Daniel Lippincott, The Daily Record Newswire
With April 15 right around the corner, many people are busy filling out their tax returns and hoping for a nice refund. Unfortunately, for most, this year’s tax bill is likely much higher than last year’s. One of the main reasons for this is the new taxes associated with the Affordable Care Act: the 0.9 percent tax on income and 3.8 percent on net investment income if the taxpayer’s modified adjusted gross income exceeds $200,000 (or $250,000 if married filing jointly).
While there is not much that can be done to reduce 2013’s tax bill, it is imperative that investors be aware of these new taxes and realize that there are some simple steps they can take to reduce next year’s tax bill.
First, investors must realize that a loss has value and that the value of a loss has increased with the new tax. They can “harvest” their losses by selling securities trading below cost and using those losses offset capital gains, as follows:
1. Short-term losses (investment held less than one year) can be netted out against short-term gains.
2. Long-term losses can offset long-term gains.
3. Short and long-term results can be combined. In other words, a loss in one section can offset a gain in another. This means that long-term losses can be just as valuable as short-term losses.
If there are still losses left over, they may be used to offset $3,000 of ordinary income. Additionally, net losses can be carried forward to offset gains in future years.
Second, when selling a security at a gain, it is very important to know when the security was purchased. The federal government has designed tax laws to encourage long-term investment in companies (a stock becomes a long-term holding when it is held for 366 days). As a result, there is a lower tax rate for long-term capital gains as opposed to short-term capital gains.
Short-term capital gains are taxed at the same rate as ordinary income. This would equate to a tax rate of approximately 43.4 percent for those in the highest tax bracket. On the other hand, long-term capital gains are only taxed at 23.8 percent. The favorable tax treatment of long-term capital gains allows investors in the highest tax bracket to save nearly 20 percent of their gain if they sell the security after holding it for at least 366 days.
Finally, according to the IRS, the 3.8 percent tax on net investment income includes interest, dividends, capital gains, and rental and royalty income. However, tax-exempt interest from municipal bonds is not subject to the additional tax, so conservative investors looking to maximize after-tax return should consider increasing exposure to municipal bonds or municipal bond funds.
On top of the favorable tax treatment, municipal bonds currently offer a tremendous amount of value when compared to other fixed income options. In fact, an A rated 10-year municipal bond currently yields 3.18 percent. A comparable taxable bond would have to yield 5.62 percent to produce an equivalent after tax yield.
Benjamin Franklin’s famous statement “in this world nothing can be said to be certain, except death and taxes” has never been more applicable. However, I believe that with proper planning and active management, an investor can certainly reduce their investment tax bill.
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Daniel Lippincott is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. He can be reached at (585) 586-4680.
