Invest for Lower Taxes

February 6, 2013 at 1:34 PM

The 2013 tax situation for many investors is not nearly as bad as predicted.  Still, the high net worth among us face some serious increases.  The highest marginal tax rate is 39.6 percent, with a 20 percent tax on dividends and long term capital gains.  There is an additional 3.8 percent Medicare surcharge on interest and dividends, deductions are being limited, and payroll taxes are back to 7.65 percent.  What now?  Invest your way to lower taxes.

Maximize Retirement Plan Contributions.  The maximum 401(k) (or similar) plan contribution limit has been raised to $17,500 for 2013.  Those aged 50 or older can also take advantage of the $5,500 catch-up contribution.  That means a married couple can stash away as much as $46,000 in employer retirement plans, for a potential tax savings of as much as $18,216.  Tax on the investment income in those plans is deferred as well, for additional tax savings.  As an added incentive, that 3.8 percent Medicare surcharge does not apply to distributions from retirement plans, so your earnings will sidestep that as well.

Contribute to Your IRA.  Those who are eligible (incomes of $188,000 or less if married filing jointly and $127,000 or less if single) should contribute to a Roth IRA.  The maximum IRA contribution is $5,500, with an additional $1,000 catch up amount for those aged 50 or older.

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Roth IRA contributions are not deductible, but under current law, all investment growth is tax free forever when monies are withdrawn for retirement.

If you aren’t eligible for a Roth IRA, contribute to your traditional IRA.  True, your contribution is likely not deductible.  However, as is the case with a Roth IRA, investment income is tax free while it stays in the IRA.  When you take distributions, a percentage representing any non-deductible contribution comes out tax free.

Even though your IRA contribution may not be deductible, it grows tax-deferred.  That moves income out of the 3.8 percent Medicare surtax, out of the Alternative Minimum Tax, and out of taxation at your highest marginal rate.  Granted, the investment income on $5,500 or $6,500 is not much, but regular, sustained IRA contributions can make a real difference in your cumulative tax bill.

The 3.8 percent Medicare surtax on investment income gives you real incentive to move money into an IRA.  That’s because the surtax does not apply to IRA withdrawals. 

Allocate Assets to Reduce Taxes.  Consistent with your overall asset allocation, focus your fixed income in your retirement accounts and your equities in your taxable accounts. 

Interest on taxable bonds is taxed at your highest marginal rate.  If you hold those bonds in a retirement account, you pay no current tax on that interest.  This is a better result than owning tax-free municipal bonds in a taxable account.  Municipal bonds pay less interest than do taxable ones, and certain municipal bond interest is subject to the Alternative Minimum Tax.

Conversely, hold stocks in your taxable accounts to benefit from the preferred dividend and capital gains treatment.  The highest rate for these is 20 percent, with most investors capped at 15 percent.  Further, stocks have historically appreciated more rapidly than bonds, giving you relatively more capital gain to tax at that lower rate. 

Stocks are also traditionally more volatile than bonds.  If you lose money in a taxable account, you can offset that loss against investment gains.  Any loss in excess of gains can be offset against as much as $3,000 of regular income, with the remainder carried forward to future years.  This favorable tax treatment is unavailable in a retirement account.

Prefer Individual Stocks and Bonds.  Owning individual securities gives you control over the tax consequences of sales.  When you a buy a mutual fund, you inherit the fund’s cost basis in all of its holdings. 

Here’s how it works: say you buy a fund that holds IBM at $3.00 per share.  When you buy into the fund, IBM is trading at $195 per share.  You have no control over the fund’s trading, and it sells IBM for $180 per share.  Economically, you’ve lost $15 per share, but all fund holders at the time of sale are taxed on $177 of gain per share, based on IBM’s purchase price.  The fund is required to distribute out its capital gains each year, so you are stuck with the bill.

Conversely, if you own securities directly, instead of through a mutual fund, you establish your own cost basis.  You control whether and how much to sell.  You can balance winners and losers, to lower your overall tax bill.


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