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Strategy
Taxes and Your Investments
By Roger Wohlner
CERTIFIED FINANCIAL PLANNER™ Practioner, Asset Strategy Consultants
One of your portfolio's largest expenses is probably taxes. Ordinary income taxes on short-term capital gains and interest income can go as high as 35%, while long-term capital gains and dividend income are taxed at rates not exceeding 15% (5% if you are in the 10% or 15% tax bracket). One way to help keep your portfolio growing is to invest in a tax-efficient manner. Some suggestions include:
Contribute to your 401(k) plan.
Contributions are made on a pre-tax basis, so you don't pay income taxes currently (Social Security and Medicare taxes are paid) and earnings grow on a tax-deferred basis until withdrawn. In 2005, you can contribute a maximum of $14,000 to a 401(k) plan, although plans typically limit your contribution to a certain percentage of your pay to ensure the plan complies with nondiscrimination rules. Individuals over age 50 may be able to make an additional catch-up contribution of $4,000 in 2005. Many employers also match your contribution, so you get additional funds at no cost to you.
Make contributions to an individual retirement account (IRA).
In 2005, you can contribute a maximum of $4,000, plus those over age 50 can make an additional $500 catch-up contribution. Investigate whether you're eligible to contribute to a traditional deductible IRA or a Roth IRA and then decide which option is best for you. While you can't deduct your contributions to a Roth IRA on your tax return, your earnings grow tax free as long as you make qualified distributions from the IRA. With a traditional deductible IRA, your contribution is deductible on your current-year income tax return, and earnings grow tax deferred until withdrawn.
Carefully decide which investments to hold in tax-advantaged and taxable accounts.
Gains from investments held in retirement accounts, such as 401(k) plans and traditional IRAs, are taxed at ordinary income tax rates when withdrawn, rather than the lower capital gains tax rates. While it may make sense to hold investments that produce ordinary income or that you want to trade frequently in retirement accounts and investments that generate capital gains in taxable accounts, factors such as your investment period should also be considered.
Analyze the tax consequences before rebalancing your portfolio.
Portfolio rebalancing is a taxable event that may result in a taxable gain or loss. In general, avoid selling investments from your taxable portfolio for reasons other than poor performance. Bring your asset allocation back in line through other methods.
Consider municipal bonds or stocks generating dividend income if you are in a high tax bracket.
Since municipal bond interest is exempt from federal, and sometimes state and local, income taxes, your marginal tax bracket is a major factor when deciding whether to include municipal bonds in your portfolio. Thus, you should determine how a muni bond's yield compares to the after-tax yield of a comparable taxable bond. Since dividend income is taxed at rates not exceeding 15%, stocks that generate significant dividend income may be a good choice for high tax bracket investors.
Look into purchasing a home.
Owning a home has significant tax advantages. Mortgage interest and property taxes can be deducted on your tax return, reducing the cost of owning a home. Mortgage interest is deductible on up to $1,000,000 of original debt incurred to purchase a principal residence. Additionally, interest paid on up to $100,000 of home-equity debt is deductible on your tax return. When you sell your home, significant capital gains can be excluded from income. You can exclude $250,000 of gain if you are a single taxpayer and $500,000 of gain if you are married filing jointly, provided the home was your primary residence in at least two of the preceding five years. You no longer have to purchase another home to qualify for the exclusion.
Consider tax-advantaged ways to save for college.
If you are saving for college, take a look at education savings accounts (ESAs) and Section 529 plans. The annual contribution limit to ESAs is $2,000. While you can't deduct the contribution on your tax return, earnings grow tax free as long as funds are used for qualified education expenses. With Section 529 plans, you can contribute up to $55,000 to a qualified plan ($110,000 if the gift is split with your spouse) in one year and count it as your annual $11,000 tax-free gift for five years. Distributions from state-sponsored plans to pay qualified higher-education expenses are excluded from income if made after 2001 and before 2011. Distributions from private college and university plans are excluded from income if made after 2003 and before 2011.
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