The Tax Advice You Need Before 2016
Today I want to talk about an investing topic that may seem a little dry. But make no mistake: It's one of the most important determinants of long-term investing success.
They say it's not what you make. It's what you keep.
And understanding the tax implications of different types of investment accounts can help income investors keep more.
I get a lot of questions from my Daily Paycheck subscribers about which holdings in my premium newsletter are appropriate for the many different types of brokerage accounts.
I'd like to briefly review the different types of accounts and which types of securities are most appropriate for them.
Now before I go any further, I know this might seem like an odd time to think about investment-related taxes. But I find this is the best time of year to review your investment accounts.
For one thing, it gives you time to minimize your 2015 tax burden. If you had a capital gain or loss in a taxable account during the year, you may want to find an offsetting trade to make before the end of the year.
Also, if you have any questions about individual securities and taxation, this is a great time to chat with a tax professional. Once the New Year begins, they are generally too busy filing tax returns.
An autumn review can also help optimize the placement of your holdings to limit your tax liabilities for 2016 and beyond.
So in the interest of minimizing your tax bill (and maximizing your gains), let's review the three main types of accounts and which securities are best suited for them.
Breaking It Down...
The three main types of investment accounts are regular taxable brokerage accounts, tax-deferred accounts, such as IRAs, 401(k)s, etc. and Roth accounts like the Roth IRA and Roth 401(k).
The tax rules for each account are different. As a result, some income investments are more appropriate for one kind of account versus another.
Taxable Brokerage Accounts : In taxable brokerage accounts, most income distributions are taxed in the year in which they are received -- even if you reinvest those dividends to buy more shares. Taxes on capital gains are also owed for any securities you sell in a given year, although these can be offset by any capital losses you incur in the same year.
Many securities held in taxable brokerage accounts, however, are eligible for special lower tax rates. Most dividends issued by corporate equities are eligible for the qualified dividend rate, which is 15% for the majority of tax filers. The income issued by many municipal bonds qualifies for a 0% federal income tax rate. The long-term capital gains tax -- for securities held more than one year -- is just 15% for most filer
Bottom Line : Securities like municipal bonds, muni bond funds, above-average yielding equities and funds that pay high return-of-capital rates that qualify for special tax rates are best held in a taxable brokerage account.
One last thing, and I cannot state this one clearly enough: Master limited partnerships (MLPs) like Magellan Midstream Partners (NYSE: MMP ) or Enterprise Products Partners (NYSE: EPD ) should always, always be held in a taxable account .
MLPs can pay a percentage of their distributions in the form of "unrelated business taxable income" (UBTI). There can be unfavorable tax consequences for investors if they earn more than $1,000 in UBTI in a tax-deferred account.
Tax-Deferred Accounts : In tax-deferred accounts such as 401(k)s and IRAs, income distributions and capital gains are not taxed in the year in which they occur. All withdrawals from tax-deferred accounts, however, are taxed at your ordinary income tax rate. Special investment tax rates do not apply.
Bottom Line : Securities paying income that's taxed at the ordinary income tax rate are best held in tax-deferred accounts. This means securities like fixed-income and floating rate bonds, bond funds, business development companies ( BDCs) and real estate investment trusts ( REITs) belong in these accounts.
Roth Accounts : In Roth IRAs and Roth 401(k)s, income distributions and capital gains are not taxed in the year in which they occur. Better yet, all withdrawals from Roth accounts are tax-free.
Bottom Line : Roth accounts are a favorite among dividend reinvestors. After all, what's not to like about tax-free, compound growth? Securities that have a high probability of appreciation or securities you think you may hold for less than one year are especially good for Roth IRAs.
This means short-term capital gains payers would be a good candidate for a Roth account. Likewise, securities with lower yields but higher appreciation potential -- like Paychex (Nasdaq: PAYX ) , a longtime Daily Paycheck holding, or my October Security of the Month -- are also attractive Roth IRA holdings.
Bringing It All Together
Of course you certainly don't need all three account types to benefit from income investing or dividend reinvesting. These are just general considerations.
Sometimes the decision about a security's account placement isn't cut and dry. Also, your current personal tax bracket may effect which type of account you chose to place a security. So is the tax bracket you expect to be in when you begin to withdraw money from a tax deferred account.
But with a little examination and due diligence, you can use this brief overview as a starting point for making sure you have the right kinds of income payers in the right account.
I'm glad my Daily Paycheck subscribers care just as much about saving on their tax bill as collecting increasing dividends each and every month by using my Daily Paycheck Retirement Plan . After all, it would be foolish to simply leave money on the table by paying more than you should in taxes. If you'd like to know more about how my strategy could lead to 365 dividend checks a year for you, simply click here .
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