No one wants to think about 2014 tax planning when the 2013 tax season is finally ending. However, tax planning should be a year round activity if your goal is to minimize your taxes. This is especially true for investors. Tax implications should not be the leading factor when making investment decisions but it should be part of the process. There are many tax rules and regulations impacting investments and it’s easy for investors to become overwhelmed. This is where your tax accountant and financial adviser need to work together to structure an investment strategy and tax strategy that work together.
Here are some important investment decisions that can have significant tax implications to consider:
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 be held in the taxable account. The least tax efficient investments such as corporate bonds, Real Estate Investment Trusts, and income oriented mutual funds should be held in the tax deferred accounts. Use the Roth IRA to balance out the asset allocation.
Master limited partnerships (MLP)
MLPs have become popular in our current low interest rate environment because they must distribute 85% of their income. Many MLPs generate unrelated business income. These investments belong in a taxable account even though they are income oriented. If held in a tax deferred account they may produce the Unrelated Business Taxable Income (UBTI). When UBTI is greater than $1,000, the investor must complete and file a rather complex Form 990 and pay additional income tax.
Gold and other collectibles
The IRS categorizes gold (and other precious metals) as a collectible rather than an investment. Collectibles are not eligible for capital gains treatment which has a maximum tax rate of 15% (20% for the top tax bracket). The federal tax for long-term gains on collectibles is 28 percent. This same rule applies to Exchange Traded Funds (ETFs) that are backed by physical gold. The gain on your gold ETF may be taxed as a gain on a collectible.
Foreign stocks (and stock funds)
You may have noticed a tax credit on the 1099-DIV you just filed away. Line 6 of this form shows the amount of foreign taxes that were withheld on dividends paid. US taxpayers get to recoup this tax withholding in the form of 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 and for taxpayers in the 15% tax bracket they are tax free. Short-term capital gains are taxed the same as ordinary income which is a higher rate. Before selling a security, be sure to check when it was purchased. Delaying the sale for a week or so could result in a large tax savings.
Combine charitable intentions with investment management
Before selling a security with a capital gain consider using it instead to fulfill your charitable 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 nearly always 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 will have low income from other taxable sources. Do partial conversions to maximize tax savings. Well planned Roth conversions over time will minimize required minimum distributions at age 70 ½ and provide a tax-free source of funds when needed for large purchases.
Harvest capital gains in low income years
Anyone in the 15% tax bracket should seriously consider realizing long-term capital gains up to the top of the 15% tax bracket. The top of the 15% tax bracket is $39,600 for single taxpayers and $73,800 for married filing joint. This is income after deductions. Long-term gains are taxed at zero in this tax bracket. Taxpayers living in states that tax capital gains will want to consider their individual state’s tax treatment before implementing this strategy.
Making investment decisions is difficult enough on its own, but adding the complexity of tax implications can seem daunting. The top marginal tax rate is now 39.6% plus the Medicare surtax on investment income adds an additional 3.8%, making tax efficiency 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 important part of a long-term tax strategy.