Monday, December 28, 2009


One of the entries in Kay Bell’s recent Tax Carnival was “Fourteen Tax Management Techniques”, a guest post from Marotta Wealth Management at the FREEMONEYFINANCE blog. As I always say, bloggers love to make lists.

The post does indeed discuss 14 good tax planning techniques. The introduction to the list includes some great words of wisdom - “Don't file your taxes in April and then forget about them for the next 10 months. By investing a little time throughout the year, you can create compounded value.”

I want to call your attention to some especially good advice – item #10 on the list:

Putting investments in the correct investment accounts can also generate significant savings. Fixed-income investments belong in traditional IRA accounts. Interest is taxed at ordinary income tax rates, but the entire value of an IRA account is taxed at ordinary income tax rates anyway upon withdrawal. Appreciating assets should be in taxable investment accounts where the growth will be at a 15% capital gains rate, which is likely much lower than your ordinary income tax rate. Additionally, any foreign tax paid on foreign stock investments is tax deductible in a taxable account. Finally, those investments with the greatest potential for growth belong in Roth accounts where no tax will ever be paid. This tax management alone may boost your after-tax returns by as much as 1% annually.”

You will, as MWM says, increase the net after-tax yield on your investments if you put the correct investments in the correct types of account.

Let’s look at the types of investment accounts available to the average taxpayer.

First there is the currently taxable, liquid investment account. Interest, dividends and capital gains on this type of account are currently taxable, except for statutory tax-exempt securities like municipal bonds or muni bond funds.

You then have “retirement” accounts, traditional and ROTH IRAs and traditional and ROTH 401(k)s, and other types of accounts available to the self-employed. With “traditional” accounts, current earnings are “tax-deferred” until withdrawal. The eventual withdrawals are usually fully taxed in the year the distribution is made. If there is a “basis” in the account from “non-deductible” contributions the distributions will be partially tax free. However the accrued earnings on these accounts are fully taxable. With ROTH accounts the current earnings are exempt, and there is no tax on withdrawals. “Premature” withdrawals from retirement accounts, traditional and ROTH, can result in a 10% tax penalty. Excess contributions are also penalized.

Now let us look at how different types of investment income are taxed.

Interest and dividends are generally taxed as “ordinary income”. The tax on this type of income depends on your regular income tax rate. If you are in the 25% federal tax bracket you will pay $250 in tax on income of $1,000. If you are a victim of the dreaded Alternative Minimum Tax (AMT) you will pay either 26% or 28% tax on this income.

Under current law certain “qualified” dividends are taxed at special “capital gains” tax rates, as are “capital gain distributions” from mutual fund investments. For 2009 the special rates are 0% or 15%, depending on your level of income. The 0% rate becomes 5% in 2010.

“Long-term capital gain” on the sale of investments are taxed at the special capital gains tax rates. A “long-term” gain is realized if you hold the investment for more than one year – at least a year and a day. Investments that you hole for one year or less are taxed at ordinary income rates.

Qualified dividends, capital gain distributions, and long-term capital gains are also taxed at the special rates under AMT, but the amount of income in these categories do increase net taxable income, and therefore Alternative Minimum Taxable Income, and may cause one to become a victim of the dreaded alternative tax.

And of course earnings (but not capital gains from the sale) from tax-exempt municipal bonds or funds investing in tax-exempt municipal bonds are exempt from federal income tax. However, some otherwise tax-exempt interest and dividends, those from “private activity bonds” may be taxed under the dreaded AMT. And it is possible that the amount of tax-exempt interest can cause more of your Social Security or Railroad Retirement benefits to be taxed at ordinary income rates.

Taxable distributions from retirement accounts, like IRAs and 401(k)s, are taxed at ordinary income rates, regardless of the source of the income that has accumulated within the account. Qualified dividends, capital gain distributions, and long-term capital gains earned within a tax-deferred retirement account are taxed at ordinary income when the money is withdrawn from the account.

So you can see it is important to put the correct types of investments in the correct types of account.

As the post points out, both tax-deferred and tax-exempt retirement accounts (i.e. traditional and ROTH) should, for the most part, contain “fixed income” investments that will generate income that is taxed at ordinary income tax rates. This way you do not lose any tax benefit from reduced tax rates.

There is another good reason to have investments that will not substantially increase in value over the years, like growth stocks, in traditional retirement accounts. Not only do you take full advantage of the tax benefit resulting from the special capital gains tax rates, but your retirement savings will not be hit by economic hard times. If you contribute $200,000 to a retirement account over the years you should have more than $200,000 available at retirement. As we saw in the recent financial mucking fess, retirement account values dropped by as much as 50% and individuals ended up with balances that were less than the amounts they had actually contributed.

Appreciating assets should be in taxable investment accounts”, as should investments that produce “qualified” dividends and capital gain distributions. This way you will be able to take advantage of the special tax benefit provided by the special capital gains tax rates.

Of course you should never invest retirement account money in tax-exempt municipal bonds or mutual funds that invest in tax exempt municipal bonds. This income is, for the most part, exempt from federal income tax, although such earnings accrued within a traditional retirement account will be taxed at ordinary income rates when money is taken out of the retirement account.

You can actually invest ROTH account monies in any type of investment, except muni bonds. Having income totally exempt from tax is better than paying tax at capital gain rates.

I must point out that the above advice is based on tax law as it now exists. There will no doubt be some substantial changes to the Tax Code in 2010 or 2011. If all dividends once again become taxed at ordinary income rates, or the capital gain tax rates are substantially increased or done away with altogether, then the advice I, and Marotta Wealth Management, have provided may no longer apply.

One final word – it is important to run investment recommendations made by your broker past your tax professional before making decisions. Don’t assume that a broker or a banker knows his arse from a hole in the ground when it comes to the tax law.