Tax Planning

As just about every investor knows, it’s not what your investments earn, but what they earn after taxes that counts. After factoring in federal income and capital gains taxes, the alternative minimum tax, and any applicable state and local taxes, your investments’ returns in any given year may be reduced by 40% or more.

For example, if you earned an average 8% rate of return annually on an investment taxed 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 and Tax-Free Accounts

Tax-deferred accounts include company-sponsored 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 Earnings that accumulate in Roth accounts can be withdrawn tax free if you have held the account for at least five years and meet the requirements for a qualified distribution.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 tax-deferred 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 tax-deferred 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”).

Consider Government and 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 taxable-equivalent 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 underreported 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.

Source/Disclaimer: ¹Example 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.

Required Attribution Because of the possibility of human or mechanical error by DST Systems, Inc. or its sources, neither DST Systems, Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall DST Systems, Inc. be liable for any indirect, special or consequential damages in connection with subscriber’s or others’ use of the content.

© 2017 DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.

The last thing anyone wants to think about is taxes. But if you are looking for ways to minimize your tax bill, there’s no better time for tax planning than before year-end. That’s because there are a number of tax-smart strategies you can implement now that will reduce your tax bill come April 15.

As the year begins to draw to a close, consider how the following strategies might help to lower your taxes.

Put Losses to Work

If you expect to realize either short- or long-term capital gains, the IRS allows you to offset these gains with capital losses. Short-term gains (gains on assets held less than a year) are taxed at ordinary rates, which range from 10% to 39.6%, and can be offset with short-term losses. Long-term gains (gains on assets held longer than a year) are taxed at a top rate of 20% and can be reduced by long-term capital losses.¹ To the extent that losses exceed gains, you can deduct up to $3,000 in capital losses against ordinary income on that year’s tax return and carry forward any unused losses for future years.

Given these rules, there are several actions you should consider:

• Avoid short-term capital gains when possible, as these are taxed at higher ordinary rates. Unless you have short-term capital losses to offset them, try holding the assets for at least one year.
• Take a good look at your portfolio before year-end and estimate your gains and losses. Some investments, such as mutual funds, incur trading gains or losses that must be reported on your tax return and are difficult to predict. But most capital gains and losses will be triggered by the sale of the asset, which you usually control. Are there some winners that have enjoyed a run and are ripe for selling? Are there losers you would be better off liquidating? The important point is to cover as much of the gains with losses as you can, thereby minimizing your capital gains tax.
• Consider taking capital losses before capital gains, since unused losses may be carried forward for use in future years, while gains must be taken in the year they are realized.

When evaluating whether or not to sell a given investment, keep in mind that a few down periods don’t mean you should sell simply to realize a loss. Stocks in particular are long-term investments subject to ups and downs. Likewise, a healthy unrealized gain does not necessarily mean an investment is ripe for selling. Remember that past performance is no indication of future results; it is expectations for future performance that count. Moreover, taxes should only be one consideration in any decision to sell or hold an investment.

Unearned Income Tax

A 3.8% tax on “unearned” income went into effect in 2013, effectively increasing the top rate on most long-term capital gains to 23.8%. The tax applies to “net investment income,” which includes interest, dividends, royalties, annuities, rents, and other passive activity income, among other items. Importantly, “net investment income” does not include distributions from IRAs or qualified retirement plans, annuity payouts, or income from tax-exempt municipal bonds. In general, the new tax applies to single taxpayers with a modified adjusted gross income (MAGI) of $200,000 or more and to those who are married and filing jointly with a MAGI of $250,000 or more.

IRAs: Contribute, Distribute, or Convert

One simple way of reducing your taxes is to contribute to a traditional IRA, if you are eligible. Contributions are made on a pretax basis, so they reduce your taxable income. Contribution limits for the 2017 tax year — which may be made until April 17, 2018 — are $5,500 per individual and $6,500 for those aged 50 or older. Note that deductibility phases out above certain income levels, depending upon your filing status and if you or your spouse are covered by an employer-sponsored retirement plan.

An important year-end consideration for older IRA holders is whether or not they have taken required minimum distributions. The IRS requires account holders aged 70½ or older to withdraw specified amounts from their traditional IRA each year. These amounts vary depending on your age, increasing as you grow older. If you have not taken the required distributions in a given year, the IRS will impose a 50% tax on the shortfall. So make sure you make the required minimums for the year by year-end.

Another consideration for traditional IRA holders is whether to convert to a Roth IRA. If you expect your tax rate to increase in the future — either because of rising earnings or a change in tax laws — converting to a Roth may make sense, especially if you are still a ways from retirement. You will have to pay taxes on any pretax contributions and earnings in your traditional IRA for the year you convert, but withdrawals from a Roth IRA are tax free and penalty free as long as you’re at least 59½ and the converted account has been open at least five years. If you have a nondeductible traditional IRA (i.e., your contributions did not qualify for a tax deduction because your income was not within the parameters established by the IRS), investment earnings will be taxed but the amount of your contributions will not. The conversion will not trigger the 10% additional tax for early withdrawals.

Regardless of what Congress does in the future, there are many steps you can take today to help lighten your tax burden. Work with a financial professional and tax advisor to see what you can do now to reduce your tax bill in April. 

Source/Disclaimer:

¹Under certain circumstances, the IRS permits you to offset long-term gains with net short-term capital losses. See IRS Publication 550, Investment Income and Expenses.

Required Attribution


Because of the possibility of human or mechanical error by DST Systems, Inc. or its sources, neither DST Systems, Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall DST Systems, Inc. be liable for any indirect, special or consequential damages in connection with subscriber’s or others’ use of the content.

© 2017 DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.