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at 28%, your after-tax rate of return would
be 5.76%. A $50,000 investment earning 8%
annually would be worth $107,946 after 10
years; at 5.76%, it would be worth only $87,536.
Reducing your tax liability is key to building the
value of your assets, especially if you are in one
of the higher income tax brackets. Here are five
ways to potentially help lower your tax bill. (1)
Invest in Tax-Deferred & Tax-Free Accounts
Tax-deferred accounts include companysponsored
retirement savings accounts such as
traditional 401(k) and 403(b) plans, traditional
individual retirement accounts (IRAs), and
annuities. Contributions to these accounts may
be made on a pretax basis (i.e., the contributions
may be tax deductible) or on an after-tax basis
(i.e., the contributions are not tax deductible).
More important, investment earnings
compound tax deferred until withdrawal,
typically in retirement, when you may be in
a lower tax bracket. Contributions to nonqualified
annuities, Roth IRAs, and Roth-style
employer-sponsored savings plans are not tax
deductible. Earnings that accumulate in Roth
accounts can be withdrawn tax free if you have
held the account for at least five years and meet
the requirements for a qualified distribution.
Pitfalls to avoid
Withdrawals prior to age 59½ from a qualified
retirement plan, IRA, Roth IRA, or annuity may
be subject not only to ordinary income tax,
but also to an additional 10% federal tax. In
addition, early withdrawals from annuities
may be subject to additional penalties charged
by the issuing insurance company. Also, if you
have significant investments, in addition to
money you contribute to your retirement plans,
consider your overall portfolio when deciding
which investments to select for your taxdeferred
accounts. If your effective tax rate—that
is, the average percentage of income taxes you
pay for the year—is higher than 15%, you’ll want
to evaluate whether investments that earn most
of their returns in the form of long-term capital
gains might be better held outside of a taxdeferred
account. That’s because withdrawals
from tax-deferred accounts generally will be
taxed at your ordinary income tax rate, which
may be higher than your long-term capital gains
tax rate (see “Income vs. Capital Gains”).
Income vs. Capital Gains
Generally, interest income is taxed as
ordinary income in the year received and
qualified dividends are taxed at a top rate of 20%.
(Note that an additional 3.8% tax on investment
income also may apply to both interest income
and qualified (or non-qualified) dividends.) A
capital gain (or loss)—the difference between
the cost basis of a security and its current price—
is not taxed until the gain or loss is realized. For
individual stocks and bonds, you realize the gain
or loss when the security is sold. However, with
mutual funds you may have received taxable
capital gains distributions on shares you own.
Investments you (or the fund manager) have
held 12 months or less are considered short
term, and those capital gains are taxed at the
same rates as ordinary income. For investments
held more than 12 months (considered long
term), those capital gains are taxed at no more
than 20%, although an additional 3.8% tax on
investment income may apply. The actual rate
will depend on your tax bracket and how long
you have owned the investment.
Consider Government & Municipal Bonds
Interest on U.S. government issues is subject
to federal taxes but is exempt from state taxes.
Municipal bond income is generally exempt
from federal taxes, and municipal bonds issued
in-state may be free of state and local taxes as
well. An investor in the 33% federal income-tax
bracket would have to earn 7.46% on a taxable
bond, before state taxes, to equal the tax-exempt
return of 5% offered by a municipal bond. Sold
prior to maturity or bought through a bond
fund, government and municipal bonds are
subject to market fluctuations and may be worth
less than the original cost upon redemption.
Pitfalls to avoid
If you live in a state with high state income
tax rates, be sure to compare the true taxableequivalent
yield of government issues, corporate
bonds, and in-state municipal issues. Many
calculations of taxable-equivalent yield do not
take into account the state tax exemption on
government issues. Because interest income
(but not capital gains) on municipal bonds
is already exempt from federal taxes, there’s
generally no need to keep them in tax-deferred
accounts. Finally, income derived from certain
types of municipal bond issues, known as
private activity bonds, may be a tax-preference
item subject to the federal alternative minimum tax.
Look for Tax-Efficient Investments
Tax-managed or tax-efficient investment
accounts and mutual funds are managed
in ways that may help reduce their taxable
distributions. Investment managers may employ
a combination of tactics, such as minimizing
portfolio turnover, investing in stocks that do
not pay dividends, and selectively selling stocks
that have become less attractive at a loss to
counterbalance taxable gains elsewhere in the
portfolio. In years when returns on the broader
market are flat or negative, investors tend to
become more aware of capital gains generated
by portfolio turnover, since the resulting tax
liability can offset any gain or exacerbate a
negative return on the investment.
Pitfalls to avoid
Taxes are an important consideration in
selecting investments but should not be the
primary concern. A portfolio manager must
balance the tax consequences of selling a
position that will generate a capital gain versus
the relative market opportunity lost by holding
a less-than-attractive investment. Some mutual
funds that have low turnover also inherently
carry an above-average level of undistributed
capital gains. When you buy these shares, you
effectively buy this undistributed tax liability.
Put Losses to Work
At times, you may be able to use losses in
your investment portfolio to help offset realized
gains. It’s a good idea to evaluate your holdings
periodically to assess whether an investment still
offers the long-term potential you anticipated
when you purchased it. Your realized capital
losses in a given tax year must first be used
to offset realized capital gains. If you have
“leftover” capital losses, you can offset up to
$3,000 against ordinary income. Any remainder
can be carried forward to offset gains or income
in future years, subject to certain limitations.
Pitfalls to avoid
A few down periods don’t necessarily mean
you should sell simply to realize a loss. Stocks in
particular are long-term investments subject to
ups and downs. However, if your outlook on an
investment has changed, you may be able to use
a loss to your advantage.
Keep Good Records
Keep records of purchases, sales,
distributions, and dividend reinvestments so
that you can properly calculate the basis of
shares you own and choose the shares you sell in
order to minimize your taxable gain or maximize
your deductible loss.
Pitfalls to avoid
If you overlook mutual fund dividends
and capital gains distributions that you have
reinvested, you may accidentally pay the tax
twice—once on the distribution and again on
any capital gains (or under—reported loss)—
when you eventually sell the shares.
Keeping an eye on how taxes can affect
your investments is one of the easiest ways you
can enhance your returns over time. For more
information about the tax aspects of investing,
consult a qualified tax advisor. ☐
1. Example does not include taxes or fees.
This information is general in nature and
is not meant as tax advice. Always consult
a qualified tax advisor for information as
to how taxes may affect your particular
situation. For more info see Ed Hill ad p.9.
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p.8 The Pinehurst Gazette, Inc. No. 133