Tax and Financial News for September 2011

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Minimizing Taxes on Your Investment Income – Part II

Last month, we discussed ways to minimize taxes on your investment income through tax-deferred investments, including qualified retirement plans. This month, we will discuss various other investments and their tax ramifications.

Tax-Exempt Investments

Tax-exempt investments include obligations issued by state and local governments, as well as mutual funds that own these types of investments.

There are pros and cons to investing in specific bonds vs. bond funds; however, both vehicles allow you to earn income on a tax-free or tax-reduced basis. In general, obligations of state and local governments are free from regular federal income tax. In the case of individual securities, interest income will not incur federal taxes. Interest income in the form of dividends from bond mutual funds will generally be free from federal tax but can still produce some taxable income.

Although interest on tax-exempt investments is free from regular federal income tax, be sure to talk with your investment advisor about alternative minimum taxes. Some bonds issued to fund private activities can be subject to the AMT. Mutual funds that invest in these bonds will also produce income subject to the AMT, so choose your investments carefully to minimize your exposure.

Tax exempt investments might not be totally tax-free, depending on what state you live in. Typically, if your state imposes income taxes, only bonds issued by your state of residence (and its political subdivisions) will be tax-free. When purchasing bonds or bond funds that generate interest from other states, you will generally owe state and local taxes on that income.

Capital gains from state and local obligations will, in general, be taxable income.

Taxable Investments

There are numerous taxable investments, including common and preferred stock, real estate investment trusts, corporate bonds, money market funds and bank deposits. For federal purposes, obligations of the U.S. Government and its agencies are also taxable investments. When it comes to taxes, the trick is in knowing what kind of income your investment is likely to produce.

If you do not need current income, a truly tax efficient vehicle for you might be a growth stock that pays no dividends or a mutual fund that invests in such stocks. The return on these types of stocks comes in the form of capital gains when you sell the investment. If you hold them long enough to produce long-term gains, they are taxed at a current maximum of 15 percent, as opposed to a 35 percent top rate on ordinary income. Since you pay no tax on the value increase until you sell it, taxes on individual stocks can be deferred far into the future, although mutual funds can produce capital gains from year to year.

If your goal is to produce current income plus some future growth, ask your advisor about investing in stocks or mutual funds that produce qualified dividends (taxed at a maximum rate of 15 percent, even as the dividends are paid throughout the year). Note that you will have to pay income tax annually now and will not be able to defer the tax to future years when the investment is sold.

If you invest in mutual funds, be careful not to purchase an income fund, which occurs when you buy a fund that has already produced taxable income but has not been distributed to shareholders yet. The fund must pay this income out in dividends by year’s end, creating taxable income for you without providing an investment return.

For example, you invest $10,000 in a mutual fund that includes in its value $1,000 in capital gains that have not yet been distributed to shareholders. At year’s end, that fund will declare a dividend in order to distribute those gains to shareholders, producing a taxable gain of $1,000. Assuming no change in value, you will pay tax on the $1,000 without enjoying any real investment return.

The same thing can happen when you purchase a stock just prior to what is known as the ex-dividend date. If you are buying it just before that date, the stock’s value will include the expected dividends. The value is likely to drop immediately after that date to reflect the portion of the value related to the dividend.
Interest earned on taxable investments and investments that produce nonqualified dividends will generally be taxed at your ordinary rate, making it the least efficient investment vehicle.

Capital Gains

Capital gains are generated when you sell an investment for more than you paid for it. Likewise, capital losses come from selling investments for less than your original cost. If you time your sales of these investments properly and try to offset gains with losses, you can minimize your income tax.


Tax law can be tricky, which you can readily see in the case of investments. If you are concerned that you are not structuring yours to minimize your tax burden, give us a call and let’s discuss ways to help you keep more of your investment income.


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