Investing and Tax Considerations: Minimizing The Tax Burden On Investments

Investing and Tax Considerations

A hallmark of good investing is managing the tax implications.  Investing can be complicated and taxes are always complicated. It sure doesn’t make it any easier by putting them both together.  To help you keep as much of your investment earnings as possible, we will cover some of the basic tax considerations.

  • Tax efficiency is simply how much of an investment’s return still remains after all the tax obligations have been taken care of.

A good general rule to remember is that the more an investment’s return is dependent on income rather than an increase in share price, the worse the tax burden usually is, or the less tax efficient it is.

Taxable or Non-Taxable

Investment accounts are classified as either taxable or non-taxable. If an account is taxable, then the taxes must be paid on investment income in the same year in which it is received. This would include bank accounts, money market mutual funds, and your basic individual or joint investment account.

Non-taxable accounts are free from taxes as long as the money stays in the account. When you start taking money out, your tax liabilities kick in. This would include any type of retirement account, like your 401(k) and IRA.

  • A good rule to follow is to use your non-taxable accounts for the less efficient investments and the taxable accounts for the more efficient investments.

The Effect of Your Tax Bracket

If you’re going to invest with taxes in mind, be aware of your tax bracket. You must determine your marginal income tax bracket and also whether or not you’re subject to the alternative minimum tax. The higher your tax bracket, the more important it is to be in tax efficient investments.


Current Income versus Capital Gains

There are also differences between taxes on current income and taxes on capital gains. Any current income is usually taxed at your tax bracket rate. Capital gains are categorized as either short-term or long-term. Short-term investments are those held less than a year; long-term would be anything longer than a year. Typically, short-term gains are taxed as income and long-term gains are at the preferential rate.


Tax Treatment for Typical Investments

Consider these tax treatments for the investments you’re considering:

  • Dividends are normally taxed at a lower preferential rate. So dividends are likely to be a better for an investor in a higher tax bracket than for one in a lower bracket.
  • Bonds provide interest and are usually taxed at the marginal (income tax bracket) rate. This would not be a tax efficient investment for someone in a higher tax bracket.
  • The gains realized from stocks that are held for over a year and then sold would be taxed at the preferential rate.
  • Some investments with poor tax efficiency would include junk bonds and preferred stock. This is due to the high interest received and the high, fixed dividends that are received, respectively.
  • High tax efficiency investments would include stocks and municipal bonds. Municipal bonds are not taxed at the federal level and the yields are quite low. Stocks are typically held for more than a year, so the gains are taxed at the preferential rate. Both can be held in retirement accounts, which would make them even more tax efficient.

Minimizing the tax burden on investments is well within the reach of any investor, even beginners. Simply take a look at your marginal tax bracket and the preferential tax rate and make a plan. If your marginal tax rate is relatively low, you have a lot more flexibility. If it is high, then more planning will really pay off.

The 529 College Savings Plan: An Easier Way To Save For Your Child’s College

529 Plans – Send Your Kids to College and Save a Ton on Taxes

Paying for a child’s education is certainly one of the greatest gifts you can give. But the costs of higher education have been rising at a shocking rate. With in-state expenses at a public school averaging just below $20,000 per year, you may be wondering what you can do.

One excellent solution to ease the financial challenge of paying for college is the 529 College Savings Plan. These are state sponsored savings plans that allow for tax-free earnings. Contributions are not deductible for federal income tax purposes, but are deductible in many instances for state tax purposes.

To open a 529 Plan, here are some basics you’ll need to know:

  1. Tax write offs can be huge. Every five years, account holders can write off up to $55,000 from their estate per beneficiary without having to pay federal gift tax. For married couples, the limit is $110,000.
    • As an example, a wealthy couple with 5 grandchildren could deposit $550,000 ($110,000 x 5) towards their grandchildren’s education and eliminate that amount from their estate. They could do that every 5 years until the maximum is reached ($300,000+ per beneficiary in many instances).
  2. You maintain control of the assets. If you decided to close the account, you would have to pay a 10% penalty and income tax on any earnings. The balance is yours to do with as you wish.
  3. The beneficiary can be changed. If your son decides that he’s not going to college, the account can be reassigned to someone else. The account must be transferred to an eligible individual within the same family.
  4. Different states, different plans. Each state has its own plan(s), and some are much better than others. But you can invest in nearly every other state’s plans.
    • In theory, you could be an Arizona resident, invest in a Connecticut 529 plan, and send your child to school in Florida. A lot of flexibility is available, so be sure to shop around before you open an account.

The fees associated with the various plans are also important to consider. Some will be much higher than others. In fact, many experts consider the extra charges to be the most important criteria when choosing a plan. Some fees are incurred when opening the account; there are also annual maintenance charges.

If you know for certain where you want to send your child to school, many universities offer prepaid 529 plans. This would allow you to lock in the cost of future credit hours at the current rate. Unfortunately, there are penalties should you decide to later send your child somewhere else. So if you choose this option, be very sure where you’ll be sending your kid to college. On the down side, investment options are rather narrow, and the ability to switch between available investment options is also limited. The tax code currently curtails changes to once per calendar year.

Is A 529 Plan Right For You?

Like any investment, 529 plans may or not be right for you. There are numerous other options to finance a college education, each with their own benefits and limitations. However, if you’ve evaluated your investment options thoroughly, you may find that a 529 plan is an excellent option to ease the burden of paying for a college education. The tax benefits are considerable, and you always maintain control of your account. With the rising cost of college, your kids will thank you for investing in their futures.