One day, hopefully at some distant point in the future, we will all pass from this earth. Till then, we will pay taxes. Year in, year out.
All investors share three commonalities. Hope, death and taxes. Hope? The energy that powers our lives. The others? Loathed, lamented yet inevitable. The difference, of course, being that the government rarely mismanages your death. Your tax dollars? A different story.
Still, this missive will not lament the opportunity costs of all those wasted tax dollars. Fact is, most tax dollars contribute mightily towards making this nation the greatest there is.
Taxes represent an inevitable facet of investing. The tax code complicates investment planning. And the impact of taxes has steadily increased as the Federal government attempts to cover expanding shortfalls and the public's investment planning becomes more individualized.
Careful planning enables you to minimize the impact taxes have on investments. Still, don't get hung up on the minutia. The focus should always be the return generated over the course of an investment. That specific objective being the best overall rate of return a thoughtful portfolio can muster. Yet, after tax and transaction returns collude to make taxes an important investment concern. So should they warrant careful scrutiny in all capital allocation endeavors.
Types of Taxes
A endless list of potential taxes can impact your investments, portfolio and net worth. Some of the more critical are as follows:
Interest earned on investments--typically from bonds and large cash holdings--is subject to the same tax rates as your ordinary income tax rate.
You'll pay taxes on dividends yielded from stock you own. These are taxed with preferential treatment in comparison to ordinary income and interest income. To receive this treatment, the dividend must meet several requirements to be considered a qualified dividend.
When portfolio value increases from the purchase price and you sell investments for a profit, a capital gains tax is triggered. Similar to dividends, long-term capital gains are taxed at lower rates than ordinary income.
Investors with significant holdings will contend with the specter of estate taxes following their deaths. These taxes can represent a substantial erosion of the total value inherited by heirs or charities. Planning for estate taxes is critically important, as there are many strategies to minimize the value of portfolio holdings, and so mitigate one's estate tax burden.
Qualified and non-qualified retirement plans, usually those savings deferral plans utilized through employers and businesses, represent some of the last, great American tax loopholes.
One of the most prominent means of benefiting by tax-friendly regulations is to open retirement accounts. These include 401(k)s or 403(b)s (depending on type of employer), defined benefit pension plans (for select businesses), Individual Retirement Accounts (IRAs) Simplified Employee Pension plans (SEPs) and Simple IRAs.
These retirement plans qualify for preferential tax treatment. The benefits of deferring taxes dramatically compounds over time. For example, $1,000 invested in an IRA at a tax-deferred rate of 8 percent grows to $10,063 over 30 years. In a taxable account (assuming 28-percent tax rate), the funds would grow to only $5,366.
But the game isn't confined to employer-sponsored plans. Individuals can play as well, enjoying the same upfront tax deferrals, as well as the tax-advantaged investment status throughout the lifetime of the accounts. Roth and traditional IRAs represent two such retirement savings vehicles.
A Roth IRA enables you to contribute money that has already been taxed in exchange for the ability to make tax-free withdrawals upon retirement. Imagine having an asset on which you'll never pay another penny in taxes. One that leverages the same compounding power as every other. That's a powerful concept. Importantly, Roths are available in both the IRA as well as the 401(k) formats. Curious about a Roth 401(k)? Speak with your employer.
Traditional IRAs allow your pre-tax contributions to defer taxes throughout the lifespan of the account. You will only pay taxes on distributions after the age of 59 ½.
Difficulty in determining which account type is better suited for you? Consider your future tax rate compares to your current tax rate. If you assume your individual tax rate will not change between now and retirement, then the net result will be the same, regardless of which type of IRA. When looking at changing tax rates, focus on two separate considerations: first, the changing landscape of tax rates between now and retirement and, secondly, how changes in your income will impact your personal tax bracket.
Typically, as people age they earn more money and enter higher tax brackets. In this case, and assuming no change in the overall level of taxes, it would be more beneficial to pay taxes now, at a lower rate. However, if you believe that your tax rate will decrease, then a traditional IRA will be more beneficial.
Coverdell and 529 plans are tax-advantaged accounts that are similar in nature to 401(k) and IRA accounts. The difference? Coverdell and 529 accounts can only take advantage of tax deferrals if used for qualified educational purposes. Like retirement accounts, this characteristic can help maximize the funds that are set aside for educational funding needs. There are numerous rules for these plans depending on their type and the state in which the account is initiated. So, appropriate planning is important before utilizing such accounts.
In addition to tax-advantaged accounts, you can choose among a variety of tax friendly investments. Some of which provide tax-free income. Others provide specific tax benefits, if not direct tax deductions.
Municipal bonds represent an ideal fixed-income investment that simultaneously limits the effect of taxes. Municipal bonds are issued by a U.S. city or other local government. The interest received by bondholders is generally exempt from the federal income tax and from income tax in the state in which they are issued.
Municipal bonds are often priced higher to account for these tax effects. However, the tax exemption on interest income will be more beneficial for individuals with significant income. Making them a favored income-production tool for affluent investors, as they can minimize the tax impact for individuals in higher tax brackets.
Intangible drilling costs (IDC) represent some of the cost associated with developing oil or gas wells. These include all operational expenses incidental to, yet necessary in, the drilling and preparation of wells for production of oil and gas. Such expenses can include survey work. Ground clearing. Drainage. Wages. Fuel. Repairs. Supplies. Among many others. Expenditures are counted as IDCs when they have no salvage value.
Investors in oil and gas partnerships receive the IDC deduction as a means of attracting investment capital to the high-risk exploration business. Drilling technologies like fracking, however, have reduced some of the risk associated with such investments. Yet the IDC tax benefits remain. Providing a tax-friendly compliment to the income and appreciation opportunities that such investments might provide.
Land conservation easement (LCE) projects can also provide affluent investors with significant tax deductions. Here, an investor contributes money to a partnership that acquires land with the purpose of preserving that land from development. The partnership completes a qualified appraisal of the land's potential value under various development models, after which the partnership may be eligible for a Federal income tax deduction equal to some multiple of the original contribution to the partnership.
While less known than other tax strategies, these LCEs can provide significant tax deductions to high-income individuals seeking to mitigate their tax burden.
Of course, each of these strategies should be discussed with a qualified CPA or tax advisor. Only then can an investor determine if such strategies and tactics may be applicable and beneficial to his personal situation.
As Balzac noted, it's easy to sit up and take notice. It's difficult to get up and take action. Nowhere is this more evident than with investor's tax situations. About which investors perpetually whine and moan, but rarely act upon.
Once, while lounging on a beautiful beach in the Caribbean, I befriended a gentleman who proceeded to regale me with his many adventures in investing and tax avoidance. The story involved a multitude of exotic locales, tax havens, strategies, and a few harrowing standoffs with government agents.
"In the end, " he explained, "I simply wanted to be able to put some money away for my kids, their kids, and always be able to pay my bar tab." Of course, somehow I ended up paying for his drinks.
Like any of life's nagging burdens, taxes can generally be more effectively contended with. Even partially mitigated. Yet, relief will only be had by those willing to be proactive. To determine what might align with financial realities and long-term objectives. And willing to chart a course for brighter horizons.