The first time we meet with a new client, we ask for tax returns and quarterly investment statements that includes how much they paid for their securities. I review the return with them line by line, showing them how they are making money, and how much it is costing in taxes. W-2 income, which is money that you get from work, is very hard to control and really the only thing you can do is the 401(k) plan. Investment income is very controllable and for many successful people, their investments are costing them a fortune!
Many of our clients are in very high tax brackets, so the goal is not just focused on higher returns, but more importantly, reasonable returns in a tax-efficient manner. In New Jersey and many other states, it is possible to have a marginal tax rate with the federal and state income tax, of over 50 percent. If your investments are not tax efficient, this means you can lose half of your money from returns to Uncle Sam and friends!
Let's use as an example New Jersey, which doesn't even have the highest tax rate on investments. Here is a quick summary of the tax rates on investment income:
So as you can see, the rates can get very high — even if you are not making a huge income. Having a proactive tax strategy can easily save you thousands each year.
Here are six tips for reducing the amount of money you're paying in taxes on your investments:
1.Do not buy a stock or fund unless you plan on keeping it for a year! When I review a client's Form 8949 that lists all the trades, I often find hundreds of short-term trades where they lose up to half the gain if they are right. At minimum, buy the stock for at least 1 year — or don't buy it!
2.Time your sales. If you need to sell a stock or fund because you have a large gain, review where you have losses that you can sell to offset these gains. The goal is to have losses offset all your gains plus an additional $3k that you can use to offset your regular earned income. This is known as "harvesting losses."
3. Reduce or eliminate taxable interest. Banks are paying almost nothing and on top of that, you are losing half of that in taxes. Look at tax-free money-market accounts and tax-free muni bonds, which generally have higher returns on an after-tax basis.
4. Sell higher-costing securities. Let's say that you have been buying Apple for years at all different prices ranging from $100 to $700. Sell specifically the $700 shares and now you have a "loss" for income-tax purposes, even though your stock is worth more than you paid for it. Most people use either "average price" or "first in, first out" and generally that increases the taxable gain.
5. Watch "turnover ratios" in mutual funds. This tells you how often a money manager turns over their portfolio. An index fund is basically zero vs. an actively-traded fund, where the ratio can be over 100 percent. At 100 percent or more, that entire gain is taxable at your highest possible rate vs. an index fund that is taxable mainly when you sell it — and at lower capital gains rates.
6. Give it away. If you are giving money to charity or family, give them appreciated stock so you do not have to pay taxes on the gain. Charities do not care if you give them dollars or doughnuts, as long as it converts into money. Family members may be able to sell the stock and pay no taxes (10- or 15-percent tax bracket), or a lower capital-gains rate than you if they are not subject to the new higher tax rates.
Jan. 1 is right around the corner. You have a few weeks to really impact your taxes for 2013, so take advantage of it. A vacation is always better when it is paid by the savings on your tax return!
— By Jerry Lynch.
Jerry Lynch is a certified financial planner and president of JFL Total Wealth Management, a registered investment-advisory firm. Follow him on Twitter