No one wants to think about tax planning after April 15. However, if your goal is to minimize incomes taxes, tax planning should be a year-round activity. This is especially true for investors. Tax implications should not be the driving factor when making investment decisions, but they should be part of the process. Many tax rules and regulations impact investments, and it is easy for investors to become overwhelmed. This is where your tax accountant and financial adviser need to collaborate to structure an investment strategy and tax strategy that work together.
Here are some essential investment decisions that can have significant tax implications:
Allocation among accounts
Investors should consider using the New Three-Legged Stool™ approach to savings, allocating funds to taxable, tax-deferred, and tax-free (Roth) accounts. The most tax-efficient investments, such as municipal bonds, non-dividend paying stocks, and growth-oriented passive mutual funds and ETFs, should usually be held in a taxable account. The least tax-efficient investments—such as corporate bonds, real estate investment trusts, and income-oriented mutual funds—might serve you better in a tax deferred account.
Master limited partnerships (MLP)
MLPs are popular in low-interest-rate environments because they must distribute 85% of their income. Many MLPs generate unrelated business income, and these investments usually belong in a taxable account even though they are income oriented. If held in a tax-deferred account, they may produce unrelated business taxable income (UBTI). When UBTI is greater than $1,000, the investor must complete and file Form 990 and pay additional income tax.
Gold and other collectibles
The IRS categorizes gold and other precious metals as collectibles rather than investments. Collectibles are not eligible for capital gains treatment, which has a maximum tax rate of 20% for taxpayers in the top tax bracket. The federal tax for long-term gains on collectibles is 28%. This same rule applies to exchange traded funds (ETFs) backed by physical gold, and the gain on your gold ETF may be taxed as a gain on a collectible.
The IRS classifies cryptocurrency as property, and cryptocurrency transactions are taxable. Taxes are due when you sell, trade, or dispose of cryptocurrency in any way for a gain. Trades between cryptos are also considered taxable events. If you trade one cryptocurrency for another, it is reportable in U.S. dollars on your tax return.
Just like stocks, cryptos are taxed as either long-term or short-term capital gains depending on the holding period. Losses in cryptos can be taken against other capital gains but are capped at $3,000 against other income.
Foreign stocks and stock funds:
Line 7 of Form 1099-DIV shows the amount of foreign taxes withheld on dividends paid. U.S. taxpayers get to recoup this tax withholding in a tax credit on their tax returns. The credit is only available when the foreign stocks are held in a taxable account.
Holding periods for capital gains
Realized gains on appreciated securities held for one year or more qualify for favorable tax treatment. Long-term capital gain tax rates are significantly lower for taxpayers, and the tax rate is zero for taxpayers in the 12% tax bracket. Short-term capital gains are considered ordinary income and taxed at a higher rate. So, before selling a security, be sure to check when it was purchased. Delaying the sale could result in considerable tax savings.
Combine charitable intentions with investment management
Before selling a security with a capital gain, consider using it instead to fulfill philanthropic goals. Donating appreciated assets makes the most sense when a taxpayer has a long-term capital gain asset with a low adjusted tax basis. The donor deducts the current appreciated value of the asset as a charitable gift and avoids the capital gain tax incurred if the asset were sold. It is often better to give appreciated assets than cash.
Roth conversions for long-term savings
When a traditional IRA is converted to a Roth IRA, tax is due on the converted amount in the year of conversion. Consider Roth conversions in tax years when you have low income from other taxable sources. Partial conversions can sometimes maximize tax savings. Over time, well-planned Roth conversions will minimize required minimum distributions at age 72 and provide a tax-free source of funds when needed for large purchases.
Harvest capital gains in low-income years
Anyone in the 12% tax bracket should consider realizing long-term capital gains up to the top of their tax bracket. For 2022, the top of the 12% tax bracket is $41,775 for single taxpayers and $83,550 for married filing jointly. After deductions, this is taxable income, and long-term gains are taxed at zero in this tax bracket. Taxpayers who live in states that tax capital gains will want to consider their individual state’s tax treatment before implementing this strategy.
Making investment decisions is complicated on its own but adding the complexity of tax implications can make it feel daunting. But with the top marginal tax rate now at 37%—and the Medicare surtax on investment income adding another 3.8%—tax efficiency is more important than ever.
- The New Three-Legged Stool approach to savings provides opportunities to create tax efficiencies by allocating investments over the three legs.
- MLPs may appear to be more tax-efficient in an IRA, but if they produce UBTI, they should be held in a taxable account.
- Roth conversions can be an essential part of a long-term tax strategy.
Originally Posted: April 24th, 2014