4. Minimize Your Tax Liabilities
Income taxes can substantially impede the growth of an investment portfolio and significantly reduce the level of available income that can be distributed to account holders. Whether building your account initially, maintaining it during retirement, or repositioning the individual components within your portfolio to generate higher income, you must be aware of the tax consequences. Fortunately, the tax code provides ample opportunities for you to minimize the tax bite, whether you are building your account balance or liquidating assets for distribution.
The opportunities include:
- Capital Gains and Losses Treatment. Profits on assets that are owned for one year or longer are subject to a lower tax than profits on those assets owned for less than a year. The capital gains tax rate applies to all assets held longer than one year; assets held less than one year (short-term) are taxed at regular income rates. For example, if your marginal income tax rate is 28%, the tax rate for profits on assets held one year or longer would be 15%. Married tax payers with a taxable income greater than $450,000 are subject to a maximum tax of 20%. In addition, losses on sales of assets can be used to either reduce capital gains, or reduce ordinary income up to a maximum of $3,000 per year. Losses in excess of the $3,000 limit can be carried forward and used in later years.
- Investment Expense Deduction. Investment expenses such as fees for investment counsel, financial publications subscriptions, attorney and other legal costs, and safety deposit boxes can be deducted from your ordinary income if they exceed 2% of your adjusted gross income. Interest paid on loans you make to purchase investments can be used to offset investment income such as dividends and interest, although “qualified dividends” – dividends that receive a preferential tax treatment – are not included. Excess investment interest costs can also be carried to future years.
- Tax-Deductible Accounts. The tax code encourages savings through a variety of tax-favored accounts, allowing contributions to the account to be deducted from ordinary income (thus investing pretax dollars) and the balance of the account to accumulate on a tax-deferred basis. Taxes on these accounts are paid when the funds are withdrawn in later years. In other words, you get a deduction immediately, but will pay taxes as you withdraw and use the there are limits to the annual contributions to the accounts, there are special provisions to allow older account holders to invest greater amounts than the limits. For 2014, the maximum you can contribute to a traditional or Roth IRA is the smaller of $5,500 ($6,500 if you are over age 50) or your taxable income for the year. Examples of these tax-favored accounts include the traditional IRA, 401k plan, 403b plan, and 457 plan – all popular ways to save for retirement. Traditional tax-deductible accounts make sense if your tax bracket will be lower when you withdraw funds than your bracket when you make the contribution to the account. Both IRAs and 401ks have Roth versions, which differ from the traditional plans. Established by Senator William Roth in 1997, a Roth version of an IRA or 401k doesn’t give you a tax deduction when contributing, but allows the balance to grow tax-free meaning that there are no taxes to pay when you withdraw the funds.