While many people may be aware of the immediate differences in taxation between retirement (IRA, Roth IRA, SEP, SIMPLE, 401(k), etc.) and non-retirement accounts, a lot of them make no conscious decision to hold different types of investments based on the account type in which the assets are held. This concept, sometimes referred to as asset location, can have an impact on long-term return potential and, under current tax laws, could help a person or married couple to reduce the taxes that would otherwise be owed from activities in their account(s).
As financial advisors, it is our job to have at least a base level of understanding of all or most parts of our clients’ financial lives. Taxes are a big part of that. While the ultimate decision making when it comes to taxes should take place with the help of a client’s trusted CPA or tax advisor, having a well-informed financial advisor can help make an accountant’s job easier, thereby making mid-April a more pleasant time of year.
This post will not delve into all types of taxable income, but ones that we see most commonly in investment accounts and the different treatment of each – bond interest income (taxable and tax-advantaged), capital gains (short and long-term), and dividends (qualified and ordinary). Knowing the differences can go a long way at tax time.
The first of these, bond interest, is relatively straight-forward – taxable bonds pay interest and that interest income is taxed at ordinary income tax rates. Interest from tax-advantaged bonds, on the other hand, is usually free from federal income tax and potentially, based on the issuer and state tax law, state tax free as well. This is one of the reasons municipal bonds may be used in taxable accounts, especially by those in higher income tax brackets. To bring it into perspective, consider the concept of tax-equivalent yield. Tax-equivalent yield is a basic calculation - you take the yield of a municipal bond and divide by (1 minus marginal tax rate). That is the yield a taxable bond would have to provide in order to give an investor an equivalent amount of net income after taxes. Armed with this information and with help from a competent CPA and advisor, an investor would have a decent understanding of how to structure the bond portion of their portfolio (there are obviously factors beyond taxes to consider).
The next type of income, that from capital gains, is a bit trickier and can involve transactions that are both within your control and not. Short-term capital gains are those realized when a security has been bought and subsequently sold in a time frame shorter than one year. Such a gain is taxed at an individual’s marginal rate. In individual securities like stocks, one can usually control this. However, there are instances in which the client does not have control over the receipt of short-term gains. For example, in a managed account, it is possible to incur gains due to trading within the account (which is not controlled by the client) in a sub-one year time frame.
When it comes to long-term capital gains, under current laws, many planning opportunities exist. Individuals in higher tax brackets may pay taxes in the 15-20% range on long-term gains; rates that are currently lower than the ordinary income rates for those brackets. For those in the two lowest brackets, there is potential to pay nothing at all on realized capital gains, creating another potential planning opportunity. No tax is paid on long-term capital gains in the first two brackets (up to $75,900). So say, for example, a married couple filing jointly has a combined annual income of $50,000. That couple could, intentionally or otherwise, realize capital gains of up to $25,900 before paying taxes on said gains. This leaves the client, advisor and CPA to decide under what circumstances gain realization may make sense. It’s important to note that if the amount of gains realized exceeded $25,900 in that instance, only the amount that takes total income over $75,900 would be taxed at capital gains rates, not the entire amount. It is also important to note, however, that in the prior example, phase outs and deductions may exist independent from the tax brackets themselves, and depending upon your individual circumstance, those tax consequences may supersede your desire to accept capital gains at a 0% rate. There are many more options when it comes to capital gains and losses, such as intentional tax-loss harvesting, all of which should be discussed with a competent tax advisor prior to making buy and sell decisions.
SCHEDULE Y-1 – MARRIED FILING JOINTLY OR QUALIFYING WIDOW(ER)*
If taxable income is over:
But not over:
The ordinary income tax is:
10% of the amount over $0
$1,865.00 plus 15% of the amount over $18,650
$10,452.50 plus 25% of the amount over $75,900
$29,752.50 plus 28% of the amount over $153,100
$52,222.50 plus 33% of the amount over $233,350
$112,728.00 plus 35% of the amount over $416,700
$131,628.00 plus 39.6% of the amount over $470,700
Finally, we come another common form of taxable income – dividends. Not all dividends are created equally from a tax perspective, hence the distinction between ordinary dividends and qualified dividends. As you may have guessed, qualified dividends receive preferential tax treatment – similar to that of capital gains (based on where you fall in the tax bracket). Ordinary dividends, on the other hand, are taxed at ordinary income tax rates, likely making them more attractive for use in a retirement account versus a taxable account. The distinction between the two is noted in IRS Publication 17, Part 2, Section 8, available on their website - https://www.irs.gov
Because of all of the factors listed above, and numerous others, it makes sense to coordinate the management of your accounts with both your financial advisor and a tax professional to help ensure that your investments not only make sense based on your time horizon and risk profile, but that they also meet your needs as a tax payer. This type of planning can make a significant difference in long-term wealth creation potential and management.
This information is provided for educational purposes only and is believed to be accurate. It is not intended to provide specific legal, tax or other professional advice. The information is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or financial services professional. Waddell & Reed does not offer tax or legal advice. The concepts presented may not be suitable for every situation. For investors subject to the alternative minimum tax, a portion of dividends may be taxable and distributions of capital gains are generally taxable. Investing involves risk, including the potential loss of principal. The value of debt securities may fall when interest rates rise. Debt securities with longer maturities tend to be more sensitive to changes in interest rates, usually making them more volatile than debt securities with shorter maturities. For all bonds there is a risk that the issuer will default.