How Can I Benefit from Tax-Advantaged Investments?
For many people, tax-advantaged investing is an excellent way to reduce their taxes. And while many of the traditional tax-advantaged strategies have been eliminated, there are still alternatives left that can help you reduce your taxes. Some are described below.
Real Estate Partnerships
Two of the most common types of real estate partnerships are low-income housing and historic rehabilitation. The federal government grants tax credits to those who construct or rehabilitate low-income housing or who invest in the rehabilitation or preservation of historic structures.
Participating in a real estate partnership has many advantages. These partnerships may provide opportunities for tax-advantaged income and long-term capital appreciation.
The tax credits generated by these partnerships can be used to offset your income tax liability on a dollar-for-dollar basis. This can make them much more valuable than tax deductions, which help reduce your taxable income, not the tax you pay. These credits are subject to certain limitations, and the rehabilitation tax credit begins to phase out for taxpayers with adjusted gross income (AGI) greater than $200,000 ($100,000 if married filing separately) and is completely phased out when AGI reaches $250,000 ($125,000 if married filing separately).
Oil and Gas Partnerships
Energy partnerships can provide shelter through tax deductions taken at the partnership level. These include deductions for intangible drilling costs, depreciation, and depletion.
The deductions may be limited; check with a tax advisor to see whether you could benefit from oil and gas partnerships.
Suitability
There are risks associated with investing in partnerships. Key among these is that they are long-term investments with an indefinite holding period and no, or very limited, liquidity. There is typically no current market for the units/shares, and a future market may or may not be available. If a market becomes available, it may result in a deep discount from the original price. At redemption, the investor may receive back less than the original investment. The investment sponsor is responsible for carrying out the business plan, and thus the success or failure of the venture is dependent on the investment sponsor. There are no assurances that the stated investment objectives will be reached. This type of investment is considered speculative. You want to ensure that the investment is not disproportionate in relation to your overall portfolio and that it is consistent with your investment objectives and overall financial situation. In order to invest, you will need to meet specific income and net worth suitability standards, which vary by state.
These standards, along with the risks and other information concerning the partnership, are set forth in the prospectus, which can be obtained from your financial professional. Please consider the investment objectives, risks, charges, and expenses carefully before investing. Be sure to read the prospectus carefully before deciding whether to invest.
The alternative minimum tax is another concern. Make sure to consult a tax advisor to evaluate your exposure to the AMT.
As long as they are suitable for your situation, these tax-advantaged investing strategies could be used to help reduce your income tax liability. A financial professional can help you determine whether such investments would be appropriate for you.
“Tax deferral” is a method of postponing the payment of income tax on currently earned investment income until the investor withdraws funds from the account. Tax deferral is encouraged by the government to stimulate long-term saving and investment, especially for retirement.
Only investment vehicles designated as “tax deferred,” such as IRAs, plans covering self-employed persons, and 401(k)s, allow taxes to be deferred. In addition, many insurance-related vehicles, such as deferred annuities and certain life insurance contracts, provide tax-deferred benefits.
There is a substantial benefit to deferring taxes as long as possible, because this allows the entire principal and any accumulated earnings to compound tax deferred. The compounding effect can be dramatic over an extended period of time and can make a big difference in the accumulation of a retirement nest egg.
Additionally, investments in tax-deferred vehicles are often made when you are earning a higher income and subject to a higher tax rate. When you reach retirement and begin taking distributions from your tax-deferred accounts, it is possible that your tax bracket will be lower.
One note of caution: When formulating your tax plan, recognize that all withdrawals from tax-deferred plans are taxed as ordinary income. Early withdrawals (prior to age 59½) may be subject to a 10% federal income tax penalty. Once again, the government is encouraging a long-term outlook.
What Happens If I Withdraw Money from My Tax-Deferred Investments Before Age 59½?
Withdrawing funds from a tax-deferred retirement account before age 59½ generally triggers a 10% federal income tax penalty; all distributions are subject to ordinary income tax. However, there are certain situations in which you are allowed to make early withdrawals from a retirement account and avoid the tax penalty.
IRAs and employer-sponsored retirement plans have different exceptions, although the regulations are similar.
IRA Exceptions
The death of the IRA owner. Upon your death, your designated beneficiaries may begin taking distributions from your account. Beneficiaries are subject to annual required minimum distributions.
Disability. Under certain conditions, you may begin to withdraw funds if you are disabled.
Unreimbursed medical expenses. You can withdraw the amount you paid for unreimbursed medical expenses that exceed 10% of your adjusted gross income in a calendar year. Individuals older than 65 can claim expenses that surpass 7.5% of adjusted gross income through 2016.
Medical insurance. If you lost your job or are receiving unemployment benefits, you may withdraw money to pay for health insurance.
Part of a substantially equal periodic payment (SEPP) plan. If you receive a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary, you may take payments over a period of five years or until you reach age 59½, whichever is longer, using one of three payment methods set by the government. Any change in the payment schedule after you begin distributions may subject you to paying the 10% tax penalty.
Qualified higher-education expenses for you and/or your dependents.
First home purchase, up to $10,000 (lifetime limit).
Employer-Sponsored Plan Exceptions
The death of the plan owner. Upon your death, your designated beneficiaries may begin taking distributions from your account. Beneficiaries are subject to annual required minimum distributions.
Disability. Under certain conditions, you may begin to withdraw funds if you are disabled.
Part of a SEPP program (see above). If you receive a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary, you may take payments over a period of five years or until you reach age 59½, whichever is longer.
Separation of service from your employer. Payments must be made annually over your life expectancy or the joint life expectancies of you and your beneficiary.
Attainment of age 55. The payment is made to you upon separation of service from your employer and the separation occurred during or after the calendar year in which you reached the age of 55.
Qualified Domestic Relations Order (QDRO). The payment is made to an alternate payee under a QDRO.
Medical care. You can withdraw the amount allowable as a medical expense deduction.
To reduce excess contributions. Withdrawals can be made if you or your employer made contributions over the allowable amount.
To reduce excess elective deferrals. Withdrawals can be made if you elected to defer an amount over the allowable limit.
If you plan to withdraw funds from a tax-deferred account, make sure to carefully examine the rules on exemptions for early withdrawals. For more information on situations that are exempt from the early-withdrawal income tax penalty, visit the IRS website at www.irs.gov.
When Must Taxes Be Paid on IRA and Employer-Sponsored Retirement Funds?
Traditional IRAs and most employer-sponsored retirement plans are tax-deferred accounts, which means they are typically funded with pre-tax or tax-deductible dollars. As a result, taxes are not payable until funds are withdrawn, generally in retirement.
Withdrawals from tax-deferred accounts are subject to income tax at your current tax rate. In addition, withdrawals taken prior to age 59½ may be subject to a 10% federal income tax penalty.
If you made nondeductible contributions to a traditional IRA, you have what is called a “cost basis” in the IRA. Your cost basis is the total of the nondeductible contributions to the IRA minus any previous withdrawals or distributions of nondeductible contributions. The recovery of this basis is not seen as taxable income.
Exceptions are the Roth IRA and the Roth 401(k) and Roth 403(b). Roth accounts are funded with after-tax dollars; thus, qualified distributions (after age 59½ and the five-year holding requirement has been met) are free of federal income tax.
Traditional IRAs, most employer-sponsored retirement plans, and Roth 401(k) and 403(b) plans are subject to annual required minimum distributions (RMDs) that must begin after the account owner reaches age 70½. (The first RMD must be taken no later than April 1 of the year after the year in which the owner reaches age 70½.) Failure to take an RMD triggers a 50% federal income tax penalty on the amount that should have been withdrawn. Roth IRA owners never have to take RMDs; however, the designated beneficiaries of IRAs and employer-sponsored retirement plans do have to take RMDs.
When you begin taking distributions from your retirement accounts, make sure to pay attention to any required beginning dates and the appropriate distribution amount in order to avoid unnecessary penalties.
Americans give freely to support the causes they value, from churches, education, and the arts to medical research. Fortunately, current tax laws encourage and even reward philanthropy. Beyond the basic tax deductions for charitable giving, setting up one or both of the following types of trusts could provide financial advantages in addition to the personal satisfaction that comes from giving.
Charitable Remainder Trust
When money, securities, property, or other assets are placed in a properly structured charitable remainder trust, the grantor or the grantor’s beneficiaries receive payment of a specified amount at least annually. When the trust expires, the designated charity receives the assets that remain.
For the grantor, there are a few potential tax benefits: (1) Assets placed in the trust may qualify for an income tax deduction on the estimated present value of the remainder interest that will eventually go to charity. (2) At death, trust assets are not subject to estate taxes because they are no longer part of the grantor’s taxable estate. (3) Any appreciated assets in the trust are also exempt from current capital gains tax.
Charitable Lead Trust
A charitable lead trust is an estate conservation tool that uses the grantor’s assets to provide income to a charity. At the end of the trust period, the remaining assets are paid to the grantor or the grantor’s beneficiaries. This type of trust could potentially reduce the estate tax due upon death, most notably on highly appreciated assets, because they are not subject to current capital gains tax.
Keep in mind that donations to both types of charitable trusts are irrevocable. This means that the assets cannot be withdrawn once the trust is formed. Also bear in mind that not all charitable organizations are able to use all possible gifts. It is prudent to check first. The type of organization selected can also affect the tax benefits that may be received.
When structured properly, these tools could possibly be used to benefit the charities of your choice and also help to reduce your tax obligations at the same time.
The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of an experienced estate planning professional and your legal and tax advisors before implementing such strategies. Trusts incur upfront costs and ongoing administrative fees.
A required minimum distribution (RMD) is the annual amount that must be withdrawn from a traditional IRA or a qualified retirement plan (such as a 401(k), 403(b), and self-employed plans) after the account owner reaches the age of 70½. The last date allowed for the first withdrawal is April 1 following the year in which the owner reaches age 70½. Some employer plans may allow still-employed account owners to delay distributions until they stop working, even if they are older than 70½.
RMDs are designed to ensure that owners of tax-deferred retirement accounts do not defer taxes on their retirement accounts indefinitely. You are allowed to begin taking penalty-free distributions from tax-deferred retirement accounts after age 59½, but you must begin taking them after reaching age 70½. If you delay your first distribution to April 1 following the year in which you turn 70½, you must take another distribution for that year. Annual RMDs must be taken each subsequent year no later than December 31.
The RMD amount depends on your age, the value of the account(s), and your life expectancy. You can use the IRS Uniform Lifetime Table (or the Joint and Last Survivor Table, in certain circumstances) to determine your life expectancy. To calculate your RMD, divide the value of your account balance at the end of the previous year by the number of years you’re expected to live, based on the numbers in the IRS table. You must calculate RMDs for each account that you own. If you do not take RMDs, then you may be subject to a 50% federal income tax penalty on the amount that should have been withdrawn.
Remember that distributions from tax-deferred retirement plans are subject to ordinary income tax. Waiting until the April 1 deadline in the year after reaching age 70½ is a one-time option and requires that you take two RMDs in the same tax year. If these distributions are large, this method could push you into a higher tax bracket. It may be wise to plan ahead for RMDs to determine the best time to begin taking them.
How Much Money Can I Put into My IRA or Employer-Sponsored Retirement Plan?
IRAs and employer-sponsored retirement plans are subject to annual contribution limits set by the federal government. The limits are periodically adjusted to compensate for inflation and increases in the cost of living.
IRAs
For the 2016 tax year (unchanged from 2015), you can contribute up to $5,500 to all IRAs combined (the limit will be adjusted annually for inflation). If you have a traditional IRA as well as a Roth IRA, you can only contribute a total of the annual limit in one year, not the annual limit to each.
If you are age 50 or older, you can also make a $1,000 annual “catch-up” contribution.
Employer-Sponsored Retirement Plans
Employer-sponsored retirement plans such as 401(k)s and 403(b)s have an $18,000 contribution limit in 2016 (unchanged from 2015); individuals aged 50 and older can contribute an extra $6,000 each year as a catch-up contribution.
If you are currently contributing to an IRA or an employer-sponsored retirement plan, it may be wise to check the contribution limit each year in order to put aside as much as possible.
Distributions from traditional IRAs and most employer-sponsored retirement plans are taxed as ordinary income and may be subject to an additional 10% federal income tax penalty if taken prior to reaching age 59½. If you participate in both a traditional IRA and an employer-sponsored plan, your IRA contributions may or may not be tax deductible, depending on your adjusted gross income.
The federal gift tax applies to gifts of property or money while the donor is living. The federal estate tax, on the other hand, applies to property conveyed to others (with the exception of a spouse) after a person’s death.
The gift tax applies only to the donor. The recipient is under no obligation to pay the gift tax, although other taxes, such as income tax, may apply. The federal estate tax affects the estate of the deceased and can reduce the amount available to heirs.
In theory, any gift is taxable, but there are several notable exceptions. For example, gifts of tuition or medical expenses that you pay directly to a medical or educational institution for someone else are not considered taxable. Gifts to a spouse who is a U.S. citizen, gifts to a qualified charitable organization, and gifts to a political organization are also not subject to the gift tax.
You are not required to file a gift tax return unless any single gift exceeds the annual gift tax exclusion for that calendar year. The exclusion amount ($14,000 in 2015 and 2016) is indexed annually for inflation. A separate exclusion is applied for each recipient. In addition, gifts from spouses are treated separately; so together, each spouse can gift an amount up to the annual exclusion amount to the same person.
Gift taxes are determined by calculating the tax on all gifts made during the tax year that exceed the annual exclusion amount, and then adding that amount to all the gift taxes from gifts above the exclusion limit from previous years. This number is then applied toward an individual’s lifetime applicable exclusion amount. If the cumulative sum exceeds the lifetime exclusion, you may owe gift taxes.
The 2010 Tax Relief Act reunified the estate and gift tax exclusions at $5 million (indexed for inflation), and the American Taxpayer Relief Act of 2012 made the higher exemption amount permanent while increasing the estate and gift tax rate to 40% (up from 35% in 2012). Because of inflation, the estate and gift tax exemption is $5.45 million in 2016 (up from $5.43 million in 2015). This enables individuals to make lifetime gifts up to $5.45 million in 2016 before the gift tax is imposed.
The estate tax is a tax on property that transfers to others upon your death. Estate taxes are assessed on the total value of your estate — your home, stocks, bonds, life insurance, and other assets of value — that is over the applicable exemption amount. Everything you own, whatever the form of ownership and regardless of whether the assets have been through probate, is subject to estate taxes.
Also referred to as the “death tax,” the federal estate tax was first enacted in this country with the Stamp Act of 1797 to help pay for naval rearmament. After several repeals and reinstatements, the Revenue Act of 1916 put the current estate tax into place. Despite its long history, this tax remains controversial.
Estate taxes are calculated on the net value of your estate, which includes all your assets less allowable debts, expenses, and deductions (such as mortgage debt and administrative expenses for the estate). The applicable estate tax exemption is subtracted, and the resulting taxable value is multiplied by the applicable estate tax rate to determine any taxes due.
The most common exception to the federal estate tax is the unlimited marital deduction. The government exempts all transfers of wealth between a husband and wife from federal estate and gift taxes, regardless of the size of the estate. (The surviving spouse must be a U.S. citizen to qualify for this exemption.) However, when the surviving spouse dies, the estate is subject to estate taxes and, unless the appropriate portability preparations have been made, only the surviving spouse’s applicable exemption can be used.
The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually increased the federal estate tax exemption until finally repealing the federal estate tax altogether for the 2010 tax year only. The 2010 Tax Relief Act reinstated the federal estate tax with a $5 million exemption (indexed for inflation after 2011) through December 31, 2012. The 2010 estate tax provisions were made permanent by the American Taxpayer Relief Act of 2012, although the top federal estate tax rate was raised to 40%. The applicable exemption amount in 2016 is $5.45 million.
Year
Exemption Amount
Top Estate Tax Rate
2009
$3.5 million
45%
2010*
$0 or $5 million
0% or 35%
2011
$5 million
35%
2012
$5.12 million
35%
2013
$5.25 million
40%
2014
$5.34 million
40%
2015
$5.43 million
40%
2016
$5.45 million
40%
Check with your tax advisor to be sure that your estate is protected as much as possible from estate taxes upon your death.
* Executors for estates of decedents who died in 2010 had the option of electing to use the 35% rate, $5 million exemption, and “stepped up” basis of inherited assets for income tax purposes or zero estate tax liability with “carry over” basis of inherited assets for income tax purposes.
Capital gains are the profits realized from the sale of capital assets such as stocks, bonds, and property. The capital gain tax is triggered only when an asset is sold, not while the asset is held by an investor. However, mutual fund investors could be charged capital gains on investments in the fund that are sold by the fund during the year.
There are two types of capital gains: long term and short term; each is subject to different tax rates. Long-term gains are profits on assets held longer than 12 months before they are sold. The American Taxpayer Relief Act of 2012 instituted a 20% long-term capital gains tax rate for taxpayers in the 39.6% income tax bracket and extended both the 0% capital gains tax rate for individuals in the 10% and 15% tax brackets and the 15% capital gains tax rate for all other tax brackets. Short-term gains (on assets held for 12 months or less) are taxed as ordinary income at the seller’s marginal income tax rate.
The taxable amount of each gain is determined by a “cost basis” — in other words, the original purchase price adjusted for additional improvements or investments, taxes paid on dividends, certain fees, and any depreciation of the assets. In addition, any capital losses incurred in the current tax year or previous years can be used to offset taxes on current-year capital gains. Losses of up to $3,000 a year may be claimed as a tax deduction.
If you have been purchasing shares in a mutual fund over several years and want to sell some holdings, instruct your financial professional to sell shares that you purchased for the highest amount of money, because this will reduce your capital gains. Also, be sure to specify which shares you are selling so that you can take advantage of the lower rate on long-term gains. The IRS may assume that you are selling shares you have held for a shorter time and tax you using short-term rates.
Capital gains distributions for the prior year are reported to you by January 31, and any taxes that must be paid on gains are due on the date of your tax return.
Higher-income taxpayers should be aware that they may be subject to an additional 3.8% Medicare unearned income tax on net investment income (unearned income includes capital gains) if their adjusted gross income exceeds $200,000 (single filers) or $250,000 (married joint filers). This is an outcome of the Patient Protection and Affordable Care Act.
