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Regulation and Compliance > Federal Regulation > IRS

How to shield investment income from the IRS

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Given that high individual tax rates are “here to stay,” as Congress and the Obama administration are unlikely to agree on individual tax reform soon, investors should be considering municipal bonds, master limited partnerships, real estate investment trusts and the IRA/charitable contribution rollover to help shield their investment income from Uncle Sam.

That’s the advice Andy Friedman of The Washington Update gives in his latest white paper, “Investing in a Rising Tax Environment – 2015.”

Friedman notes that individual tax reform is “too heavy a lift for this Congress and this administration,” noting that he’s “more hopeful” that an agreement will be reached on business tax reform, which would lower the nation’s corporate tax rate — the highest among industrialized countries — in an effort to “stem the movement of jobs overseas.”

Although tax rates might not increase further, “taxes paid by high-income investors are likely to rise as Congress over time eliminates favorable tax treatment of more and more items to pay for annual spending,” Friedman writes. “Because any change in tax treatment is likely to apply only prospectively, investors should make sure to take advantage in 2015 of the current tax treatment of endangered items while it remains available.”

For instance, Friedman — who used to be a tax lawyer with Covington & Burling in Washington — says that an investor with a Roth IRA should consider this year making a nondeductible contribution to an IRA and rolling that contribution over to the Roth account without tax, in case Congress eliminates that option in 2016.

Within the next several months, Congress must agree on an increase in the debt ceiling, an appropriations bill to keep the government running past September and as a source of funding to replenish the highway fund and pay for road and bridge repairs this summer, Freidman says.

Of course, “these items require additional spending, which Congress will seek to try to recoup by raising additional revenue or cutting spending elsewhere.”

What can investors do to minimize taxes?

Friedman advises considering investments that shield earnings from tax, like municipal bonds, master limited partnerships, and real estate investment trusts because they shield “some or all of their distributed investment income from federal income tax. This tax savings enhances the after-tax returns these investments provide.”

The higher the tax rate, Freidman says, the higher the effective return on tax-efficient investments.

For instance, he explains that a municipal bond paying 3 percent interest pays a tax-equivalent yield of 4.6 percent in a 35 percent tax rate environment. But if the tax rate rises to 43.8 percent, the tax-equivalent yield on the same bond rises to 5.3 percent.

“Although the favorable tax treatment of municipal bonds, MLPs and REITs could be questioned during the tax reform or loophole closing processes, in my view the current treatment is unlikely to change,” he writes. “Even if Congress does change the tax-favored treatment, I would expect that current rules will continue to apply for investments existing before the date of change (although there can be no guarantee when predicting the whims of Congress).”

Friedman also advises investors to take advantage of the lower tax rates on long-term capital gains and qualifying dividend income.

“The tax rate on capital gains and qualifying dividends is about 45 percent lower than the tax rate on ordinary income,” he writes. “Thus, from a tax planning perspective, it may make sense to hold investments that produce qualified dividend income, and to hold them long enough to produce long-term capital gains on sale.”

Investors should also take advantage of the IRA/charitable contribution rollover.

Under the tax law in effect through 2014, an individual over the age of 70-1/2 was permitted to transfer up to $100,000 from an IRA to a charity and avoid all tax on the IRA distribution, he explains.

Moreover, “the distribution to the charity would count toward satisfying the individual’s required minimum distribution obligation. Amounts transferred from the IRA to the charity were not subject to the phase-outs and limitations that apply to charitable contributions claimed as deductions on Schedule A. Thus, investors over age 70-1/2 were well advised to use IRA funds to make their first charitable contributions, before using non-qualified money.

Later this year, Friedman opines, Congress will reinstate this IRA/charitable contribution rule for 2015 and perhaps for later years as well. “Thus, investors over 70-1/2 who are charitably minded should hold off taking required distributions from their IRAs or making large charitable contributions until later this year when Congress acts. Once Congress extends this provision for 2015, these investors can use up to $100,000 of IRA funds to make their donations.”

See also:

2015 tax cheat sheet for advisors and their clients

This is what happens when you just don’t file your taxes

6 top tax changes for 2015


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