My blog below was prepared with the assistance of Peter A. Weitsen, CPA, partner at WithumSmith+Brown, PC.
Tax season has just ended, and there were plenty of surprises for many taxpayers. One way to avoid being surprised is to be aware of ways you can save on taxes in the future…and to be prepared to take advantage of them. Below are some ways to save taxes by shifting around some of your investments among taxable and tax-advantaged accounts. I call this Watch Your Asset “Location,” and it can be as important as diversified asset “allocation,” which involves dividing assets among stock, bond and other types of investments.
Some essential tax rules to consider…
- Long-term capital gains and dividends are taxed more favorably than interest.
- Interest from tax-exempt bonds is not taxed, but these bonds usually have a lower yield than corporate bonds of the same duration and rating.
- All income earned in a tax-deferred account such as a traditional IRA or a 401(k) is taxed as ordinary income when distributed, regardless of the nature of the income in the IRA.
- Certain annuities that contain stocks are not eligible for capital gains treatment—all income when distributed is taxed at ordinary rates.
Consider using a tax-deferred account rather than a taxable account to trade actively. Trading usually (and hopefully) generates short-term gains, which are taxed at your highest individual rates. If you can reconfigure your activities so you would trade in a tax-deferred account, tax on any gains would be deferred, saving on current taxes. This also would apply if you trade options or write options. Note that by deferring the taxes, you should be able to hang on to more funds that you can use to trade.
By owning stocks in a tax-deferred account while holding tax-exempt bonds in a taxable account, you may be reducing your cash flow and creating a greater tax bite than necessary. Using an asset-location strategy, you would do the opposite—purchase higher-yielding corporate bonds in the tax-deferred account and own the stock in a taxable account. This would increase your total interest, and the stock would provide capital gains and dividends that would be more favorably taxed.
People with high interest income should consider switching to dividend-paying stocks that will be taxed at a 15% rate. Granted that stocks are riskier than bonds, but a well-diversified blue-chip portfolio could provide some safety. And when you consider that the tax on the dividends would be about half of the tax on the interest, it provides somewhat of a cushion.
There is a charity benefit to owning appreciated stock in a taxable account as opposed to owning stock in a tax-deferred account. Appreciated stock can be donated to a charity without requiring a recognition of the gain, while the entire value of the shares donated would be eligible for a charitable deduction. This cannot be done with an annuity that has appreciated in value.
There is a further benefit for stock owned at death in that, for the cost basis, it will be stepped up in value to the value at the date of death (or six months later if a special election is made), making all the gains from the original purchase up that point not taxable. This (and the charity benefit) cannot occur when the stock is owned in a tax-deferred account or through an annuity “wrap” account.
People with children who are subject to the Kiddie Tax should try to reduce the child’s unearned income, which would be subject to the maximum tax rate of 37% when the child’s taxable income exceeds $12,750. A shrewd strategy would be to try to reduce the taxable income by shifting some money to US savings bonds or fixed annuities that accrue tax-deferred interest…or investing in low- or no-dividend-paying stocks, alternative investments or real estate development projects that do not pay much in dividends in their early stages.
Rather than saving personally for a child’s or grandchild’s college or other education tuition, you can contribute up to $15,000 per year (or $30,000 for a married couple) to a Section 529 college savings plan. The income in such plans is deferred and then forgiven if the funds are used for college costs including tuition, fees, and room and board, or tuition for a secondary school up to $10,000 per year. If not used for those purposes, the accumulated income will then be taxed when withdrawn and will be subject to a 10% penalty. The amount contributed will never be taxed or subject to a penalty.
If you have substantial investment income and you still have a home mortgage, you can consider using some of your fixed-income funds to reduce or pay off the mortgage. Under the new federal tax rules, you might not get as big a benefit as you previously would have from paying interest on your mortgage. Also, by reducing your investment income to fund the mortgage reduction, you will not have as much taxable investment income. Further, some states do not give a full tax benefit to mortgage interest, but they fully tax interest income.
If you support an adult, consider making a gift of appreciated stock to the person (or people) you support and having them then sell the shares. If their taxable income is not more than $78,950 (or not more than $39,475 for an unmarried individual), there will be no tax on the capital gains (or dividends).
People with IRAs can roll them over to a Roth IRA and be taxed on the rolled-over assets at that time. As a result, the assets in the Roth IRA and any gains and income thereafter will never again be taxed. They also will not be subject to the required minimum distribution (RMD) rules for IRAs and other retirement accounts. New funds deposited into the Roth IRA or a Roth 401(k) will not be taxed going in and will also never be taxed in the future. Such accounts can also be used for short-term trading or for investments in high-yield stocks or bonds.
Publicly traded partnerships and hedge funds owned in a tax-deferred account such as an IRA or a tax-exempt account such as a Roth IRA will have certain of its income taxed within those plans as “unrelated business income.” A suggestion is to not own those securities in these plans unless it is a significant or meaningful investment. Either own them personally if you want those investments, or skip them altogether since they will add to your individual tax return preparation costs.
Many people with a carefully planned asset allocation believe each account should have the same asset-allocation percentages. This is not so as long as the aggregate investments in all of your accounts are in sync with the allocation plan. You should look at all your accounts and locate the stocks and bonds in the most tax-efficient manner. Example: If your asset allocation calls for 75% in stocks—and half of all of your funds are in IRAs and half in taxable accounts—then obviously you will need to invest some of the stock money in the IRA. In this case, try to position your investments to be as “tax smart” as possible by choosing well-organized asset locations.