Well, April 15th has come and gone. Following that date, many taxpayers become
intimately familiar with Ms. Pelosi’s comment about having to pass Obamacare to
find out what’s in it. The increased tax
paid by many individuals has caused us to evaluate (again) some tax strategies
for investing. We have always maintained
that the “tax tail shouldn’t wag the investment dog;” however, tax impact
certainly warrants consideration all other things being equal.
Many events can impact taxes in the investment
arena. After all, the primary goal of
investing is to maximize the after tax
return to the portfolio for the risk level chosen. Three general rules
apply:
Avoid taxes if legally possible
Defer taxes until a future date
Then if 1 and 2 are not practical, pay the taxes at the lowest rate possible.
With these general rules in mind, let’s discuss some
investment strategies with income tax ramifications.
Investment
selections
The investment chosen has tax ramifications. Mutual funds buy and sell stock throughout
the year. Those transactions generate capital
gains (hopefully) which are passed on to the mutual fund owner who is
responsible for the income taxes on the gain (in taxable accounts) Therefore,
portfolio turnover (how often the mutual fund manager buys and sells) can be a
factor in investment selection. Index
funds generally have lower turnover than actively managed funds. Municipal funds can provide income free from
income tax and the Obama care surtax.
Investment
Location
Some accounts defer taxes until the future (IRAs, 401(k)s,
and other tax qualified plans. As such,
these accounts are generally more suitable for investments with a higher known
return (such as taxable bond funds in a historical interest rate environment). Note that losses on investments are not
deductible when they occur in such a qualified account.
Tax Loss
Harvesting
This
strategy utilizes general rule 1: don’t pay taxes. In taxable accounts, gains on one investment
may be offset by the loss on another investment, a net zero addition to taxable
income. You can also offset ordinary income up to
$3000 per year with losses that exceed gains.
Withdrawal
Strategies
As a general rule, spend from taxable accounts first, and then
from tax deferred accounts. Some caveats
to this general rule exist. IRAs have
required minimum distributions (RMD) requirements that begin at age 70½. If
these RMD amounts are such that they might increase the tax bracket in later
years, consideration should be given to earlier withdrawal.
Roth IRA Conversion
Roth
IRAs do not allow tax deductions for contributions to the account; however no required minimum distribution is
required from the account and the investments grow tax free (not tax deferred). Contribution limits apply to such an account
depending on the investor’s income level.
Funds from existing qualified accounts can be rolled into a Roth IRA
regardless of income earned. A Roth
conversion strategy does require payment of taxes on the amount rolled into a
Roth account. It works best if the
investor has outside funds with which to pay the taxes. Planning techniques exist for these
conversions that we will not discuss here but that do potentially affect taxes
on the amount converted.
At
Paragon Financial Advisors we do not prepare taxes and urge you to consult your
tax professional for your personal circumstances. However, we can assist you in planning your
investment strategies to minimize the “April 15th” effect. Paragon Financial Advisors is a fee-only
registered investment advisory company located in College Station, Texas. We
offer financial planning and investment management.
