VERY VERY VERY VERY VERY VERY VERY IMPORTANT!

An incident during this past tax filing season caused me to compose an item to be included in my mid-year letter to 1040 clients.

Here is what I wrote -

“You must include in taxable income the gains from the sale of investments, and can deduct, within limits, losses from investment sales.  The gain or loss is determined by subtracting the purchase price of the investment and the costs of purchase and sale – i.e. commissions, fees and taxes - from the sale proceeds. 

As the result of past legislation, actually good legislation for once, brokerage houses are now required to provide clients with cost basis information for certain investment sales on Form 1099-B.  However, the longer you have held the investment the more likely the broker is not required to identify the cost.  Many brokerage houses will report cost basis information on the sale of all investments, whether or not required to by the law.  However occasionally the broker will report the gross proceeds with no cost basis information.

I cannot properly prepare your tax return without the cost basis information.  You must provide me with the cost basis information – date of purchase and purchase price – of all investments sold.  It is not my responsibility to determine the cost basis.  And during the tax filing season I do not have the time to waste trying to come up with the needed information. 

If the investment was acquired via mergers or spin-offs I may be able to do some basic research during the season, but even then I would need the cost basis information for the underlying investment.

If you receive a Form 1099-B from a brokerage house that does not include cost basis information for each and every investment sale do not just send it to me and expect me to pull numbers out of the air.  Contact your broker and have him or her provide you with the missing information.  If I get a Form 1099-B without cost basis information for all sales I will NOT begin work on the return until you provide me with all the missing information.

For your information, according to T.C. Memo 2003-259, if a taxpayer cannot provide proof of the cost basis of a stock or other investment sold it will be considered to have a "0" cost basis.  As a result, the entire gross proceeds will be fully taxable.

It is very important that you open and read all the tax documents you send me.  Don’t just put an envelope unopened or unread in the package you are sending to me.”

Insert “your tax professional” for “me” in the above.

TTFN

STUFF

ü  Despite being in “the business” for 45 years, I usually learn one or two new things from the various monthly and quarterly print publications of the National Association of Tax Professionals.  The latest issue of TAXPRO MONTHLY provided the following –

“Did you know that ‘CP’ stands for ‘Computer Paragraph’?  So CP2000 stands for Computer Paragraph 2000, an automated letter that is triggered by discrepancies on the tax return.” 

The form letter that you receive from the IRS indicating something may be wrong or missing on, or requesting additional information for, your 1040 (or 1040A) is identified by numbers, or numbers and letters, preceded by “CP”.  I actually never, until now, actually knew what the “CP” stood for.

The article in this issue about responding to a CP2000 reminded me of the importance of properly dealing with IRS and state tax agency letters, notices and statements.  If you receive a form letter or notice from the IRS or your state DO NOT IGNORE IT – the issue will not just go away!  And DO NOT PUT IT ASIDE TO DEAL WITH IN THE FUTURE.  Review it immediately.  If the return in question was prepared by a professional tax preparer SEND THE LETTER OR NOTICE TO YOUR TAX PREPARER IMMEDIATELY!

In my experience at least 2/3, if not 3/4, of all such notices are wrong – more with state notices than federal ones – but they definitely do need to be responded to promptly.

And, while the IRS or state wants you to respond promptly, do not expect a prompt response to your reply from the government.  In about 45 days after you rely to an IRS notice or letter you will receive a form letter from “Sam” saying that they need an additional 45 days to properly review and process your response.  45 days later you will receive a second letter telling you they need another 45 days.  When dealing with any government agency you need patience.

ü  As a point of information, all my writings about federal tax planning and preparation, here at TWTP or in any of my electronic or print publications, applies to a taxpayer who lives in a “non-community property state”, which most states are. 

The specific rules and regulations that apply to community property states are, to be honest, somewhat FU-ed.  In my 45 years as a paid preparer I have never had to deal with community property state issues, and certainly never will going forward.  So I have never had the need, or desire, to research community property state rules and regulations.

FYI, the current community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.  Alaska is an opt-in community property state that gives both parties the option to make their property community property.  So if you live in one of these states you may need to check on some of what I discuss here at TWTP with a local tax professional.

ü  A recent discussion with a client and friend had me do some research to verify what I had believed to be true regarding the tax basis of jointly-held investments for a surviving spouse.

What I had believed to be true was indeed true –

If investments are jointly owned by a married couple in a non-community property state (important) – stock, bonds, and mutual fund shares held in a joint brokerage account, or real estate jointly owned - and one spouse passes, the deceased spouse’s half of the investments will receive an automatic “step-up” in basis to the federal estate tax value, even if no federal estate tax return is filed or no estate tax is due.  This is generally the market value of the investment on the date of death of the deceased spouse, but could also be the market value 6 months from the date of death if this alternate valuation is elected on a federal return.    

My discussion with the friend and client, a stock broker, also verified what I suspected.  If a beneficiary sells a stock that he or she inherited, the cost basis reported on the Form 1099B issued by the brokerage, whether or not the sale involves a “covered” investment, will not necessarily report the correct tax basis of the investment – the “date of death” value – even if the deceased and the beneficiary had the same broker.  It may – but only if the individual broker has made the proper adjustment to the cost basis in the internal brokerage reporting system.

So it is very important for your tax professional, or you if you are self-preparing, to independently verify the correct cost basis for inherited investments sold to determine if any adjustments are needed to the Form 1099B numbers.

TTFN

 

 

 

 

 

 

 

 

 

 

 

 

 

A YEAR-END TAX QUESTION FROM A CLIENT

A client sent me the following email message this past Monday morning -

“I have a mutual fund in my CMA account with Merrill Lynch which for the last two years has shown an unrealized loss - this year being $1,264.

Since I have used up all the investment losses on last year's return, is it a good idea for me to sell this fund so I won't be clobbered by Uncle Sap - I mean Uncle Sam?”

Here is my answer –

“My preliminary comment is that your first criteria for any transaction should always be financial.  Taxes are second. 

If you, or your financial advisors, think this investment will increase in the future and eventually generate a gain, or it provides good dividends, you should not sell it just to get a tax loss.”

However, if it is truly a ‘dog’, selling it for a loss before the price goes even lower will generate a small tax savings.  You will receive at least $190 (and possibly up to $316) in tax savings with a $1,264 loss.”

Good advice for anyone with a similar question.

Don’t let the tax tail wag the financial dog.

You cannot sell the investment for a loss and immediately buy it back. That would result in a “wash sale”, which would defeat the purpose of the sale.  You must wait at least a full calendar 30 days before you can buy back the shares – and a lot can happen in those 30 days.

TTFN

 

 

 

TAX EFFICIENT INVESTING

You have several options available for investing your current, retirement, college, and health savings.  It is important to understand the tax aspects of each option, and the tax treatment of the various types of investment accounts – currently taxable, tax-deferred, and tax-exempt - to maximize your “after-tax” earnings from your investments.

DOMESTIC STOCKS

Investment in shares of stock, both domestic and foreign, can generate qualified dividends while held and, if held for more than a year, long-term capital gains when sold.  Qualified dividends and long-term capital gains are taxed at a special lower rate, from 0% (no federal income tax) to 20%, depending on your level of overall net taxable income.  Short-term capital gains (from the sale of stock held for one year or less) are taxed at ordinary income rates, from 10% to 39.6%.

Qualified dividends and long-term capital gains are also taxed at the special lower rate under the dreaded Alternative Minimum Tax (AMT).  However this type of income increases your Alternative Minimum Taxable Income (AMTI) and may cause you to become a victim of AMT and/or reduce your AMT exemption.

And, depending on your level of Adjusted Gross Income (AGI), all dividends and capital gains may be subject to the 3.8% Net Investment Income Tax.

Distributions from tax-deferred accounts, retirement accounts like a traditional IRA or 401(k) and the various self-employed retirement accounts, are taxed at ordinary income rates regardless of the source of the income within the account - so qualified dividends and long-term capital gains earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

While taxable distributions from a tax-deferred account will increase AMTI, these distributions are not subject to the Net Investment Income Tax.

Stock investments that will generate qualified dividends and long-term capital gains are taxed less if held in currently taxable accounts.

If you, or your broker, are more of a day trader, and invest in some stocks for quick turn-over short-term gains, these stocks could ultimately generate more net after-tax income if held in tax-deferred accounts. 

Regardless of where held the gains will be taxed at ordinary income rates, but holding these investments in retirement accounts will defer the taxation of gains to the future, in future dollars, when distributions are made after retirement (and when your marginal tax rate, or all tax rates, could be less than they are now).  And holding them in deferred accounts will allow for greater eventual growth as a result of the tax deferral.

I am not telling you not to invest tax-deferred funds in stocks that generate qualified dividends and long-term capital gains.  You obviously want to earn as much as possible within a tax-deferred account.  Even though you may lose the benefit of the lower tax rate, you may make up for this by the increased tax-deferred accumulation of income that will ultimately be taxed in the future in future dollars.

What I am saying is that when considering how to invest funds in currently taxable accounts it is more “tax efficient” to choose investments that will generate income taxed at the lower capital gain rates.

INTERNATIONAL STOCK

While the same considerations I discussed under domestic stocks apply to international, or foreign, stock (the stock of a company organized and located outside of the United States), the dividends from international stock will often have foreign tax withheld. 

Foreign tax withheld from dividends generated by currently taxed investments can be taken as a credit - often a 100% dollar for dollar credit against current income tax liability.  Unused credits can be carried forward to be used in future years.

While foreign tax withheld from dividends generated by investments held in a tax-deferred retirement account will reduce the income that is eventually taxed, you do not get the benefit of the tax credit.

You should hold investments in international stock in currently taxable accounts.

TAXABLE BONDS

Bonds pay interest.  Interest is always taxable at ordinary income rates.

Interest on bonds and other direct obligations of the US Government (such as savings bonds and Treasury bonds and notes), while fully taxed at ordinary rates on the 1040, are exempt from state income tax.  

Taxable bonds are a good investment for tax-deferred retirement accounts.

TAX-EXEMPT BONDS

The interest from municipal bonds (issued by the 50 states and the District of Columbia, and the bonds of US possessions like Guam, Puerto Rico and the Virgin Islands) are exempt from the “regular” federal income tax, and the state income tax of a “resident” state (interest from bonds issued by the state of NJ or a NJ municipality, and US possessions, are exempt from NJ state income tax).  Interest from certain “private activity” municipal bonds are taxable under the dreaded AMT.

You should never purchase tax-exempt bonds in a tax-deferred account.

Distributions from a tax-deferred retirement account are subject to federal income tax at ordinary income rates regardless of the source of the income within the account - so interest on tax-exempt municipal bonds earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

REAL ESTATE INVESTMENT TRUSTS

INVESTOPEDIA tells us that a Real Estate Investment Trust, or REIT, is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.

Generally the dividend payments issued by a REIT are taxed at ordinary income rates.

REITs should be held in tax deferred accounts.

LIMITED PARTNERSHIPS

My personal, albeit selfish, advice is never invest in limited partnerships in a currently taxable account.

Long-time readers of TWTP know that I hate K-1s from limited partnership investments.  Properly reporting all the items from the K-1, including those buried in attached statements, on the taxpayer’s Form 1040, and keeping track of suspensions, carry forwards and tax basis, causes considerable pain in various parts of the anatomy of a tax preparer.  And the additional tax preparation costs that result can be more than, or at least take a large bite out of, any eventual tax and financial benefits from the investment.  I truly believe that a carefully researched mutual fund will provide the same potential tax and financial benefit as any limited partnership investment (and welcome the comments of brokers on this statement).

If your broker insists that you must purchase units in a limited partnership, and no mutual fund will provide the same tax and financial benefits, then purchase the partnership in your IRA, traditional or ROTH, or another tax-deferred or tax-exempt account, so you tax professional does not have to deal with it on the 1040.

MUTUAL FUNDS

Mutual funds invest in all types of investments – domestic and international stocks, taxable and tax-exempt bonds, real estate, and limited partnerships.

Some funds invest in a mix of all investments and some funds limit investments to specific categories – small cap stock funds, growth stock funds, dividend paying stock funds, non or low dividend paying stock funds, international stock funds, corporate bond funds, either domestic or international, government bond funds, municipal bond funds, etc. etc. etc.

The taxability of dividends issued by mutual funds is determined by the rules for taxing the individual investments in the fund. Choosing what types of funds you purchase in currently taxed and tax-deferred accounts should be governed by the types of investments held in the fund.

Mutual funds can issue qualified dividends, non-qualified dividends, tax-exempt dividends, return of capital, and capital gain distributions.  Non-qualified dividends are taxed at ordinary income rates.  Return of capital distributions are not currently taxed as income – they reduce your cost basis in the fund.  Capital gain distributions are taxed at the lower capital gain tax rates.

There are “tax-efficient” mutual funds.  These funds can keep it's turnover low, especially if the fund invests in stock, and avoid or limit income-generating assets, such as dividend-paying stocks.  These funds should be held long-term in currently taxable accounts.

TAX-EXEMPT ACCOUNTS: ROTH IRAs AND 401(K)s, EDUCATION ACCOUNTS, HEALTH SAVINGS ACCOUNTS, AND MEDICAL SAVINGS ACCOUNTS

It really does not matter how you invest funds held in accounts whose distributions will never be taxed. 

Qualified distributions from a ROTH IRA or 401(k) account, a Section 529 qualified tuition program, a Coverdell Education IRA, a Health Savings Account, or a Medical Savings Account are totally tax free.  So taxes are not a consideration in determining where to invest the money.  Obviously you want to make sure that all distributions from these types of accounts are qualified distributions.

Before you invest you should consult a tax professional.  Do not rely on a broker for tax advice.

TTFN

I HATE K-1s!

The titular character of KISS ME KATE hated men.  I hate K-1s with equal fervor.  Especially those for limited partnership, publicly traded or not, investments.  I can live with K-1s for actual business activities, although they, too, have issues.

 

All K-1s usually arrive late – anytime from the end of March to the beginning of September – more often than not causing the client’s return to be extended.  I hate GD extensions just as much as I hate K-1s (the GD is not "government deferred" or anything similar - it stands for exactly what you think it does).

 

As limited partnership investments, again publicly traded or not, are passive activities, there is added complexity, work, and agita involved in (1) determining whether or not, and how much of, the various types of income, deductions and losses from the K-1 are reported on the current Form 1040 and corresponding state tax return, and the multitude of forms and schedules thereof, (2) keeping track of “suspended” losses, and (3) keeping track of “outside basis”.

 

I have seriously considered telling my clients that I will no longer do tax returns for individuals who have in their current portfolio limited partnership investments that produce K-1s.  But I have not.   

 

While I have not done any specific calculations, I firmly believe that often the additional costs to properly prepare the federal and state income tax returns for taxpayers with K-1 investments is as much as or more than the actual income, or tax benefits if any, generated from the investment.  If the money invested in these limited partnerships were instead invested in related mutual funds I expect the investor would do better.  His/her tax preparation costs would certainly be less.

 

Of course brokers never tell their clients this when selling them the investment.

 

I have no personal knowledge of this, but I suspect that brokers receive a larger commission from selling units of limited partnership investments than they do from selling shares of stock or mutual funds.  I would truly appreciate hearing from anyone “in the know” whether or not my suspicion is true.

 

The bottom line to this post is this – think very carefully before permitting your broker to purchase a limited partnership investment (unless it is in an IRA account, which has no reporting requirements).  Do some research to be sure that the income or growth potential of the limited partnership investment is truly “more better” than a more traditional investment in stock or mutual fund shares. 

 

Any comments?

 

TTFN

COST BASIS REPORTING

Last week over at ACCOUNTING TODAY Roger Russell stated the obvious - “Complexity of Cost Basis Reporting Requires Tax Expertise”.

Roger identified the problem –

“Every new piece of legislation meant to simplify certain tax areas generally adds complexity of one sort or another to the Code. {tax pros} often refer to new tax legislation as an ‘Accountants Full Employment Act.’

A case in point is the cost basis reporting requirement, in place during this past tax season. While complicated enough by itself, the situation is exacerbated by differences in the requirements for brokers and investors.”

As a tax professional, perhaps the biggest challenge, and time consumer, I faced during the past tax season was the new Schedule D/Form 8849 format.

Roger explained –

“Beginning on Jan. 1, 2011, it became mandatory for brokers and other financial intermediaries to report cost basis information on Form 1099-B to investors and to the IRS for equities acquired on or after that date. The new requirement, spelled out in the Emergency Economic Stabilization Act of 2008, also covers mutual funds acquired on or after Jan. 1, 2012, and will cover debt securities, options and private placements acquired after Jan. 1, 2014.”

And as I explained in my post “That Was The Tax Season That Was” –

“A new Form 8949 was added to report the individual short-term and long-term transactions in three separate categories – sales where the cost basis was reported to the IRS on Form 1099-B, sales where the cost basis was not reported to the IRS on Form 1099-B, and sales that were not reported on a Form 1099-B.  A separate Form 8949 was required for each of the three categories.  The Schedule D served as a summary of the 8949s.”

I went on to detail the biggest problem with this new requirement –

“The various brokerage and mutual fund houses all treated the new Form 1099-B portion of the year-end consolidated tax report differently. 

For the most part this new system required some additional time, but not additional agita.  In many cases the 1099-B reporting was excellently broken down into separate categories of short-term “covered” (transactions where cost basis was required), short-term “non-covered”, long-term, and undetermined term.  And a gain and loss analysis, with cost basis for all, or almost all, transactions provided, was also included in the report in the same format. 

In some the 1099-B received by the taxpayer included the cost basis for all transactions – although you often had to read the fine print to discover if the cost basis shown had actually been reported to the IRS.

The worst cost basis reporting formats came from Morgan Stanley Smith Barney and TD Ameritrade, with TD the bottom of the barrel.  The 1099-B for these brokerages was not broken down to list different categories of transactions (as described above).  Transactions were listed alphabetically, regardless of term or coverage, with cost basis information shown only where required. 

MSSB reports included a gain and loss analysis, but it was merely broken down by short and long term, as had been done in past years.  TD did not include a gain and loss analysis in its consolidated statement.  The client had to go online to generate the analysis, also still in the short or long only format.

The additional work required for clients of these brokerages was not so bad with only one or two pages of transactions.  But several had multiple (as many as 50) pages of transactions (can you say “churning”) – making proper reporting much more difficult and time consuming than in the past.”

Requiring brokerage and mutual fund houses to report cost basis is a good thing.  In tax seasons past the biggest challenge, and time consumer, was determining cost basis for investments sold by clueless clients.  Brokers and funds were often already providing profit and loss statements with much cost basis information, which was helpful, and when this was not automatically included in a Consolidated Year-End 1099 Statement, or some cost basis information was missing, I could in many cases get the information direct from a client’s individual broker. 

Making cost basis reporting mandatory will eventually save lots of time during tax season.  However, it will take a long time to fully phase in to maximum reporting.  By the time that comes I will be retired.

And I expect we will never have 100% cost basis reporting.  What about the stock that was inherited from a relative, or was received as a gift when the taxpayer was a child?  It is easy enough to determine the cost basis for inherited investments, assuming you know the date of death, and future regulations could require brokerages to determine cost basis based on date-of-death value at the point the investment is transferred into the account.  But determining the basis of a gifted investment can be almost impossible.

In the meantime to make things a little easier perhaps the IRS could establish a required pro-forma format for all Form 1099-Bs from all brokerage and fund houses, and all houses could come to an agreement that Profit and Loss statements included in the Consolidated Year-End 1099 Statement be done in the same pro-forma format (if industry-wide agreement is at all possible). 

Ideally, all 1099-Bs (and P+L statements) would be “broken down into separate categories of short-term “covered” (transactions where cost basis was required), short-term “non-covered”, long-term, and undetermined term.” 

And, while I am as happy as a pig in reality tv transferring broker-provided profit and loss statements to Form 8849 (and in the past Schedule D) as is, how do I really know that the information provided by the broker is correct.  And what is my responsibility as a tax pro to make sure the information is correct? 

The alternative is to have all clients keep detailed, contemporaneous, and ongoing records of all investment purchases.

Oh well, I can dream, can’t I!

TTFN    

THE NEW TAX CODE - INVESTMENT INCOME

Here is how investment interest would be taxed in my new simple, fair and consistent Tax Code.

(1) When it comes to the question of taxing municipal bond interest I am “bi” – I could go either way. I am not against taxing the interest earned on municipal bonds, and the dividends paid by mutual funds that invest in mutual bonds. But I would also be willing to continue to exempt this income from federal taxation. Or I could tax only the earnings of “private activity” bonds, which are currently taxed under the dreaded AMT.

However, I think at this point I would tend toward taxing municipal bond interest the same as any other kind of interest.

(2) My new Tax Code would do away with “qualified” dividends. All dividends would once again be taxed as ordinary income.

The reason certain dividends were allowed “qualified” status and as such taxed at lower rates was to somewhat alleviate the “double-taxation” of corporate dividends. Corporate profits are taxed on the corporate return, and dividends, which are a distribution of corporate profits, are also taxed on the individual tax return of the shareholder. My new Tax Code would do away with the double taxation of corporate dividends by allowing corporations to claim a tax deduction for “dividends paid”.

If a corporation had a net profit of $100,000, and paid $90,000 out to shareholders in dividends, it would pay federal corporate income tax on only $10,000. The shareholders would pay tax on the dividends received at ordinary income rates.

Coupled with this new “dividends paid” deduction for corporations would be the total abolition of all current special interest corporate deductions, credits and loopholes. A corporation would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss. Dividends paid to shareholders would be deducted from any gain to determine taxable income.

There would be no “special deduction” for dividend income, and charitable contributions would be 100% deductible as a business expense on the Form 1120, regardless of the amount of profit or loss.

One side benefit to doing away with the category of “qualified” dividends on the Form 1040 is that brokerage and mutual fund houses will no longer need until the middle of March to properly prepare year-end Consolidated 1099 reports. The 1099 information can be prepared and sent to taxpayers by January 31st, as was done before qualified dividends were created, and there will be no more need for one or more “corrected” copies.

(3) When it comes to the taxation of long-term capital gains, and capital gain distributions, I would return to my early days in “the business”. I would not have a separate, lower tax rate for long term capital gains (as I would not have a separate, lower tax rate for qualified dividends) – instead my new Tax Code would bring back the 50% “capital gain exclusion”.

When I first started preparing 1040s back in the early 1970s the Schedule D allowed for a 50% deduction for net long-term capital gain – only half of such gains were included in taxable income. So if net long-term capital gain was $10,000, only $5,000 was carried over to Form 1040 as income. There was only one set of tax rates for all income – no special lower rates for capital gains. This 50% exclusion was later increased to 60%.

The result would be that capital gains, and capital gain distributions, would be taxed at a rate half that of the rate for “ordinary income”, without having to create a separate set of tax rates and a separate tax calculation. If net long-term capital gain on Schedule D was $10,000, and the taxpayer was in the 25% tax bracket, the effective tax on the net capital gain would be 12.5% - calculated at 25% tax on $5,000 of income.

I would also increase the maximum net capital loss deduction from $3,000 to $5,000 and index it for inflation. And I would allow taxpayers net capital losses to elect to “carryback” losses for three years to apply against capital gains reported in prior years.

I first proposed this idea in a letter to Dubya back in 2002. Here was my thinking at the time (see my post Dear George) –

“During the late 1990s and into 2000, when the stock market was flourishing, many taxpayers realized, and were taxed on, large capital gains, including excessive capital gain distributions from mutual funds. In most cases these capital gains were reinvested in the market and in additional mutual fund shares. In 2001 and 2002 the bear market provided these same investors with substantial capital losses.”

I had clients who had 6-figure gains in one year and 6-figure losses in the next. The net effect of 24 months of investing was basically 0 gains or an actual net loss. However the clients paid tons of tax to Sam on the gains in the first year, but were limited to deducting $3,000 in losses in the next year and a loss carryover that will last for decades and, unless they have a big score in the future, may never be fully deducted.

It seems only fair in such a situation that investors be allowed to carry back the losses to apply against the earlier gains of a bull market and get a refund of the taxes paid on these gains.

FYI, in response to my letter I received a brief form “thank-you for sharing your views and concerns” letter from the “Director of Presidential Correspondence”.

(4) Since the new Tax Code will not allow a deduction for depreciation of real property, I would remove the income and deduction limitations on claiming losses from rental real estate with active participation.

Business, including rental, losses passed through to “limited” partner investors on a Form K-1 would be treated similar to investment interest, with the deduction limited to net K-1 income from all passive activity K-1s. Suspended losses could be deducted in the year the investment is sold or terminates. The “at risk” rules would remain as currently written.

As mentioned above under my discussion of corporations, all current special interest deductions, credits and loopholes for partnerships, limited or otherwise, would be abolished. A partnership would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss to be allocated on the K-1s.

So what do you think about these proposals?

TTFN

A WINTER RERUN

I have decided to leave the idiots in Congress alone for a while till we see if they do what has to be done. Besides, I have been busy with a variety of "stuff" lately, and have not had the time to write. So I thought I would post a "rerun" from last December titled "WHERE YOU INVEST IS AS IMPORTANT AS WHAT YOUR INVEST IN" -

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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 {and 2010 - rdf} the special rates are 0% or 15%, depending on your level of income.

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“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 {no such luck for 2010 - as for 2011 we can only hope - rdf}. 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.

TTFN

WHERE YOU INVEST IS AS IMPORTANT AS WHAT YOUR INVEST IN

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.

TTFN