In reading some of the great articles posted here at Seeking Alpha, I have noticed quite a few questions asked in the comments about how certain tax consequences impact investing decisions. Here are five quick tax tips and strategies that relate to investing.
0% Tax Rate on Capital Gains?
The federal government does not assess long-term capital gains tax if your taxable income is below $72,500 in 2013 and you file as a married couple. A few notes on this tax break. First, the break is on long-term capital gains, not short-term capital gains. Second, the threshold is based on your tax bracket, so taxpayers in the 10% and 15% brackets benefit, but the rest do not. Third, the break is based on your taxable income, not your adjusted gross income. This is a good thing because we get a little bit further down the tax return (after the standard or itemized deductions and personal exemptions) before we run into taxable income, as opposed to adjusted gross income. This exemption does not apply to state income taxes, so check your own state's laws to see whether a similar exemption applies. This tax break does not apply to collectibles, such as gold. Finally, this exception does not apply to certain dependents (i.e., the kiddie tax), so don't try to funnel your long-term capital gains through your 16 year old son earning $2,000 this summer in hopes that his newfound $10,000 of long-term capital gains will not be taxed. On the other hand, if you file your tax return separately from your spouse, talk with your adviser about possibly transferring appreciated securities to a spouse in the low tax bracket so that he or she could capture those capital gains tax-free.
I have been able to use this break on more than one occasion to unlock long-term capital gains and save the client thousands of dollars in taxes.
Even Bill Gates Can Contribute to a Roth-IRA
If you are married and your adjusted gross income is greater than $188,000, then you cannot contribute directly to a Roth-IRA. So Bill Gates missed this cut-off by a few dollars. He could, however, make a nondeductible contribution to a Traditional-IRA and then immediately (within 60 days) roll the contribution over into a Roth-IRA. So long as he does not take any distributions for five years after he makes his first Roth-IRA contribution and waits until age 59 1/2 to take distributions from the Roth-IRA, then the contribution and rollover is tax-free, regardless of his AGI. There is a very important exception for taxpayers that already have assets in a Traditional-IRA, which may result in taxable income on part of the rolled-over amount. There may be some strategies to minimize the application of this exception. For a good article on the topic, please see this.
Be Careful Where You Hold Master Limited Partnerships
There are two good reasons not to put MLPs in an IRA or Roth-IRA. The first is that MLPs may generate unrelated business income, and too much of it in a given tax year ($1,000) will result in tax, even in an IRA. The second is that the distributions by MLPs are often considered non-taxable "return of capital", so the benefits of a MLP's tax structure would be lost in an IRA.
Take Advantage of Tax-Loss Harvesting, but Avoid Wash Sales
Tax-loss harvesting is the simple concept of selling sufficient securities that are held in a taxable account, and which are trading at a loss, to generate $3,000 of net capital losses on your tax return each year. For the $5-$10 trading fee, you can save yourself as much as $1,000 in taxes. If you sold a security that you want to repurchase, be careful not to purchase that security within thirty days before or after the date of the sale, or else the "wash sale" rules will apply and that loss will be carried over (and therefore not deductible) until the repurchased security is ultimately sold in a transaction that does not qualify as a wash sale. Note that repurchasing the security in an IRA, or having your spouse repurchase the security, does not avoid the wash sale rule.
529 Plans are an Underutilized Resource
By now, we are likely all aware of what a 529 plan is, that the contributions are not deductible but grow tax-free and that the funds can be used for qualified education expenses such as tuition, fees, books, room, board, and certain computer technology expenses without ever paying taxes on the growth of the contributions. What most people overlook is the fact that you can set up, regardless of income, as many 529 plans as you have beneficiaries to set them up for. You can create one for yourself, your spouse, your kids, your grandkids, your neighbor's kids, your co-worker's kids, etc. If you are married, you can each contribute $14,000 into each 529 plan each year without any gift-tax consequence. Under certain circumstances, you may be able to contribute $70,000 from each spouse to each plan, provided that you elect to treat the contribution as if you made it ratably over a five year period.
None of this information may be shocking, but what is underappreciated is the flexibility in changing beneficiaries. If, for example, your aggregate contributions of $100,000 into your son's 529 grows to $200,000 by the time he starts college and, to your amazement he gets a full ride such that he ends his college career with over $200,000 in his 529, that money does not have to be withdrawn and subject to tax on the gains and a 10% penalty. Rather, you can leave the money in the account (in case he goes to grad school) and at any time change the beneficiary to your son's spouse, first cousin, child, brother/sister, niece/nephew, or even back to yourself as the parent if you decide to go back to school. There is no limit to the number of beneficiary changes, so it is possible for the 529 to benefit multiple generations. These beneficiary changes are generally tax-free, however, the generation-skipping transfer tax ("GSTT") may apply under certain circumstances.
To put some numbers behind the theory, a wealthy married couple could put $140,000 into a 529 for each child and grandchild, then, assuming no other gifts are made for the next five years, do it again at the end of that five year period. Let's assume that the wealthy married couple have four grandchildren that are two years old or younger. The wealthy married couple could make three such $140,000 contributions (assuming that the annual gift-tax exclusion doesn't increase in the meantime and the maximum 529 account balance increases enough during that 10 year span to permit such contributions), for a total of $1,680,000 that will grow tax free and remain tax free (although potentially subject to the GSTT) so long as it is used for qualified education expenses. What an opportunity to create a legacy for multiple generations! This may be an extreme example, but hopefully it gets the point across. An important caveat is that 529 plans have a maximum balance, which varies by state and relates to the projected cost to send someone to college (most states look to the cost to send a child for 4-5 years to an extremely expensive school, and limits can get as high as $300,000). Once a 529 has reached its maximum balance, no further contributions are permitted, but it can continue to grow tax free. Note that although I am glossing over the GSTT rules, they are important, so please consult with your tax adviser.
Since I am an attorney, I have to give the standard disclosures: this article is not intended to create an attorney-client relationship, it contains my opinions and not necessarily those of my law firm, and please consult a tax advisor before acting on any information contained in this article. Under Circular 230, I am required to inform you that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties imposed under the Internal Revenue Code or to support the promotion or marketing of any tax-related matter discussed herein.