For the moment, taxes on portfolios are modest. The federal rate is 15% on most dividends and on long-term capital gains. Come 2013, though, the rates shoot up.
Without a law change, the maximum federal tax on interest, dividends and short-term gains will go to 44.6%. That consists of a 39.6% stated rate, the 1.2% cost of a deduction clawback and a 3.8% surtax to pay for health care. The max for long gains will be 25% (but 23% for assets held for more than five years). Add state taxes to all of these.
What’s an investor to do? Take defensive measures. Here are ten ways to pocket investment income without paying tax on it.
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Set up a kiddie Roth
osha.gov
Did your daughter earn $4,000 last summer that she needs for college? Were you going to leave her at least $4,000 in your will? Start your bequest now. Hand her $4,000 that she can use to fund a Roth IRA. Tell her not to touch it until she is 60.
She’ll get 40 years of tax-free compounding. (At 7% a year, this would turn $4,000 into $60,000.) You’ll get money out of your estate, probably saving on state inheritance taxes.
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Buy an MLP
Master limited partnerships that own energy assets like pipelines tend to pay pretty good dividends (in the neighborhood of 5%). Those dividends, at least initially, are largely sheltered by depreciation deductions. The quarterly cash, that is, is considered a nontaxable “return of capital.”
After a decade or two this tax shelter is exhausted, but if you die owning these shares your heirs get to start the process over with a new, higher tax basis. There’s more on MLP taxation here.
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Go Ugma
Use the Uniform Gift to Minors Act (a.k.a. Uniform Transfers to Minors Act) to set up a brokerage account for your son or daughter. The first $950 of annual income is free of tax; the next $950 is taxed in the kid’s low bracket.
The downside is that at age 18 Junior takes ownership and might not spend the money on college, as you intend. So fund the account modestly—$30,000 is plenty—and concentrate the holdings on investments that (a) generate a lot of taxable income and (b) are compelling additions to the overall family portfolio. The idea is to make full use of that $1,900-a-year shelter while parting with a small amount of capital.
Here are several examples of investments that make sense in a diversified portfolio and that spew out a lot of ordinary income:
–exchange traded funds that hold a lot of Ginnie Maes and the like (MBB) or the whole bond market (BND).
–the ETF for junk bonds (JNK).
–high-yielding blue chips like Verizon, AT&T and Pfizer.
–preferred stocks.
Two cautions. (1) To avoid gift tax wrinkles, limit each year’s contribution to $26,000 per child ($13,000 if you are single). (2) Don’t set up Ugmas if you think your kid will qualify for college financial aid. Any assets in the kid’s name will be snatched by aid officers.
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Open a 529
A Section 529 plan lets you accumulate investment income tax free, provided the proceeds are used on schooling. Drawback: Sometimes stiff fees erase the income tax saving.
The account is likely to be a good idea where the costs are low (as in Utah) or there’s a break on state income tax for parents chipping money in (as in New York).
As with Ugmas, 529s are not a good idea for families likely to get tuition assistance.
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Own commercial real estate
As long as your building doesn’t have too much of a mortgage, depreciation deductions will make a good chunk of your rental income free of current income tax. There’s more on the economics of these dealshere.
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Own muni bonds
Interest on the general obligations of state and local governments is free of federal income tax. In most states you also get a pass on state income tax for home-state bonds. Caution: Some states are in financial trouble. Check out the Forbes Moocher Ratio before buying.
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Give away stock profits
You put $3,000 into Netflix, wait at least a year, then give away the shares to charity when they’re worth $8,000. You get a deduction for the whole $8,000. Your $5,000 gain is never taxed.
Two other ways to shelter appreciated property from capital gain taxation: leave it in your estate, or give it to a low-bracket relative.
Bequeathed property benefits from a step-up, meaning that gains unrealized by an owner at the time of his death permanently escape income taxation.
Low bracket taxpayers (people who would be in a 25% or lower bracket if all their capital gain were taxed as ordinary income) get a free ride on long-term capital gains. But if the donee is a son or daughter 18 or younger (23 if in school), beware the kiddie tax, which applies to investment income over $1,900 a year.
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Capture losses
When the market is down, swap out of losing positions into similar but not identical ones. For example, you could exit an S&P 500 index fund and immediately buy the Vanguard Megacap Index Fund. In this fashion, you can run up a capital loss carryforward that will make future capital gains tax free. For more on loss harvesting, go here.
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Buy a safe
thesafewarehouse.com
If your $400 investment saves you $45 a year in safe deposit box fees, you’ve got an 11% yield, tax free. The only exception on the tax side would be if you are one of those rare birds in a position to deduct miscellaneous items like the rental on a strongbox to hold your gold coins. Miscellaneous deductions are usable only to the extent they exceed 2% of your adjusted gross income; not many taxpayers get anywhere near this threshold.
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Be a cheapskate investor
Are you paying someone 1.5% a year to have your assets managed? Cut this cost in half by haggling. A dollar saved in this fashion is a dollar earned free of tax, unless you are claiming miscellaneous deductions, which is unlikely.
