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.
Taxable
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.
