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A Tax Tune-Up for Your Non-Retirement Account

November 13, 2019

S Rossi 2014

A Tax Tune-Up for Your Non-Retirement Account
By Stephen A. Rossi, SVP, Senior Equity Strategist – CNB Wealth Management

Published on November 11, 2019 in the Rochester Business Journal

Retirement accounts such as an IRA, a 401(k), a 403(b) or a 457 plan are a tax-efficient group of investment vehicles, in as much as the taxation of all income and capital gains generated by these accounts is deferred until funds are actually withdrawn. At that point, and provided the individual is old enough to make withdrawals without penalty (generally after age 59 and a half), all distributions are taxed at the individual’s ordinary income tax rate. Income paid and capital gains realized in a non-retirement account, however, are taxed in the year the income is received, or the year in which the gains are realized. In light of these very different tax treatments, there are ways that investors, particularly those in higher marginal tax brackets, can minimize their year-end tax liability outside of their more traditional retirement accounts.

One of the easiest tactics investors can use to minimize their tax liability in a non-retirement account is to hold an investment for at least a year before selling it. If you sell the investment for more than what you paid for it at that time, you’ll pay tax on the gain, but at a more attractive long-term capital gains tax rate ranging from 0% to 20% for a single filer. These rates are generally lower than the tax you’d pay on gains for an investment held for less than a year, where ordinary income tax rates ranging from 10% to 37% would apply. An additional 3.8% tax may also apply for individuals that earn more than $200K that year.

A second tactic related to the holding period of an investment relates to the concept of a qualified dividend. Dividends refer to the income paid out by a corporation on their common or preferred stock. To be considered a qualified dividend, an investor must have held the common or preferred stock for a minimum period of time, prior to and after the ex-dividend date (generally for a period of 60 to 90 days, depending on the security). The ex-dividend date is the first day that investors who bought the stock wouldn’t be entitled to the very next quarterly dividend payment. For those that don’t satisfy the minimum holding period, dividends collected are considered to be ordinary dividends and the income collected would be subject to less favorable ordinary income tax rates. Satisfying the minimum holding period avails an investor to the more favorable long-term capital gains tax rates on the dividend income instead.

What you buy in a non-retirement account can be as important as how long you hold it, as far as taxes go, particularly in the case of actively managed mutual funds. For example, if an investor purchased 100 shares of an actively managed mutual fund at the beginning of the year and did nothing but hold the fund for the entire year, it would seem that there wouldn’t be any year-end tax liability to worry about, since the investor’s shares were never physically sold to realize a taxable gain or loss. However, this may or may not be the case. In reality, any gains realized that year by the active manager inside the fund are typically passed out to the funds’ investors (proportionately) at the end of the year and taxed accordingly. To avoid this pass-through of gains, an investor might consider purchasing individual stocks and bonds or passive exchange-traded funds (ETFs) for their non-retirement accounts as opposed to actively managed funds.

Aside from owning individual securities and ETFs as an alternative to actively managed mutual funds, owning fully or partially tax-free bonds is another great way to minimize an investor’s year-end tax liability in a non-retirement account. Bonds issued by the Federal government and some Federal government agencies are typically free from state and local tax, while bonds issued by municipalities can often be free from Federal, state and local tax. For example, a resident of New York City could purchase a bond issued by the City of New York and collect income that was free from Federal, state and local tax. In contrast, a comparable bond issued by Coca-Cola, would be subject to all of these taxes at the investor’s ordinary income tax rate. Municipal bonds tend to pay less interest than comparable taxable bonds, largely because they’re not subject to as much tax, so the higher one’s marginal tax bracket, the more significant the tax benefit is for owning U.S. government and municipal bonds in a non-retirement account. For people in lower tax brackets, it may actually be more advantageous to buy taxable bonds of some sort.

In instances where municipal bonds do make sense, it may also be prudent to purchase these bonds at a premium. Buying bonds for more than their initial par value of $1,000 per bond is typically necessary when the bond’s coupon rate of interest is higher than what the market is currently bearing for a new issue with comparable terms. In essence, you pay a premium for a stream of income that is higher than what you otherwise would have been entitled to, based on current market rates, in exchange for losing that premium between the time the bond is purchased and the time the bond matures. The premium you give up is exactly enough to bring your total return on investment (excluding taxes) down to a rate commensurate with what the new issue with the lower coupon rate of interest would have otherwise provided you at the time of purchase. Buying premium bonds, therefore, can be beneficial in two important ways. First, the investor avails him or herself of a higher stream of tax-free income than would otherwise have been available on a comparable new issue on the date of purchase and, second, the premium given up or amortized over time effectively becomes a loss that can be used to offset other gains or income.

Let’s face it, nobody likes to pay taxes, but paying attention to these tips and tricks in a non-retirement account can help you keep more money in your own pocket. For Uncle Sam, these tips and tricks represent lost revenue. For you, they can represent an unexpected treat.

To see his column in the RBJ, click here.