Financial Planning > Tax Planning

22 Days of Tax Planning: What I Do in My Practice, Pt. 2: Tax Aware Investing

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This is the second in a series of blog postings from advisor Mike Patton on how he works with clients during tax season and throughout the year to maximize his value to clients on tax planning. Future blogs in the month of March will include postings how to work with a client’s tax preparer on planning and referrals. See AdvisorOne’s Special Report on the 22 Days of Tax Planning Advice for 2012, with separate articles on each business day of the month to help you with your tax planning efforts for clients and yourself.

As the tax season heats up, it seemed prudent to discuss tax aware investing. Basically, all financial investments fall into one of three categories: taxable, tax free or tax exempt, and tax deferred. Naturally, there are pros and cons to each, and the individual’s profile also has a significant impact on the decision.

This category might be defined as having no substantial tax benefits. However, even here, there are some benefits. Assuming that we all understand what types of investments fall into this category, we’ll drill down a bit further. I stated that there are no “substantial” tax benefits. However, ‘qualified’ dividends are taxed at the capital gains rate, which is a “benefit.” To some, it can be rather substantial. For instance, if you are in the 15% marginal income tax bracket (MTB) or lower, your long-term capital gains rate (LTCG) for 2012 is 0%. That’s a “substantial” benefit. The question is: How many people in this bracket have capital gains? For MTB’s above 15%, the LTCG rate is 15%, which is still a great benefit. Short-term capital gains are taxed as ordinary income.

If Congress fails to act, then capital gains rates will increase on January 1, 2013. This could cause an acceleration of selling in 2012, but as long as there are plenty of buyers, it may not cause a drop in stock values. This increased activity could also cause a slowdown in 2013 as higher taxes tend to be an impediment to capital gains transactions. 

There are a couple of additional benefits here. In general, at death, investments in this category receive a “step-up” in basis, which can be a substantial tax benefit. In addition, though you didn’t receive a tax deduction when you invested, your benefit comes when you withdraw, since distributions from this category have no tax implications. That is, unless you had to sell something first and there was a gain. 

Tax Deferred
In this category, you may have received a tax deduction when you invested. Moreover, your earnings are not taxed until withdrawn. However, when it comes time to withdraw, you will be required to pay the tax. Although the benefits can be substantial, when it comes time to make withdrawals, you must distribute more than you need to account for the taxes due. For example, you may have to withdraw $1.25 to net $1.00 after tax. Therefore, this makes more sense if you have a longer period of time to invest. 

At death, tax deferred money is considered very inefficient. Why? Because there is no step up in basis and it can create Income in Respect of a Decedent (IRD). We’ll have to discuss this another time, but suffice to say that it can be very impactful. 

Tax Free
Ah, at last, tax free! Obviously, this is most beneficial for taxpayers in a higher MTB. However, in today’s environment, because so much money has been invested in municipal bonds recently, yields are quite low. I recently had to build a bond ladder for some clients in the 35% MTB. I chose to use corporate bonds, not municipal bonds, because the after-tax rate for corporate issues was much higher. Of course, if municipals should experience a large selloff, yields would rise, and they would become more attractive.

Thanks for reading and have a great week!

See AdvisorOne’s Special Report22 Days of Tax Planning Advice for 2012, throughout the month of March.

Concerned about estate planning in light of the possible termination of the Bush-era tax cuts? Join AdvisorOne sister publication Tax Facts Online on March 7 at 2:00 PM EST for a free case-study webinar on “Estate Planning with Exemption Uncertainty.”