Investments & Dividends

"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."
-Howard Choder

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.

Installment 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 lower 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 2010 for $2,400 (including commission), giving you a basis of $24 per share. In January 2011, you purchased 100 more shares, this time for $2,800. Your basis in each share is $28. In January 2012, you purchased another 100 shares for $3,000, giving each share a basis of $30.

When the stock hit $40 a share in April 2013, 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 2010 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 2012, 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 15% 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 37% in 2019.


A cryptocurrency, such as Bitcoin, is a form of digital money. In most countries cryptocurrency is taxed as property. Therefore if the asset appreciates in value and you sell or trade it for profit, the gains are taxed like capital gains. If the asset depreciates in value and you sell or trade it at a loss, you can deduct the losses against other capital gains or carry-forward the loss.

Similar to stocks, the amount of tax you pay on a sale depends on how much capital gain/loss there has been on the asset and how long you have held the asset. Because each taxable event may create a capital gain, you need to know the date, cost basis, sale value, and any fees associated with each transaction. It is critical you personally track (or use a service to help track) your sales/ trades because most online brokerages do not accurately track the data for you at this time. This is particularly true if you withdraw the assets from an exchange and personally take custody. Transferring cryptocurrency from one wallet you own to another wallet you own is not a taxable event.

Generally speaking, these are considered taxable events:

  • Selling cryptocurrency for fiat currency (i.e. USD, CAD)
  • Trading cryptocurrency for other cryptocurrency
  • Using cryptocurrency to buy a good or service
  • Receiving cryptocurrency as a result of a fork or from mining


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 39.6% bracket, the divisor would be 0.604 (1 – 0.396) and the taxable-equivalent yield would be 6.04%.

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.

Get an Edge on Your Taxes.

 Gains and Losses on Municipal 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.

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.

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 15% or 10% rate for many taxpayers.

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 24% in 2019.

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, 24% 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.