How to Keep More of What You Make

by Alexander Green, Investment U’s Chief Investment Strategist
Monday, October 25, 2010: Issue #1373

Last week, I met with a tax advisor who said something a bit ominous – but also true, I think:

For the rest of our lifetimes, income and capital gains tax rates will never be lower than they are today.

This is a bit startling when you consider that tax rates aren’t particularly low right now. Income, in particular, is taxed at up to 35%, compared to 28% when Reagan was in office.

When you add in Social Security taxes, unlimited Medicare taxes and an average state income tax of 6%, federal and state governments may take up to half of what you earn.

Of course, the Obama Administration is itching to let the Bush tax cuts expire and allow the top marginal tax rate to rise another 13% (to 39.6%).

Thanks to the fiscal crisis that Congress has created over the past decade, tax rates are likely to keep rising in the months and years ahead.

Clearly, you need to take whatever actions are permissible to keep as much of what you’ve earned as possible. And for investors, that starts with tax-managing your portfolio…

Effective Tax Management in Five Easy Steps

Here are the five basic steps to tax-managing your portfolio properly:

  • Use Your Retirement Account: Whenever possible, use your retirement account for short-term trading activity. That way, your short-term gains – rather than being taxed at the same level as your income – compound tax-deferred.
  • Less is More: You should minimize trade turnover in your non-retirement accounts. As Warren Buffett once pointed out, “The capital gains tax is not a tax on capital gains, it’s a tax on transactions.”Hold your winners for at least a year, if possible. If you do, you’ll qualify for long-term capital gains treatment at the maximum rate of 15%. (This may change after January 1.)
  • Offset Capital Gains: The IRS allows you to offset all of your realized capital gains with realized capital losses. And you can take up to $3,000 in additional losses against earned income.
  • Use Tax-Deferred Accounts: Use your IRA, pension, 401(k) or other tax-deferred accounts to own corporate and Treasury bonds (since interest income is taxed at the same rate as earned income) and real estate investment trusts (since REIT dividends are taxed the same way).
  • Use Index Funds: If you invest in mutual funds, use index funds rather than actively managed funds in your non-retirement accounts. Index funds tend to be highly tax-efficient since changes to benchmarks are rare. Managed funds often have high turnover and Federal law requires them to distribute at least 98% of realized capital gains each year. You can get hit with a big capital gains distribution even when you haven’t sold a share – and even if the fund is down for the year.

Take these steps and you’ll substantially lessen the government’s tax bite. The few remaining choices are simple ones – for example, owning tax-free rather than taxable bonds, especially if you reside in a high-tax state like New York or California.

An Artful Solution to Cutting Your Taxes

The 1995 Tax Act also allows you to donate – to any IRS-approved charity – works of art at their fair market value, not their cost basis.

Moreover, you can deduct the charitable gift’s fair market value on your tax return without being subject to the dreaded alternative minimum tax.

Pillar One Advisor Mike Kuschmann works closely with published artists and sometimes acquires limited edition prints or serigraphs at a substantial discount to their current market value.

As Kuschmann explains, “Clients of mine purchase them far below published cost – often for just a few thousand dollars – and later donate them to a local hospital or university at fair market value, allowing them to save thousands of dollars in federal taxes.”

For more information, contact Mike Kuschmann, president of Fine Arts Ltd, at: 800-229-4322 or 407-702-6638. He’ll send you a complimentary brochure pack explaining his services and detailing the tax savings available.

Over the next few weeks, I’ll highlight several other year-end tips for reducing your tax liabilities.

Because – remember – it’s not how much you make. It’s how much you keep.

Good investing,

Alexander Green