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Taxes are an inevitable part of investing.

While taxes alone should not typically drive investment strategy, with careful planning it is possible to minimize the effect that taxes have on your investments. The constantly evolving tax landscape, and how these changes relate to investment planning, makes it critical to stay informed on new tax law developments and to discuss strategies to minimize your tax burden with your Advisor as well as your CPA.

A seemingly endless list of potential tax issues can affect your investments, portfolio and net worth. Some of the more critical ones are detailed below:


The interest you earn on investments (typically from bonds and large cash holdings) is subject to tax rates that are the same as your ordinary income tax rate.


Dividends distributed by stock you own are taxable.  However, some dividends are taxed at capital gains rates (currently 0%, 15%, and 20% depending on income) as opposed to higher ordinary income tax rates. To receive this treatment, the dividend must be considered a ‘qualified dividend,’ which requires that the dividend meet several prescribed requirements.

Capital Gains

The sale of investments in stocks, bonds or other assets that have increased in value from the purchase price will trigger capital gains. Similar to qualified dividends, long-term capital gains are taxed at lower rates (currently 0%, 15%, and 20% depending on income) than ordinary income tax rates. However, if an investment is sold at a gain within a year of purchase, it will be considered a short-term capital gain and will be taxed at ordinary income tax rates.

Estate Tax

Estate tax doesn’t apply to everyone. In fact, the current estate and gift tax exemption is $11.18 million per individual, or $22.4 million per married couple. However, for investors with assets in excess of the exemption, estate taxes can have a substantial effect on the total value they can pass on to the recipients of their estate. Planning for estate distribution is especially important and there are many strategies to insulate your assets from excess taxes.

 Tax Advantaged Accounts

Certain types of accounts that relate to retirement or education savings are given preferential tax treatment over other types of accounts. Being aware of the availability of these types of investments, and making deliberate decisions with regards to the way you contribute and allocate your pre- and post-tax dollars can have a substantial impact on your savings goals over time.

Retirement Accounts

One of the most impactful ways to take advantage of tax-friendly regulations is to establish retirement accounts. These accounts include, but are not limited to: pension plans, profit sharing plans, 401(k)s, 403(b)s, and Individual Retirement Accounts (IRAs). All of these accounts qualify for deferred tax treatment and therefore are often referred to as ‘qualified accounts’.

The benefits of deferring taxes can dramatically compound over time. For example, $10,000 invested in an IRA (tax-deferred) at a rate of return of 8 percent grows to $100,627 over 30 years before being taxed on distributions. In a taxable account (assuming a 28 percent tax rate, with taxes paid out of the account annually), the funds would grow to only $53,659.

Roth and traditional IRAs are both effective ways to save for retirement. With a Roth IRA, you contribute money that has already been taxed in exchange for the ability to enjoy tax-free growth and make tax-free withdrawals upon retirement. In a traditional IRA, your contributions are pre-tax, but you pay taxes on all distributions later on.

But how do you choose between the two? Your choice depends on how you think your future tax rate compares to your current tax rate. If you assume your individual tax rate is not going to change between now and retirement, then the net result will be the same regardless of which type of IRA you choose. When looking at changing tax rates, it is most important to focus on both the changing landscape of tax rates as a whole, as well as how changes in your income will affect which tax bracket you fall under. Generally, as people age they earn more money and enter higher tax brackets. In this case, and assuming no change in the overall level of taxes, it would be more beneficial to pay the taxes now, at a lower rate and make use of a Roth IRA contribution (for those who qualify) or a Roth conversion. However, if you believe that your tax rate will decrease, then a traditional IRA may be more beneficial. Be sure to discuss the benefits and limitations of both traditional and Roth IRAs with your tax professional before making any decisions

Educational Accounts

Coverdell and 529 plans are tax-advantaged accounts that are similar in nature to Roth IRA accounts as they are funded with after-tax contributions, and grow tax-free. The difference is that Coverdell and 529 accounts can only be distributed tax-free if they are used for qualified educational purposes. Qualified education expenses include not only things like tuition and room and board, but also school supplies and computers.  Recent tax law changes have extended the use of 529 accounts to cover secondary education expenses up to a certain amount per year. 529 accounts can be used to fund an unlimited amount of qualified college and university expenses, though there are yearly contribution limits. Like retirement accounts, this characteristic can help maximize the funds that are set aside for educational funding needs. There are many different rules for these plans depending on their type and the state the account is initiated in, so appropriate planning is important before initiating educational accounts.

Tax Friendly Investments

In addition to tax-advantaged accounts, you can also maximize tax savings by employing low tax or tax free investments. For instance, for individuals in high tax brackets, municipal bonds are an ideal way to invest in fixed income while limiting the effect of taxes. Municipal bonds are any bonds issued by a U.S. state, city, county, or other government entity. The interest received by bondholders is generally exempt from federal income tax and from income tax in the state in which they are issued. Therefore, investing in municipal bonds may produce higher after tax returns for individuals in higher tax brackets.

 Asset Location Optimization

The type of accounts in which you choose to purchase certain investments can also have an impact on the after tax performance of a portfolio. In many cases, it may be optimal to purchase income producing assets in tax-deferred accounts (e.g. an IRA) where income will accrue over time. Locating your highest growth assets in tax-free accounts (e.g. a Roth IRA), or in taxable accounts (e.g. a Trust or Individual account) where they will be tax free or taxed at relatively low long-term capital gains rates may be more beneficial than placing them in tax-deferred accounts that are taxed at ordinary income rates upon distribution.

Investing on a portfolio basis rather than an account basis allows for the implementation of asset location optimization. However, it can lead to a divergence in performance between different account types. Thus, when assessing performance we always look at the total portfolio. Well engineered portfolios can minimize tax drag and enhance long-term wealth accumulation.

Projections and other data outlined above are for planning purposes only; they are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.  It should not be assumed that future performance of any specific investment or investment strategy will be profitable. Different types of investments involve varying degrees of risk, but all investments carry the risk of loss, including the permanent loss of principal. Nothing herein should be interpreted as investment advice. Past performance is not a guarantee of future results.

 Parts of this article were written by Advicent Solutions, an entity unrelated to HoyleCohen, LLC. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. HoyleCohen, LLC does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. © 2012,2014 Advicent Solutions. All rights reserved.


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