if an investor is charitably inclined, he or she can take advantage of what’s called the qualified charitable distribution. You direct your financial institution to make the distribution to a qualified charity. The benefit to that is you don’t have to report that income as an investor. It doesn’t really hit your tax return. So you don’t get a charitable deduction, but you don’t have to because it’s never reported as income anyway. So that’s a pretty neat feature for those that are charitably inclined.

The other thing that I get a lot of questions from retirees is, well, what if I don’t need my distribution? Do I have to take it or what do I do with it? And the answer is, yes, you have to take it. It doesn’t necessarily mean you have to spend it. And for those investors that are in the good fortune that their RMD exceeds their spending needs, you can reinvest those net proceeds in a nonretirement account, a regular taxable account. But the key there is to be very mindful of being as tax-efficient as possible. So some good investments to think about are broad market index funds or ETFs or municipal bond funds, for instance.

Jason Method: Isn’t it best to start planning for this well ahead of retirement?

Maria Bruno: Absolutely, it can be. I often say that the time to plan for RMDs is not when you reach age 70½ but well before that.

Many retirees that are leaving the workforce today, they’re leaving with these large tax-deferred balances; and once they reach age 70½, as you had mentioned earlier, there’s other income that comes into play. The other one is Social Security. And particularly for those that have deferred Social Security to age 70, their tax bill could be pretty hefty. Sometimes we call this a tax torpedo.

So there are some planning strategies that one can consider. I mean certainly if you’re working, you can be mindful in terms of how you direct those contributions to either tax-deferred or Roth accounts. Again, [with] Roth accounts you don’t get a tax deduction when you make the contributions; but the account grows tax-free, and the accounts are not subjected to distributions on the IRA side, especially during your lifetime.

For those that are retired, and I like to think through individuals perhaps in their 60s that retire, it’s very reasonable that they may be in a lower tax bracket during these years, relatively speaking. So that can be an opportunity to accelerate taxable income, and there’s typically two ways to do that. One would be to draw from these traditional deferred accounts. The other can be to do a series of partial conversions, partial Roth conversions. The benefit here is that, yes, you’re accelerating income; but you’re paying income at a presumably lower marginal income tax rate. Sometimes this is called filling up the low brackets. So there’s a benefit there, and then you’re also decreasing your IRA balances, which would then decrease the RMDs in the future.

Jason Method: There is a lot of complexity here. Can most people figure this all out on their own?

Maria Bruno: It can be very complex. This is where working with an advisor or tax professional can be very beneficial because through annual tax planning, there [are] a lot of opportunities that can be garnered through these types of strategies. You really want to work through the numbers. An advisor can do that with you and make some recommendations that are much more personalized than what we’re talking about today.

Jason Method: Speaking of advisors, many of them talk to their clients about rebalancing about this time—at their annual meetings. Tell us about that.

Maria Bruno: Rebalancing is one of the most important maintenance strategies when you think about portfolio construction. There [are] a couple things to think through. When you rebalance your portfolio, you’re looking at the overweighted asset class, and you want to pare back on that. That’s to maintain the risk profile of the portfolio. But when you rebalance, you want to really keep an eye toward minimizing the taxes that result from the rebalancing transactions.

If you have tax-deferred balances, which we’ve just talked about, rebalancing in those accounts is basically a free rebalancing transaction from a tax standpoint.

For those that have taxable accounts, There [are] a couple of options. One can be, for those that are charitably inclined, gifting appreciated assets or assets that have low taxable basis can be quite attractive from a planning strategy. So There [are] a couple benefits. One is that you transfer the full value of the account, as well as the low basis, to the charity, but yet you get a tax deduction on the full amount that you pass to the charity, and then the charity gets the full benefit since they don’t have to pay taxes on the gift.

Another strategy for those that are not charitably inclined is to take advantage of annual gifting opportunities. So an individual can, in 2017, gift up to $14,000 to any number of individuals. And if you’re married, you can gift up to $28,000 to individuals, and that’s without incurring any type of gift-tax consequences.

Another thing that I’d like to talk about as well, on the rebalancing side: There’s two other things to think about. One would be if you have any cash flow, so year end, maybe you’re getting your year-end bonus at work, for instance. You know, use that as a way to strategically direct the proceeds, if you’re investing in your portfolio, to the underweighted asset class. That can make sense to target that cash flow.

And oftentimes we think about portfolio-based strategies such as tax-loss harvesting as a way to rebalance with an eye toward taxes. But the reality of it is, many investors aren’t sitting on lots of losses because the markets have been so generous over the past few years. This tax-loss harvesting is probably more of a cap gains harvesting story, and with this, basically what you’re doing is you’re selling assets that have a higher gain.

And the benefit to this, if you’re rebalancing and you’re in a low tax bracket, maybe the 10% bracket or the 15% bracket, your cap gains rate is 0%. So that, if strategically executed, can be a free rebalancing event as well.

Jason Method: Then there is the net investment income tax, which can hit a lot of households, including many dual-income households. Can you tell us about that?

Maria Bruno: Sure, so the net investment tax, it’s sometimes called the Medicare surtax, was introduced in 2013. And what basically it is, it’s a 3.8% tax that is imposed to households above a certain income threshold, so currently if you’re a single filer, $200,000 or above; married, filing jointly, $250,000 or above.

And the way the tax is calculated, it’s the greater of your net investment income, net of certain expenses, or the amount by which your modified adjusted gross income exceeds the limits that I had just mentioned.

And what goes into this net investment income are things like, generally speaking, investment income, capital gains distributions, dividends, rent, royalties. So it’s a little bit of a calculation, but basically the tax is assessed on the greater of your net investment income or the amount that your income is greater than these thresholds.

If you’re getting up to these limits or if you’re already toward that limit, you want to be mindful of not just your marginal rate but also these surcharges on top of that, that could trigger and then overall result in a higher tax rate than you may have anticipated.

Jason Method: We know that there is a lot happening in Washington right now in terms of tax proposals. Is there anything we need to keep our eye on?

Maria Bruno: Well, Jason, we get this question a lot. What we have right now is a framework from Republican lawmakers, and I just want to stress it’s exactly that. It’s a framework. We expect more details to come. When we get more final details, then we’ll have a really good sense in terms of what is actually going to happen and when.

Vanguard will certainly be at the forefront providing guidelines to our investors. If you’re working with an advisor, for instance, your advisor will be proactive in thinking through this with you. And at that time, once we have clarity, then you want to look at your overall financial plan and see how the tax changes fit into that plan.

Jason Method: As we do near the year end here, what sort of financial housekeeping items do we need to keep in mind?

Maria Bruno: Let’s think about first what year end brings. So for those that are working, I always like to remind investors to make sure that they’re maxing their tax-advantaged accounts; so these are 401(k)s, IRAs, for instance. IRAs, you certainly have until April 15 of the following year to make the contributions. Employer-sponsored plans, however, have year-end deadlines. So you want to make sure that you’re maxing out your tax-advantaged retirement accounts.

And then for those that are thinking about college planning, 529s also fall under that list of tax-advantaged accounts. So you want to make any 529 contributions by the end of the year if possible as well. Then we can shift to some other housekeeping things that I always like to bring up as annual checkups, whether it’s at the end of the year or maybe it’s another common date if it’s a birthday or an anniversary or something like that. But at least once a year, you want to first go back and take a look at what your goals are and make sure that your goals haven’t changed, and your time horizon for those goals, because those are key inputs to the asset allocation decision. So you want to make sure that your asset allocation is prudent. Then you want to also look at your portfolio and make sure that you’re properly diversified.

A couple of the other things that I also want to bring up is you want to make sure that you take a look at your beneficiaries, whether it’s beneficiaries of retirement accounts or life insurance policies. Make sure that your beneficiaries are current, and then you want to also take a look at your life insurance and make sure that you’re adequately insured at the household level as well.

Jason Method: Is this an area where an advisor can help you?

Maria Bruno: Oh, absolutely. You know, an advisor—we often think about advisors helping with portfolio-based decisions—but advisors really can look at your entire financial situation. And while we’ve talked a lot about general guidelines today, advisors can actually work with individuals and personalize their financial plan and make strategic decisions based upon the individual situation.

Jason Method: Wow, that covers a lot of ground. Well, just as there is plenty of planning for the holidays, there can be a need to look at the future and, as best we can in an uncertain world, chart a course at this time of year.

Thanks, Maria, for sharing your vast experience and for joining us for this Vanguard Investment Commentary Podcast. To learn more about Vanguard’s thoughts on various financial topics, check out our website and be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.

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