Tax Efficient Investing, Part I

| April 1, 2013 | 0 Comments

For the first time in over a decade, tax rates on income and investment gains have risen. In addition, a new Net Investment Income tax has been imposed on all investment income for taxpayers whose Adjusted Gross Income (AGI) is above certain thresholds ($200,000 for single filers and $250,000 for married filers).

So, given these higher tax rates, how can investors maximize their after-tax returns? To do this, you first need to understand what kinds of income are generated by different investments. This is the first step in designing an investment strategy to maximize the amount of income you keep within the framework of existing tax laws. The caveat here, of course, is the word “existing;” nobody can predict what or how tax laws will change in the future.

There are basically two types of investment earnings: income and capital gains. Let’s start with income.

Investment income comes in two different flavors: interest and dividends. According to Investopedia(.com), interest is “the charge for the privilege of borrowing money… Lenders make money from interest, borrowers pay it.” When you purchase a bond, you are in essence lending money to the issuer of the bond, and they will pay you interest income in return. Most interest income is taxable as ordinary income; it will be taxed at your regular income tax rates just like your wages or pension income.

Some income, generally from bonds issued by state and local governments (municipal bonds), may be exempt from federal and/or state taxes. Note that not every municipal bond is tax-free, but most are. Offsetting the benefit of this this tax-free income, most municipal bonds pay lower interest rates than corporate bonds with similar credit risks and maturities. For most high-income investors, the low tax-free interest from municipal bonds will provide better after-tax income than higher yielding taxable bonds. For investors paying 25 percent or less of their income in taxes, higher yielding taxable bonds will usually provide a higher after-tax income. A tax professional or a Certified Financial Planner® professional can help you figure out which is better for your situation.

The other kind of income is Dividend income. Dividends are paid by corporations to the owners of their stock, and are basically payments of a share of profits to the owners of a company. Dividend income used to be taxed the same way as interest and wage income, but is now taxed at a special tax rate of either 15 or 20 percent, depending on your income level.

The other basic type of investment earnings is capital gains. This is the profit you earn by selling an investment for more than you bought it. Net capital gains on investments held for less than one year, called “short-term capital gains” are taxed at your ordinary income tax rates. Long-term gains, those on investments held for more than a year, are taxed at a special “capital gains’ tax rate,” currently 15 percent (20 percent for higher income taxpayers). Some capital losses can be written off against ordinary income.

There are also some special tax rules surrounding capital gains and mutual funds. When a fund manager sells an investment stock for a gain, he is required to distribute that gain to shareholders. Thus, towards the end of every year, mutual funds will make “capital gains distributions” to shareholders. Note that these are NOT extra income; a fund worth $100 that distributes $10 as capital gains will be worth $90 after that distribution. The shareholder will go from having $100 of fund shares to holding $90 of fund shares and $10 in cash.

Some other investment income may be treated in other special ways, such as distributions from partnerships, but that’s beyond the scope of this article. Next month I’ll go into how to position your investments in light of the kinds of income they generate and the tax implications of that income.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at Rick and his family live in Mission Hills.

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