|
Investment
Strategies
 As part of your year-end tax planning, total up your
gains and losses for the year. If trades to date have
resulted in a net gain, take a hard look at the securities
still in your portfolio that show paper losses. Maybe
now is the time to unload some of those stocks, using
the loss to offset the gain on other deals and pull
down your tax bill. It's not a cockamamie idea to realize
losses to save on taxes. After all, you suffered the
loss when the securities fell in value. Selling just
makes it official and makes the IRS pick up part of
the loss.
On the other hand, if your sales so far this year
have produced a net loss, perhaps you should go in
for some year-end profit-taking. Remember that only
$3,000 of net losses a year can be used to offset income
other than capital gains, with the tax value of extra
capital losses postponed to future years. However,
you can benefit from such losses this year by taking
gains for the losses to absorb. That lets you take
profits, up to the amount of your losses, without increasing
your tax bill.
Don't let the search for tax savings lead you into
bad investment decisions. Your investment goals must
be your primary concern. But if a particular investment
is on the sell-or-hold borderline, perhaps the tax
consequences can be decisive.
Last-Minute Sales
Since it takes several days to settle a securities
trade-between the time you order the sale to the time
you get your money-sales during the last few days of
the year often straddle year-end. As far as the IRS is
concerned, a gain or loss should be reported on the return
for the year the trade occurs, regardless of when settlement
takes place. That means profits and losses taken as late
as the closing bell on New Year's Eve go on the current
year's return.
Instalment
Sales
This method lets you hold off reporting taxable income
from a sale until you receive the proceeds. You can't
use the installment method to defer recognition of income
from the sale of publicly traded stocks and bonds. But
it is available to individuals who sell a vacation home,
for example, or rental property on an installment note.
If the buyer will pay you over a number of years, you
can report the income as you get it rather than all at
once in the year of the sale. If you are receiving installment
payments on a deal made before the long-term gain rate
was lowered in 1997, congratulations: You get the benefit
of the 20% long-term-gain rate on the postponed gains
you are now receiving.
Bond
Swaps
This is another classic year-end maneuver. The point
of the swap is to lock in a tax loss by selling bonds
that have fallen in value and reinvesting the proceeds
in other bonds. Done right, you can maintain the income
stream from your bonds. Consider this example:
Assume you own $100,000 worth of AA-rated bonds with
a 7% coupon and a maturity date in 2016. In November,
as you begin your year-end planning, the market price
of your bonds has slipped to $84,750. If you sell at
that price, you'll have a $15,250 loss. At the same
time, assume you can buy $100,000 face value of an
AAA-rated bonds, with a 7% coupon and a 2015 maturity,
for $83,612.
If you sell one set of bonds and buy the other, look
what happens: Since they have the same par value and
coupon rate, your annual income remains the same: $7,000.
Your bond rating increases from AA to AAA. You pull
$1,138 out of the investment- the difference between
what you got for the old bonds and what you paid for
the new ones. And you can claim a $15,250 tax loss.
If it offsets gains that otherwise would have been
taxed at 28%, you save $4,270.
As with much year-end tax planning, the earlier you
begin scouting for promising candidates for swapping,
the better. The supply dwindles and competition from
other investors heats up as the year draws to an end.
Stocks,
Bonds, and Other Investments
Keeping track of the basis of all your shares is essential
for successful tax planning, particularly when you
buy the stock of the same company at different times
and at different prices. When you decide to sell some
of the stock, being able to identify which shares to
part with will permit you to control the tax consequences
of the deal.
Basis is, in brief, your investment in the property-the
amount you will compare to the sales proceeds to determine
the size of your profit or loss. The higher you can
prove your basis to be, the less gain there is to be
taxed... and therefore the lower your tax bill.
Consider this example. You bought 100 shares of ABC
stock in January 1999 for $2,400 (including commission),
giving you a basis of $24 per share. In January 2000,
you purchased 100 more shares, this time for $2,800.
Your basis in each share is $28. In January 2001, you
purchased another 100 shares for $3,000, giving each
share a basis of $30.
When the stock hit $40 a share in April 2003, you
sell 100 shares. If you simply tell your broker to
sell 100 shares, the IRS FIFO rule-first in, first
out-comes into play. It is assumed that the first shares
you purchased-the 1999 group with the $24 basis-are
the first ones sold. That would create a taxable profit
of $16 a share or $1,600. But if you directed your
broker to sell the shares purchased in 2001, with a
$30 basis, the taxable profit will be $10 a share,
or just $1,000.
In either
case you'll get $4,000 from the sale of the stock
and because you've owned all the shares more than
12 months, your profit will get long-term gain treatment.
But, your tax bill would be significantly different:
$320 versus $200. In most cases, you'll probably
want to structure the sale to produce the smallest
taxable profit. It's possible, though, that circumstances
will warrant selling the shares with the lowest basis
first--if you have sufficient losses from other sales
to offset the larger gain, for example. Also, you
have to be careful if you want to make sure your
profits qualify as tax-favored long-term gains. You
get long-term gain treatment-and the flat 10% or
20% tax rate-only if you have owned the securities
for more than 12 months. Sales of assets owned 12 months
or less produce short-term profits, taxable in your
top tax bracket, as high as 38.6% in 2002 and 2003.
(For taxpayers in the 10% or 15% bracket, sale of assets
owned more than five years qualifies for "five-year
gain"
treatment and a flat 8% tax rate.)
Municipal
Bonds
Just as U.S. government securities are exempt from
state and local income taxes, IOUs issued by states
and municipalities escape the grasp of federal revenuers.
Known generically as municipal bonds, these tax-exempt
issues usually carry a lower interest rate than fully
taxable bonds. Investors make up the difference-and
sometimes more-via tax savings.
The higher the rate you avoid, the more valuable avoiding
tax becomes.
To know whether municipals make sense for you, compute
the taxable-equivalent yield-that is, how much you
would have to earn on a taxable investment to have
as much left over after taxes.
Taxable-Equivalent
Yields
Here's the formula for figuring the precise
taxable-equivalent rate for any bond you consider: subtract
the federal tax bracket percentage from the number one,
and divide the tax-free rate by the result.
For example, assume you are in the 30% tax bracket
and are offered a 4% tax-free bond. You would divide
4 by 0.70 (1 - 0.30) and find that the taxable-equivalent
yield is 5.71%. In other words, you'd need a taxable
investment paying more than 5.71%% to beat the return
on the 4% tax-exempt. In the 38.6% bracket, the divisor
would be 0.614 (1 - 0.386) and the taxable-equivalent
yield would be 6.51%.
There's a similar formula for figuring things the
other way, to find the tax-exempt equivalent of a taxable
yield: subtract the federal tax bracket percentage
from the number one, and multiply the taxable rate
by that number. The result is the tax-free rate.
Assume you are considering a taxable investment yielding
6%. If you are in the 30% tax bracket, multiply 6 by
0.7 (1 - 0.3). The result is 4.2, telling you that
a 4.2% tax-free yield will put the same amount in your
pocket, after tax, as an 6% taxable yield. In the 38.6%
bracket, the multiplier would be 0.614 (1 - 0.386),
so a tax-free yield of 3.68% will match a taxable yield
of 6%.
Taxable equivalents get a boost when you buy bonds
issued within the boundaries of your own state if it,
like most, exempts the income from state tax. If you
happen to face a city income tax, municipals can brag
of triple tax-free status-shielded from federal, state
and local income tax.
Figuring taxable-equivalent yields gets more complicated
if your investment dodges both state and federal tax.
Because state income taxes paid are deductible on your
federal return (if you itemize) you can't simply add
the state rate to the federal rate in the formulas
above. First, you must find the effective state tax
rate-what you pay minus the tax savings of deducting
that amount.
For example, if you pay a 10% state tax and deduct
it in the 30% federal bracket, your effective state
tax rate is 7% (the 10% state tax rate minus 30% of
that rate). Thus, in the formula for figuring taxable
equivalents, the tax rate used in the divisor would
the combination of your federal rate (30%) and your
effective state rate (7%), or 37%. So the divisor is
1 - 0.37, or 0.63. If you are considering a 4% municipal
that is exempt from both state and local taxes, you
would divide 4 by 0.63 and find that the taxable equivalent
is 6.35%.
In most states, there's an advantage to buying in-state
municipals because these states tax the income on out-of-state
bonds but give the tax-free nod to in-state obligations.
A few states, though, give tax-free status to munis
from all other states and a few others even tax some
of their own munis. To know where you stand, check
with a state tax official or a broker who sells munis.
Gains
and Losses
on Municipalal Bonds
Although interest from municipal bonds is
exempt from the federal income tax, the IRS doesn't ignore
the gain or loss that results when you sell the bonds.
If you sell a bond for more than your basis, the profit
is a capital gain; if you sell it for less, it's a deductible
capital loss.
In general, your basis is figured the same way as
for taxable bonds. However, if you buy a tax-exempt
bond at a premium, you must amortize the premium over
the period you own the bond. This amortization reduces
your basis in the bond, but unlike a taxable bond,
you can't deduct the amortized amount. Because the
interest you earn is tax-free-and you paid the premium
to get a higher-than-current-market, tax-free rate-the
premium amortization is not deductible.
If you buy a bond originally issued at a discount,
you increase your basis each year as is required with
taxable bonds, but you don't have to report the annual
amortization of the discount as income. It, like interest
paid on the bond, is tax-free.
Things are different,
though, if you buy a municipal bond at a market discount.
And, different rules apply depending on when you
buy the bond. For those purchased before May 1, 1993,
you don't amortize the market discount. Rather, your
basis remains stable, and when you redeem the bond
at face value, the difference between what you paid
and what you receive is a taxable capital gain. When
Congress hiked the top tax bracket to 39.6% (it is
38.6% for 2002 and 2003) but kept lower
rates for capital gains taxes, however, the lawmakers
decided this rule was too generous.
Now, when you sell a market-discount tax-exempt acquired
after April 30, 1993, gain attributable to the discount
is treated as ordinary income and taxed in your top
bracket. Rather than report the full amount at the
time you dispose of the bond, you have the same option
available to taxable bondholders discussed earlier:
to report a portion of the discount annually as it
accrues.
Life
Insurance
As Congress has squeezed the tax benefits out of many
investments, life insurance has taken on a special
glow. Policies that combine investments with insurance-including
whole life, universal life and single-premium life
policies-enjoy tax-favored status.
Part, and sometimes a very substantial part, of the
premiums go not to pay for insurance but into investments
that build cash value. Earnings on the cash value are
protected from the IRS. The tax bill is deferred until
you cash in the policy, or if it is in force when you
die, the proceeds go to your beneficiary completely
free of any federal income tax.
There are even ways to get at those earnings tax-free
without dying for the privilege. Policyholders are
permitted to borrow against the cash value in their
policies. They are very special loans, too, since they
never have to be paid back. Any outstanding loan at
the time of death is simply deducted from the proceeds
paid to beneficiaries. Although borrowers have to pay
interest on the loan, in the sweetest deals the cash
value in the policy earns just as much as the interest
charged.
Insurance companies are always working to create policies
that exploit the tax benefits of life insurance. And
sometimes they're too successful. Consider, for example,
a type of policy that was widely promoted as the last
great tax shelter after Congress passed the Tax Reform
Act of 1986: Single-premium life insurance policies.
These policies are mostly investment, with barely
enough insurance veneer to qualify for the tax breaks.
As the name implies, you pay the premium only once
and that buys you a paid-up policy. The death benefit
is small, but the key here is the investment. With
most policies, the entire premium immediately starts
earning interest-or may be invested in your choice
of various stock and bond funds-and starts building
cash value. The cost of insurance comes out of your
earnings.
Because the investment is wrapped inside an insurance
policy, the earnings accumulate tax-free, just as money
in an individual retirement account grows without annual
interruption from the IRS. A $100,000 investment in
a single-premium policy yielding 8% annually, for example,
would grow to over $466,000 in 20 years. The same amount
in a taxable investment would reach just over $271,000
in two decades, if annual taxes in the 36% bracket
were paid out of investment earnings.
The sweetest thing about single-premium policy-before
a congressional crackdown discussed below-was that
the earnings could be completely tax-free. Although
the earnings would be taxed if the policy were cashed
in, investors could dance around the tax bill by borrowing
against the policy. Many policies were designed so
that there was effectively no charge for the loan.
Interest on the loan was offset by earnings that continued
to be credited to your cash value. Although structured
as a loan, it worked like a withdrawal since such loans
don't have to be repaid.
If that sounds too good to be true, your hearing is
good. Congress has closed the door on tax-free loans
from single-premium policies. Basically, unless you
pay premiums for at least seven years, policy loans
are considered taxable withdrawals. In addition to
the tax, there's a 10% penalty unless you're at least
59 1/2 years old or disabled. There's an important
exception for single-premium policies purchased before
June 21, 1988. Those older policies retain the tax-
and penalty-free loan feature.
Despite
the crackdown on single-premium policies, other cash-value
life insurance policies still sport the tax advantage
of tax-free buildup of cash value and the loan privilege.
Insurers were quick to create "seven-pay" policies
to stretch premiums over a long enough period to maintain
the policyholder's right to tax-free loans.
Some policies allow partial withdrawals of cash value,
too. As long as the policy isn't caught up in the single-premium
life rules, such withdrawals can be tax-free. The IRS
assumes that the first money pulled out is a return
of your premiums rather than the earnings. When withdrawals
exceed your total investment in the policy, however,
additional withdrawals are considered taxable
income.
Annuities
These are also life insurance products sporting tax
advantages. But there's no life insurance involved.
(Well, almost none. You are guaranteed that your heirs
will receive at least as much has you have invested
in the annuity, even if your investments have lost
money.) The real attraction of an annuity is that earnings
accumulate tax-free until you begin to withdraw the
funds. Holding off the IRS in the interim supercharges
the power of compounding and leaves you well ahead
even after paying the deferred tax bill.
Annuities come in two basic flavors: fixed and variable.
With a fixed annuity, your investment earns interest
at a rate set by the insurance company, a rate that
can change periodically in line with market interest
rates. A variable annuity gives you investment options
much like a family of mutual funds. The insurance company
offers you the choice of several funds-stock, bond,
money-market, etc.-and your return depends on the success
of the investments you choose.
Unlike bank CDs and mutual funds, however, the annuity
contract serves as an impenetrable wrapper that keeps
the tax collector's hands off your earnings. No tax
is due until you pull funds out of the contract, presumably
in retirement, either in a lump sum or by annuitizing
the contract and having the company make payments to
you for life.
Such tax-deferred growth gives funds invested in an
annuity the same advantage as cash stashed in an individual
retirement account. Unlike an IRA, though, you can't
deduct amounts put into an annuity.
If you cash in the annuity before retirement, you'll
pay dearly. For one thing, most contracts impose surrender
charges during the first several years. Any earnings
pulled out of the annuity are taxable, and if you're
under age 59 1/2, you'll be hit with a 10% penalty
tax. But what portion of a withdrawal is earnings?
That's easy, if you cash in the annuity and pull out
all the funds. You are taxed, and possibly penalized,
on the difference between your original investment
and what you get.
It's trickier, though, if you pull out only part of
the money and it depends on when you made the annuity
investment. If it was on or before August 13, 1982,
the IRS considers the first money pulled out of the
annuity to be a tax-free return of your investment.
Only after you have recovered your full investment
is any further withdrawal taxed. For investments after
that date, however, the rule is turned around. The
first money out is considered earnings-taxable and
potentially subject to the 10% penalty.
Say, for example, that you now invest $10,000 in an
annuity and its value grows to $25,000 in ten years.
If you were to cash in the contract, $15,000 would
be taxed, and if you were under age 59 1/2, the 10%
early-withdrawal penalty would apply to that portion.
The other $10,000 would be a tax-free return of your
original investment.
If you simply withdrew $10,000 from the contract,
it would all be taxed and penalized. If this investment
had been made on or before August 13, 1982, however,
that $10,000 withdrawal would be a nontaxable return
of your investment. (If you choose to receive lifetime
payments, a portion of each one is tax-free.)
The 10% penalty does not apply to payouts to taxpayers
under age 59 1/2 who are disabled. Nor does it apply
to any payment that is part of a series of periodic
payments based on your life expectancy. If you decide
to annuitize a contract at age 50 (or any age) and
receive equal payments over the rest of your life,
for example, you'd dodge the early-withdrawal penalty.
A key to shopping for an annuity is to watch that
the fees charged by the insurance company don't devour
a good portion of the tax breaks. Also realize this:
funds withdrawn from an annuity will be taxed in your
top tax bracket, even if the source of the profits
was capital gains on stock mutual funds owned inside
the annuity. Critics complain that this means annuities
convert tax-favored capital gains to heavily-taxed
ordinary income. That's even more of a disadvantage
now that capital gains are taxed at a flat 20% or 10%
rate.
Passive
Investments
As year-end draws near, the pain of the passive-loss
rules becomes acute. These are losses from rental activities
(except for the $25,000 allowance for active real estate
investors), limited partnerships and any business in
which you do not materially participate. Such losses
can no longer be used to shelter other income.
Losses generated by passive activities can be used
only to offset income produced by passive activities.
Any excess loss is suspended for use in future years
when you have passive income. (It's possible they'll
be worth more to you than they would be currently-if
tax rates head back up, for example.)
Year-end planning demands
that you focus on losses you can't use. Promoters
may try to interest you in a PIG-passive-income generator.
These are investments, such as limited partnerships,
designed to produce passive income to soak up passive
losses. Be careful not to let your pursuit of tax
savings lead you into a bad investment. Any investment
touted as "tax-favored''
around year-end-when many taxpayers are desperate for
tax savings-begs for especially careful scrutiny.
A potential year-end tax-saver would be to unload
the activity that's producing the passive losses. When
you sell a passive investment, any losses produced
during the year-and any losses suspended from previous
years-are free to be deducted against other kinds of
income.
Back
Up Withholding
It
is possible for a bank or business to claim a
chunk of taxable interest or dividend payments
as "backup
withholding.'' The rate is a flat 30% in 2002 and 2003.
Backup withholding applies when the bank or other
payer doesn't have, or doesn't think it has, your Social
Security number-the taxpayer identification number
used to report the income to the IRS. If you forget
or refuse to give the bank or business your Social
Security number, or the IRS tells the payer that you
provided an incorrect number, 30% of your dividends
or income will be diverted to the IRS.
Backup withholding can also be ordered by the IRS
if it concludes you failed to report on your tax return
interest or dividends you received during the previous
year.
Backup withholding shouldn't cause you any trouble
if you've been reporting all your interest and dividend
income properly-although foul-ups will inevitably trip
up some taxpayers
Back to
Top |
