Reviewing your tax form may provide insight into opportunities for investing with greater after-tax savings. On Form 1040, you should pay special attention to the Taxable Interest, Tax-Exempt Income, and Dividend Income lines. Your tax bracket critically affects the effective yield of your investments.
Municipal Bonds
Tax-exempt municipal bonds are an excellent tax-advantaged investment, especially if you are in a high income-tax bracket, or if you have increased your tax bracket owing to a promotion or career change. In the latter case, the fixed-income investments appropriate for your current tax bracket may also change. For instance, in a certain tax bracket, interest from municipal bonds may have a greater after-tax yield than corporate bond interest. (Check with your tax advisor for your particular circumstances.)
Any interest earned on municipal bonds is exempt from federal income taxes and, in most states, from state and local taxes for residents of the issuing states (although income on certain bonds for particular investors may be subject to the Alternative Minimum Tax).
Plan Your Capital Gains/Losses
Capital gains and losses result when capital assets, such as stocks, bonds, or options are sold. Comparing the differences between the proceeds you received upon the sale of the asset and the tax basis of the asset sold gives you your capital gain or loss.
Determining when to recognize your capital gains or losses depends on whether you want to postpone the tax liability (by postponing the recognition of gains) or recognize capital gains or losses during the current year. If the gains will be subject to a higher rate of tax next year (due to a change in tax bracket), or if you may use capital losses to offset capital gains, you may choose to recognize capital gains this year.
Please contact your tax advisor to learn more about the various capital gains strategies and about the possibility of postponing recognition this year.
Identification of Securities Transactions
Identifying different securities transactions is important when you have various lots of the same security bought and sold at different times and at different prices. If you have more than one lot of the same security, you may create a tax-planning opportunity if you adequately identify the lot to be sold. Identification allows you to create the amount of gain or loss to be recognized and create a short-term or long-term capital gain or loss. The 15% maximum capital gains tax rate applies to sales of assets held for more than 12 months (0% through 2012 for those in the 15% or lower tax bracket). If you do not adequately identify the lot of securities to be sold, U.S. Treasury regulations impose the first-in, first-out method of identification where the securities sold are deemed to be the securities you held for the longest time.
Consider Tax Swaps
When evaluating a portfolio for performance and asset allocation, consider the potential benefits of making a tax swap. If there is a depressed stock, bond, mutual fund, or other financial instrument, a swap may generate a tax loss and facilitate the purchase of another investment that will upgrade the portfolio.
If you sold or want to sell an appreciated security, the capital gain may be reduced or eliminated by selling a security for a capital loss. If the gain is completely offset by a loss, you have effectively created a current tax-free source of income and increased the portfolio's overall after-tax return.
When swapping, you may purchase a security that is similar to the one that was sold. However, if the newly purchased security is substantially identical to the security sold, then the wash sale rules may disallow the loss for the current year. Remember that Prudential Financial, its affiliates, and their financial professionals do not provide tax advice, and clients should consult with their tax advisor before implementing any tax-related strategy.
Portfolio Allocation and Reallocation
A long-term investment strategy does not imply a passive invest-and-forget approach. Once your asset allocation is set, you should periodically review it. For one thing, your investments may grow at variable rates, changing the balance of the asset allocation. Since the long-term capital gains tax rate for assets held over 12 months is as low as 15% (0% for taxpayers in the 15% or lower brackets), your portfolio allocation of growth and income investments becomes even more significant.
Review your IRA Opportunities
Due to financial planning, market appreciation, and tax deferral, the value of your IRA may have grown substantially. Rollovers from your qualified retirement plans also may have increased the size of your account. As a result, your IRA may constitute a sizable asset. Understanding the IRA rules is critical to:
- maximize flexibility on the timing and amount of IRA distributions;
- reduce the annual required distribution and tax impact for your heirs; and
- maximize the tax deferral as long as possible for your heirs.
Consider All Your Rollover Options
If you are retiring or changing jobs, you will have to decide what to do with the assets in your company's pension and 401(k) plans. You could arrange a rollover into an IRA, leave your assets in your current employer's plan, or take a cash distribution. If you choose to roll over your retirement plan assets, you can choose to roll over to a new or existing traditional IRA or you can convert into a Roth IRA, so long as your adjusted gross income (AGI) does not exceed $100,000 (whether single or married filing jointly) in the year of conversion. Conversions into the Roth IRA are subject to ordinary income tax, although they are not subject to early distribution penalties. The $100,000 income limit is repealed as of 2010. For conversions in 2010 only, you also can make an election to pay the tax ratably in 2011 and 2012.
Estate Conservation Strategies
There are many ways to reduce estate taxes. One is to make gifts of your assets, which removes the assets from your estate, thereby reducing the amount that is ultimately subject to federal estate taxes. Another is to take advantage of the unified credit, which gives you a tax credit equal to the estate taxes due on an estate valued at $5 million in 2011. Your Prudential financial professional would be happy to meet with you and your tax advisor and attorney to review strategies to reduce taxes on your estate. The applicable exclusion amount is indexed for inflation for 2012, but in 2013, under current law, the estate tax applicable exclusion amount returns to $1 million, resulting in an exclusion amount of $5.12 million. For 2012, the gift and estate tax applicable exclusion amount is portable, meaning that if someone dies without fulling utilizing it, their surviving spouse can take advantage of their remaining amount. This is also set to expire after 2012.
Life Insurance
Life insurance may provide your beneficiaries with the cash to pay estate taxes and may be an attractive solution to liquidity problems inherent in many estates (e.g., family-owned businesses, large real estate holdings, and collectibles). Though life insurance proceeds pass to beneficiaries free of income tax (See IRC Section 101(a)), the proceeds are not necessarily free of estate taxes.