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Tax Management

Tax Management

| October 31, 2018

In my blog post dated September 18, 2018, we addressed the third of six keys to creating a financial plan: Investment Concepts.  I highlighted some of the key concepts to consider in Investment Planning and Portfolio Development.

The fourth key area in any sound financial plan is Tax Management.  In my experience, Americans are united in their dislike of taxes.  Just about everyone feels that taxes are too high and that the tax code is too complicated.  It has been that way for a long time.  Benjamin Franklin once wrote a friend, “Nothing is inevitable except death and taxes.”  That brings up an interesting question: What is the main difference between death and taxes?  The difference is that death does not get any worse whenever Congress goes into session!  Taxes seem to be an inevitable part of our lives.

Taxes have come a long way in 95 years.  In 1913, paying income tax involved a simple one-page form.  Taxes ranged from 1% to 7%, and less than 1% of the population made enough money to have to pay the tax.

Today there are different rules for various types of income.  Deductions and credits are available for certain activities.  It is tough to keep everything straight.  So, let us spend a few minutes to get a brief overview of the most common investment tax issues.

Capital Gains

When you sell an investment at a profit, you usually get taxed.  If you sell within the first year you own that investment, you will pay tax at ordinary rates as high as 35%.  But the tax code encourages longer-term investments, so if you have held on longer than a year, you will pay a lower rate - a maximum of 15% for most stocks and funds.

In addition, you will also pay capital gains tax on some mutual fund distributions, even if you do not sell shares of the fund.  When the fund itself sells some of its holdings internally, the taxable gains are passed on to you.  Remember that mutual funds are pass-through entities.

Special rates apply on other types of investments.  Homeowners pay no tax on profits from selling their primary residence, up to $250,000 for single filers and $500,000 for couples. Collectibles, such as gold coins or antiques, have a higher maximum rate of 28% on gains.   Futures contracts have more complicated rules that tax part of your gain at long-term rates, even if you only hold them for a short time.

Dividends and Other Income

In addition to profits from selling investments, you will pay tax on any interest, dividends, rental or other income you receive.  Here again, the tax code encourages some investments over others.  Qualified dividends on stocks and stock mutual funds are eligible for the same lower maximum 15% rate.

In contrast, interest on bonds, income from rental property, and most other investment income typically gets taxed at higher ordinary income rates.  One exception is interest from municipal bonds, which is tax-free on your federal return and can offer state income tax benefits as well.

Use Those Retirement Accounts!

Investors can take advantage of a wide array of special types of accounts to get additional tax breaks.  Traditional IRA and 401(k) contributions can reduce your taxable income and give you tax-deferred growth, where you will only pay tax when you take money out.  Roth IRAs impose no tax on interest or dividends, as long as you follow the rules.

More Tax Breaks for Tax-Favored Accounts

Investments for other purposes get tax treatment as well.  Health savings accounts let you invest tax-free for medical expenses.  You can get tax-free treatment for college costs with 529 plans. Many of the financial institutions that offer IRAs give you access to these accounts as well.

Capital Losses

Inevitably, you will have to take a loss on an investment.  Generally, you can claim losses against any capital gains you have.  If you have more losses than gains, you can usually take $3,000 of losses against other types of income, including your wages.

Harvesting losses is a common technique late in the tax year.  But be careful of the wash sale rules, which can take away your deduction if you try to buy back what you have sold within 30 days.

The Bottom Line

Tax-efficiency is within reach of most investors.  If you want to keep more of your investment earnings and stay out of a higher tax bracket, choose investments that offer the lowest tax burdens relative to their interest income or dividend income.  A basic understanding of taxes on investments can help you assemble a portfolio that minimizes the amount of tax you have to pay.  And, as always, we are available to help you navigate the tax maze successfully.  Please call with any questions you may have.

Until next time, cheers!


  Emerald Publications  
  Motley Fool