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Minimizing Taxes on Your Investment Income - Part 1

Tax and Financial News

August 2011

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Minimizing Taxes on Your Investment Income - Part 1

If you watch television, surf the Internet, listen to the radio or read any news publication, you’ve heard a lot about income taxes. Say what you will, but every American has a stake in the ongoing debate in Washington about who is taxed and how high their rate should be.

Much of the debate centers on what the tax code classifies as portfolio income. When you talk to a tax preparer or financial commentator, you will likely get a definition of portfolio income equating it to investment income. Let’s broaden that definition a little to include any income generated by money you invest, hoping you will have more when you need it and are ready to spend it.

Portfolio vs. Investment Income

Dividends, interest, royalties and capital gains are generally the types of money that fall into the portfolio income bucket. In essence, portfolio income is that generated by investments; but not all investment income is equal.

For instance, the stock or mutual fund shares you buy outside of a qualified retirement plan will probably produce portfolio income. If you sell the shares for a gain, you will generate portfolio income. Dividend, interest or royalty income from these investments will produce portfolio income.

Money you invest in a Roth or Traditional IRA or other retirement account is certainly investment income in the sense you invest in it hoping to grow your wealth; however, when you withdraw it down the road, it is not treated as favorably as most portfolio income. When you start taking withdrawals from the purchase of a tax-deferred annuity, any gain on the investments underlying that annuity is treated as ordinary income rather than as a gain on the sale of an investment.

Tax Planning Basics

While the absolute dream scenario in the tax planning world is to pay no tax at all, that is often impossible. So the second best strategy is to pay taxes at the lowest possible rate. Many times, however, you might not be able to escape taxes so much as put them off for 10, 15, 20 or more years, as in the case of retirement savings. All of these have their place in tax planning and, more likely than not, the average taxpayer’s strategy will be to lower the rate by putting off the payment of tax far into the future.

Tax Deferred Investments

Qualified Retirement Accounts
If you are an employee and your employer offers a qualified retirement plan, maximize your contributions to the plan. These retirement plans offer several advantages, including deferral of income tax, tax-free growth of the investment and, if your employer matches your contributions, an immediate return on your investment.

Sometimes your employer’s plan will also offer the option to invest after-tax dollars in a Roth account. Since withdrawals from a Roth account are tax-free after five years, you should strongly consider this investment option. Despite not offering immediate tax savings, the eventual tax-free withdrawal of the income can be very attractive.

Health Savings Accounts
Why, you may ask, would this article include a Health Savings Account under the heading of investments? After all, this is money you save to pay medical bills, right?

That may be, but could we suggest another alternative? There is nothing in the current Internal Revenue Code that says you have to pay your medical bills using the money you put in your HSA.

First, you have to have medical bills to pay and, hopefully, your bills will never equal your deductible. Small medical costs like copays at the doctor’s office and drug copays can often be paid from other sources of funds.

Second, even if you have big medical bills from time to time, it might make more sense to pay them from other resources and leave your HSA intact. For example, if you have $1,000 in a savings account earning 0.1 percent interest and an HSA earning 12 percent, the sensible thing is to keep earning the 12 percent.

Third, if you are using the HSA to save for catastrophic medical costs, the longer it can grow tax-free, the more you will have if and when the time comes you really need it.

The value of an HSA from the investment perspective is that it can be used as a secondary retirement account. While there are penalties for withdrawals of HSA funds to pay non-qualifying expenses, these penalties are waived once an individual reaches the age of Medicare eligibility. At that point, any distribution will be subject only to income tax.

Tax Deferred Annuities
While they come in various forms, tax deferred annuities basically allow you to invest after-tax dollars in a vehicle that lets your investment grow tax-free. Many of these vehicles have guaranteed principal and even minimum investment income. A secondary feature of many tax deferred annuities is that they are tied to life insurance, which can give comfort regarding the amount of funds available to heirs (note: as previously stated here, income from a tax deferred annuity is not treated as a capital gain upon its eventual withdrawal).

The Good
Tax deferred investments offer several advantages. Many of them offer an immediate tax savings, while all of them offer tax deferral on their growth until some future use. In the case of accounts designed to provide retirement income, the tax deferral can last for decades. Under the assumption that a dollar today is worth more than a dollar tomorrow, this tax savings can add significantly to your wealth.

One of the basic principles underlying retirement planning is the assumption that when you withdraw funds from your retirement account, you will be in a lower marginal tax bracket.  Hence, when you do eventually pay tax on your retirement savings, you will pay less net tax using less valuable dollars.

For example, assume you are in the 28 percent tax bracket now and you invest $15,000 in your 401(k) plan. Assume further that your marginal rate will be 15 percent when you start withdrawing from your retirement account 20 years from now. The math shows that when you pull the $15,000 out, you will pay $1,950 less in Federal tax as a result of the rate difference (28 percent minus 15 percent = 13 percent x $15,000). This, of course, assumes Congress doesn’t change the tax code between now and the time you retire.

The Bad
Where there is good, there is also bad. For each of the investments discussed above, there are substantial penalties for withdrawing the funds early or for a non-qualifying use. Accordingly, take care in determining how much you will invest in such vehicles.

In this article, we discussed how you can minimize taxes on investment dollars using only tax deferred vehicles. Next month, we will look at other types of investments that can produce taxable and tax-exempt income. If you have questions about the tax effects of your current investment strategy and how you might better utilize the tax code to your advantage, don’t wait for next month’s article – give us a call now and let’s look as your current situation.

Have a terrific month.

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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