Tax Location in Today?s Uncertain Environment

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The tumultuous political climate in Washington has heightened anxiety around the country, and the uncertainty left when Congress adjourned without tackling any of the looming tax changes has left taxpayers and investors wondering just what is in store for 2011.  Though the crystal ball remains cloudy, and while taxes may rise for no one, everyone, or just the wealthiest Americans, steps taken today can help tax planners and their clients be better prepared – no matter what the politicians do.

With or without a change in policy from Washington, every investor’s first step should be to place each asset in its optimal location for tax purposes.  There’s no need to wait for year-end planning; tax evaluation should be a continuous process, with reallocation as needs and conditions change.  Staying abreast of where and how assets are distributed can yield significant savings over the long and short terms.  For example:

  • Buy-and-hold equities (an S&P 500 index fund, for instance) are almost always best placed in a taxable account.   Appreciation on these investments is not taxed until the equity is sold, and then the tax should be at a favorable long-term capital gains rate. If an investor never sells a stock, their heirs may not have to pay taxes on the appreciation, thanks to a “step up in basis” provision in the tax code.

    Conversely, if the gain is inside a tax-advantaged account, such as an IRA, the appreciation will eventually be taxed as ordinary income at a higher rate, and there is no “step up in basis” for heirs.  Losses in taxable accounts can also be used to offset gains accrued indefinitely into the future, but losses in retirement accounts can never be used to offset taxable gains. 

  • On the other hand, short-term gains from high-turnover equities are usually best suited for tax-advantaged accounts. In a taxable account, these gains would be taxed at an investor’s top marginal rate. Corporate bonds, which have no favorable tax treatment on their yields, also belong in retirement accounts. In an IRA, these yields will not be taxed until the account is drawn down, at which time the owner will presumably have retired and may be in a lower tax bracket than during their years of high income accumulation.

Read more articles by Glenn Frank