Tips for Tax-Savvy Investing

Tax Savvy Investing in Nashville

We would all like to have the problem that high income earners do: how do I reduce my yearly tax burden while maximizing long-term investing strategies?  While the U.S. marginal tax brackets are still historically low, the top brackets for income and investment earnings did increase for the 2013 tax year and going forward.  Some changes to note:

  • The top income tax bracket increased from 35% to 39.6% for individuals earning more than $400,000 ($450,000 for joint filers, $425,000 for heads of household).
  • The Personal Exemption Phaseout (PEP) was reinstated at threshold levels of $300,000 for joint filers and surviving spouses; $275,000 for heads of household; $250,000 for singltaxe filers; and $150,000 for married taxpayers filing separately.
  • Capital gain & dividend rate increase for high earners beginning in tax year 2013. Top rate rises from 15% to 20%.
  • New taxes include: 3.8% Medicare Tax on Net Investment Income and an Additional 0.9% Medicare Tax on Wages/Self-Employment Income for Taxpayers with modified adjusted gross income (MAGI) over $200,000 who file individually or $250,000 for married couples filing jointly ($125,000 if married and filing separately).

So what are some strategies available for tax-savvy investing?

1)       Max out your employer-sponsored plan.

This is usually step #1.  You can defer pre-tax up to $17,500 into your employer-sponsored 401(k) plan, and an additional $5,500 if you are over age 50.  Most employers offer a matching contribution.  For example, your company will match 50% on up to 6% of your deferrals.  In this case, you would want to make sure to contribute at least 6% of your pay, so that you receive the employer 3% maximum match.  This is free money, the only guaranteed 100% return!

2)       Max out your IRA.401k savings ira

It is unlikely you will be able to contribute to a Roth IRA, which provides tax-deferred growth and potentially tax-free withdrawals, if you are a high income earner due to the phaseout rules.  But you can contribute up to $5,500 (and an additional $1,000 if over age 50) to an IRA.  Although the contributions may (and probably will not be) deductible, you will enjoy tax-deferred growth until withdrawals (which must begin at age 70 ½).  Also, if you do not have an IRA, consider the backdoor Roth conversion.  By maxing out your IRA contribution and immediately converting the funds to a Roth IRA, you pay no tax and enjoy the benefits of a Roth IRA going forward!

3)       Contribute to an HSA.

If your employer offers a high-deductible health insurance plan option, consider choosing it so that you can contribute to a health savings account (HSA).  Contributions are tax-deductible and withdrawals are tax-free if used for qualified medical expenses (including deductibles and co-pays, but not premiums).  The maximum contribution for 2014 is $3,300 for an individual and $6,550 for a family (and an extra $1,000 for those over age 55).  HSA balances roll over year to year, and you can choose to invest the cash in many plans, giving you another long-term investment strategy.

4)       Buy municipal bonds.

Municipal bonds issued by states, cities and municipalities can potentially offer federal, state and local tax-free income.  In general bonds provide more conservative investment growth and pay monthly, semi-annual or annual income (known as coupons or yield).  While they can provide a great vehicle for tax-free earnings, make sure you understand the risks involved with individual municipal bonds or municipal bond mutual funds.

5)       Invest using tax-deferred variable annuities.

Annuities are complex investment instruments.  Because they can provide guarantees and downside protection, they are very popular during and directly after bear markets.  However, there are many hidden fees and commissions that you need to know and understand before purchasing a variable annuity. Variable annuities offer a means of investing in stocks and bonds without paying taxes on earnings year to year.  Contributions are made with after-tax dollars and you enjoy tax-deferred growth while the funds remain in the annuity.  However, the growth will be taxed as ordinary income upon withdrawal.  So it probably makes more sense to purchase a variable annuity if you know you will be in a lower income tax bracket when you begin taking distributions.