It's What You Keep that Counts


It's What You Keep that Counts

To counter or reduce the overall impact of taxes, it’s important to evaluate your income sources.

October 6, 2015

Have you ever heard of the saying, “It’s not what you make, but what you keep that counts?” Plenty of tax-savvy, high-income earners have. They know that to counter or reduce the overall impact of taxes, it’s important to evaluate your income sources. Once you’ve made this assessment, you can develop tax-advantaged strategies to lower your annual tax bill.

Your earned income may be taxed at a different rate than investments, and different investments have varying tax rates. For example, corporate bonds are subject to the same rate as your earned income, but long-term gains and qualified dividends are taxed at the long-term capital gains rate. Moreover, the long-term capital gains rate is different for taxpayers based on how much you earn: 0% if you’re in the 10% or 15% income tax bracket; 15% if in the 25%, 28%, 33% or 35% bracket; and 20% if in the 39.6% bracket.

Since some investments generate higher taxable distributions than others, it’s important to evaluate your investments, after-tax returns, portfolio turnover ratio and historical distributions to get a sense of your annual tax liability. Then you may wish to consider whether to rebalance your asset allocation, as certain investments are optimized in certain types of accounts from a tax standpoint.

For example, income-producing investments may be better suited for a tax-advantaged account such as a 401(k) or IRA, in which taxes are deferred until later years. For a taxable brokerage account, opt for stocks held long term or tax-advantaged municipal bonds. Municipal bonds are exempt from federal and in many cases state income taxes in their state of issue, and can be particularly effective for taxpayers in higher tax brackets.*

Also, when rebalancing your portfolio, consider using new money such as year-end bonus or a stock option conversion to invest instead of selling investments. This will allow you to realign your allocation with your financial objectives without having to pay capital gains taxes. If you need to take required minimum distributions (RMD) from a retirement account or an annuity, consider using your distributions as new money to rebalance your portfolio.

Another way to reduce your tax burden during your lifetime is through charitable donations. These typically count as an itemized deduction in the tax year they are donated. However, consider donating highly appreciated stocks instead of cash so that you that you benefit from the deduction without having to incur a gains tax liability.

It’s important to work with an experienced financial advisor to tailor a tax strategy appropriate for your income sources.

*While interest on municipal bonds is generally exempt from federal income tax, keep in mind that it may be subject to the federal alternative minimum tax, state or local taxes. Profits and losses on federally tax-exempt bonds may be subject to capital gains tax treatment. In addition, certain municipal bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax. Dividends are not guaranteed and will fluctuate.

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