TAXES


Tax Savings for Affluent Families

College Savings

Use a Roth to save for college. Sure, the “R” in IRA stands for retirement, but because you can withdraw contributions at any time tax- and penalty-free, the account can serve as a terrific tax-deferred college-savings plan. Say you and your spouse each stash $5,000 in a Roth starting the year a child is born. After 18 years, the dual Roths would hold $375,000, assuming 98% annual growth. Up to $180,000 — the total of the contributions — can be withdrawn tax- and penalty-free and any part of the interest can be withdrawn penalty-free, too, to pay college bills.

Save for college the tax-smart way. Stashing money in a custodial account can save on taxes. But it can also get you tied up with the expensive "kiddie tax" rules and gives full control of the cash to your child when he or she turns 18 or 21. Using a state-sponsored 529 college savings plan can make earnings completely tax free and lets you keep control over the money. If one child decides not to go to college, you can switch the account to another child or take it back.

Roll over an inherited 401(k). A recent change in the rules allows a beneficiary of a 401(k) plan to roll over the account into an IRA and stretch payouts (and the tax bill on them) over his or her lifetime. This can be a tremendous advantage over the old rules that generally required such accounts be cashed out, and all taxes paid, within five years. To qualify for this break, you must be named as the beneficiary of the 401(k). If the account goes to the owner’s estate and then to you, the old five-year rule applies..

Investments and Retirement Savings

Check the calendar before you sell. You must own an investment for more than one year for profit to qualify as a long-term gain and enjoy preferential tax rates. The "holding period" starts on the day after you buy a stock, mutual fund or other asset and ends on the day you sell it.

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Don't buy a tax bill. Before you invest in a mutual fund near the end of the year, check to see when the fund will distribute dividends. On that day, the value of shares will fall by the amount paid. Buy just before the payout and the dividend will effectively rebate part of your purchase price, but you'll owe tax on the amount. Buy after the payout, and you'll get a lower price, and no tax bill.

Mine your portfolio for tax savings. Investors have significant control over their tax liability. As you near the end of the year, tote up gains and losses on sales to date and review your portfolio for paper gains and losses. If you have a net loss so far, you have an opportunity to take some profit tax free. Alternatively, a net profit on previous sales can be offset by realizing losses on sales before the end of the year. (This strategy applies only to assets held in taxable accounts, not tax-deferred retirement accounts such as IRAs or 401(k) plans).

Avoid the wash sale rule. If you sell a stock, bond or mutual fund for a loss and then buy back the identical security within 30 days, you can't claim the loss on your tax return. The IRS considers the transaction a wash because your economic situation really hasn't changed. It's easy to avoid being stung by the "wash sale" rule, though. Watch the calendar, or buy similar but not identical securities.

Think twice about selling stock for a profit if you're subject to the AMT. Although long-term capital gains benefit from the same 20% maximum rate under both the regular tax rules and the alternative minimum tax, a capital gain can effectively cost more than 20% in AMT-land. The special AMT exemption is phased out as income rises so, for example, a $1,000 capital gain can wipe out $250 of the exemption, effectively exposing $1,250 to tax. That means your tax bill rises by more than $150 for that $1,000 gain.

Consider tax-free bonds. It's easy to figure whether you'll come out ahead with taxable or tax-free bonds. Simply divide the tax-free yield by 1 minus your federal tax bracket to find the "taxable-equivalent yield." If you're in the 33% bracket, your divisor would be 0.67 (1 - 0.33). So, a tax-free bond paying 5% would be worth as much to you as a taxable bond paying 7.46% (5/0.67).

Keep a running tally of your basis. For assets you buy, your "tax basis" is basically how much you have invested. It's the amount from which gain or loss is figured when you sell. If you use dividends to purchase additional shares, each purchase adds to your basis. If a stock splits or you receive a return-of-capital distribution, your basis changes. Only by carefully tracking your basis can you protect yourself from overpaying taxes on your profits when you sell. If you're not sure what your basis is, ask your brokerage or mutual fund company for help. (Financial services firms must now report to investors the tax basis of shares redeemed during the year. For the sale of shares purchased in 2012 and later years, they must also report the basis to the IRS.)

Tell your broker which shares to sell. Doing so gives you more control over the tax consequences when you sell stock. If you fail to specifically identify the shares to be sold, the tax law's FIFO (first-in-first-out) rule comes into play and the shares you've owned the longest (and perhaps the ones with the biggest gain) are considered to be sold. With mutual funds, an "average basis" can be used when determining gain or loss; but that alternative isn't available for stocks.

Beware of Uncle Sam's interest in your divorce. Watch the tax basis — that is, the value from which gains or losses will be determined when property is sold — when working toward an equitable property settlement. One $100,000 asset might be worth a lot more — or a lot less — than another, after the IRS gets its share. Remember: Alimony is deductible by the payer and taxable income to the recipient; a property settlement is neither deductible nor taxable.

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