reducing the tax impact on investment portfolios the tax impact final 2.pdf · • mlp...

Presented by:

James J. Holtzman, CFP®, CPA

Sponsored by:REDUCING THETAX IMPACT ON

INVESTMENTPORTFOLIOS

James J. Holtzman, CFP®, CPA James J. Holtzman, CFP®, CPA is an Advisor and Shareholder

with Legend Financial Advisors, Inc.® (Legend)

Jim has been selected two consecutive times by MedicalEconomics as one of “The 150 Best Financial Advisors forDoctors in America.”

Jim serves as the firm’s Income Tax and Education Fundingand Planning Specialist.

Jim’s previous professional experience includes employmentwith various CPA and Financial Advisory organizationswhere he provided tax, accounting, auditing and financialconsulting services to individuals and businesses.

Jim’s areas of concentration include income tax planning, estate planning, stock optionexercise planning, insurance, retirement planning and Section 529 Plans.

Jim is a member of the Pennsylvania and American Institute of Certified Public Accountants.He is also a graduate of the Pittsburgh Leadership Development Initiative, which providesyoung leaders with the tools necessary to affect positive change in the Pittsburgh region, andPittsburgh Leadership Onboard Programs.

Jim also serves on the LaRoche College Board of Governors, is a member of Pittsburgh Cares,and is a former member of the Finance Committee for the Pittsburgh Downtown Partnership.

Jim is a frequent guest featured on Pittsburgh Business Radio (WMNY 1360 AM). He has alsobeen quoted in The Wall Street Journal, The Wall Street Journal Online, MSN Money, CBSMarketwatch, Pittsburgh Post-Gazette, Bloomberg Wealth Manager, Financial Planning Magazine,Financial Advisor Magazine, National Underwriter, Smart Money, Investment News, Physician’sPersonal Advisory, and in Bottom Line Personal. Jim has been interviewed on CNNfn’s “YourMoney” and “Business Unusual,” as well as WPXI-TV’s “Our Region’s Business” televisionprograms.

1. High Yield Bonds

2. Taxable Bonds

3. Treasury Inflation-Protected Securities

4. Real Estate Investment Trust

5. Foreign equities (Due to Non-Qualified Dividend Status)

TYPES OF TAX-INEFFICIENT INVESTMENTS

REPRINTED WITH PERMISSION OF LEGEND FINANCIAL ADVISORS, INC.®

SOURCE: LEGEND FINANCIAL ADVISORS, INC.®

COPYRIGHT 2012 LEGEND FINANCIAL ADVISORS, INC.®

1. Traditional IRA (Deductible and Nondeductible)

2. Roth IRA

3. Roth IRA Conversion

4. Individual 401(k)

5. SEP and SIMPLE IRA

6. Work-Sponsored Retirement Plans (401(k), 403(b))

TYPES OF TAX DEFERRED ACCOUNTS




• Aggressive investments can be placed into taxable accounts so that if theinvestment does not perform well, you can harvest capital losses.

WHAT TYPE OF ACCOUNT SHOULD AGGRESSIVEINVESTMENTS BE PLACED INTO?




• Not always, if a bear market causes shareholders to redeem an equitymutual fund that tracks an index, the mutual fund would sell holdingspossibly generating capital gains even though the mutual fund might havenegative performance.

ARE INDEX FUNDS MORE TAX EFFICIENT THANACTIVELY MANAGED FUNDS?




• Also known as Alternative Minimum Tax (AMT) Bonds.

• Not taxable for regular tax but are taxable for AMT.

• Private activity bonds are issued to finance various types of facilitiesowned or used by private entities, including airports, and stadiums.

• The yields on AMT bonds are higher, reflecting the risk that they couldbecome taxable to some investors.

PRIVATE ACTIVITY BONDS




• MLP distributions are sheltered from depreciation charges resulting ina lot of the income being treated as a return of capital.

• You will receive a K-1 for an MLP.

• Depreciation recapture has a federal tax rate of 25.0%

• If return of capital takes the basis to zero, additional return of capitalis subject to long-term capital gains.

• Reductions in basis caused by depreciation deductions must berecaptured as ordinary income at the time of sale.

MASTER LIMITED PARTNERSHIP (MLP) TAXATION




• There might be higher tax return preparation fees because of thesometimes complex tax return reporting requirements.

• An exchange-traded product’s tax treatment depends on both the assetclass it covers and its particular structure.

EXCHANGE-TRADED FUND DISADVANTAGES




EXCHANGE-TRADED FUNDS CONTINUED: TAXATION

• Most Exchange-Traded Funds receive the same taxtreatment as open-end mutual funds but still have aclear advantage:

– Individual redemptions from the fund itself rarely occur

• Shares can be bought and sold in the open market without theneed for shares to be created or liquidated

– Individual holdings within an ETF rarely need to be soldbecause the redemptions are treated as an in-kindtransfer, which is not a taxable event

– Open-end mutual funds must sell securities when sharesare redeemed





• Exceptions:

– ETFs structured as Limited Partnerships• ETFs that hold futures contracts must be structured as L.P.’s

• All gains passed on to limited partners, the shareholders

• 60% of gains taxed as long-term capital gains, 40% taxed as short-term capitalgains each year

• K-1

– ETFs that invest in foreign currencies• All gains from foreign currency exposure, regardless of investment vehicle, are

considered debt, and thus taxed as ordinary income by the IRS.

– ETFs structured as grantor trusts that own physical precious metals• Example: SPDR Gold Shares (GLD)

• The physical commodities such as gold and silver are viewed as collectibles andare taxed at a higher rate (28%).





• Exceptions Continued:

– ETFs that utilize leverage (including short)

• These ETFs utilize index swaps and other derivatives which must be taxedat the short-term capital gains rate, regardless of holding period.

• Interest on the cash pool is taxed as ordinary income.

• There is the potential for significant capital gains if there are substantialredemptions.




EXCHANGE-TRADED NOTES CONTINUED: TAXATION

• Exchange-Traded Notes are typically very tax efficient

– Capital gains taxes are applied to the holding period

– No capital gains distributions etc…

• The only exception: Currency ETNs

– Again, always taxed as ordinary income

• The ETN structure is more favorable for commodities, all otherrisks constant

– An ETF would need to be structured as an L.P. to hold commodityfutures contracts.




INVESTMENTS SUBJECT TO PHANTOM INCOME

• Limited partnerships because earnings are taxed and not received

• Zero-Coupon Bonds

• Treasury Inflation-Protected Securities: Investors are taxed on annualincome and the amount of the adjusted principal (a.k.a. as phantomincome)




OIL AND GAS INVESTMENTS

• Offer large deductions for drilling and development costs.

• Usually purchased though limited partnerships.

• Depreciation deductions.

• Depletion allowance.

• Tax Credits.




• It might make sense to recognize short-term and long-termcapital gains and control the tax rate that you are in.

• If you are in the lowest two ordinary income tax brackets, yourlong-term capital gains rate could be zero. (The zero percentcapital gains tax brackets ends after 2012)

RECOGNIZING TAXABLE REALIZED CAPITALGAINS IN CURRENT YEAR MIGHT MAKE SENSE




• Some investors, especially in the late 1990’s decided that they would ratheravoid paying capital gains taxes and then lost 80.0% of the value of certaintechnology investments in the 2000-2002 cyclical bear market.

WOULD YOU RATHER INCUR A 15.0% CAPITALGAINS TAX OR AN 80.0% TAX?




• The wash sale rule prevents you from claiming a loss on a sale of stock ifyou buy replacement stock within 30 days before or after the sale.

• Avoid the wash sale rules by buying an investment with similarperformance as the stock you are claiming a loss on. Using exchange-traded products can be an easy way to accomplish this.

BE AWARE OF WASH SALE RULES




• Sometimes investors use transaction costs and capital gains taxes as areason not to rebalance or reduce a significantly overweighed position.

• Transaction costs and capital gain taxes incurred as a percentage of theportfolio are usually relative small compared to the potential loss by notrebalancing.

TOTAL COST OF RECOGNIZING CAPITAL GAINS




• Normally, deferring a capital gain into the next tax year makes sense due tothe time value of money.

• The potential increase in capital gains tax rates beginning in 2013 shouldprompt a review of whether or not it makes sense to liquidate largeunrealized capital gain positions in 2012.

INCURRING LARGE CAPITAL GAINS BEFOREDECEMBER 31, 2012




• Be aware that generating large capital gains can reduce or eliminate theAlternative Minimum Tax exemption and sometimes cause an investorto pay the AMT.

UNINTENDED RESULT FROM INCURRING LARGECAPITAL GAINS




• Given the historic low interest rate environment that we are in, there couldbe fixed income investments that are more tax-efficient then equity funds,especially if qualified dividend tax rates no longer apply starting inJanuary 2013.

ARE TAX-INEFFICIENT INVESTMENTS TODAYGOING TO BE MORE TAX-EFFICIENT TOMORROW?




• Starting January 1, 2013, the favorable tax rates on qualified dividendsexpire.

• If qualified dividend rates expire and federal income tax brackets go backto a top tax rate of 39.6%, someone paying 15.0% for qualified dividends in2012 could pay 39.6% for qualified dividends in 2013.

CERTAIN INVESTMENTS COULD BECOME MORETAX-INEFFICIENT

STARTING IN JANUARY 1, 2013




• Does a capital loss carryover exist? The prior year tax return should beobtained in order to make this determination.

• Capital loss carryovers can reduce a client’s concern about paying capitalgains on existing investments with large unrealized capital gains.

• Capital loss carryovers should be viewed as an asset. The valuation of thisasset can be calculated by taking the total of the capital loss carryover andmultiplying it by the client’s tax rate.

• Capital gains shouldn’t be recognized only because a capital loss carryoverexists.

CAPITAL LOSS CARRYOVERS




• Dividend reinvestments

• Capital gain distribution reinvestments

• Commissions on investment

• Splits and Takeovers

• Gifted or inherited shares

• Return of capital

DON’T FORGET ABOUT BUILDING COST BASIS




2008 Emergency Economic Stabilization Act requires brokers to report costbasis for:

• Stocks acquired on or after January 1, 2011.

• Mutual funds and dividend reinvestment programs acquired on or afterJanuary 1, 2012.

• Bonds, options, derivatives, etc. acquired on or after January 1, 2013.

• Custodian will assume that taxpayers are using average cost basis formutual funds and FIFO for everything else.

IMPACT OF NEW COST BASIS RULES




• Always review every tax lot before selling.

TAX LOSS HARVESTING




• If your IRA invests in anything other than a traditional investment (stock,bonds, etc.), Unrelated Business Taxable Income (UBTI) could apply andyou could be subject to the Unrelated Business Income Tax .

• There might be a need to file a separate tax return for your IRA.

UNRELATED BUSINESS TAXABLE INCOME (UBTI)




• Be aware of when a mutual fund’s distribution date is before making thepurchase. You may be paying taxes on someone else’s gain.

• What is the mutual fund’s unrealized capital gain or loss?

• Does the mutual fund have a capital loss carryover?

• Review the mutual fund’s turnover ratio.

INFORMATION TO REVIEW BEFORE PURCHASINGA MUTUAL FUND




• Tax-Cost Ratios, Tax-Adjusted Returns, and any other tax efficiency ratiosshould be part of the review process.

• Mutual funds with redemption charges might have better tax-managedstatistics because investors are less likely to redeem.

ARE TAX RATIOS IMPORTANT TO REVIEW FORMUTUAL FUNDS




• Measures the replacement of holdings in a mutual fund

• Value funds tend to have lower turnover ratios

• Growth funds tend to have higher turnover ratios

• Not a perfect ratio to use for making investment decisions

TURNOVER RATIOS – ARE THEY VALUABLE?




• Compares a load-adjusted pretax return to its tax-adjusted return.

• Represents the percentage of an investor’s assets that are lost to taxes fromdistributions.

TAX COST RATIO




• Estimate of the percent of a mutual fund’s assets that represent capital gains.

POTENTIAL CAPITAL GAINS EXPOSURE




• Are Section 529 plans tax advantages worth it based upon poor investmentoptions?

• Coverdell Education Savings Accounts provide better investment options thanSection 529 Plans because of wider investment platform.

• State tax advantages for section 529 plans are less important than investmentoptions.

• Once a calendar year rebalancing rule makes rebalancing tricky for Section529 plans.

• Custodian accounts are taxable and you need to be aware of the “kiddie tax”.

EDUCATION FUNDING INVESTMENT TAXATIONISSUES




• Due to the budget crisis that many states are facing and the resultant increasein their income tax rates, it is more important than ever to understand theimpact that investment decisions have on state income taxes.

INVESTMENT DECISION IMPACT ON STATE INCOMETAXES




In 2013:

1. Ordinary income tax rates revert to 2001.

2. Favorable long-term capital gain tax rates increase from 15.0% to 20.0%.

3. Reduction of the AMT exemption.

4. Personal exemption phase-out and itemized deduction phase-out repeal.

5. Qualified dividends rate of 15.0% reverts to ordinary income tax rates.

6. New Medicare Tax on unearned income. The taxpayer will determine theLESSER of (1) net investment income OR (2) the excess of AGI over the$200,000/$250,000 AGI thresholds. Thus, if net investment income is thesmaller amount, then the 3.8% tax is applied only to the net investmentincome amount. If the excess over the thresholds is the smaller amount,then the 3.8% tax would apply only to the excess amount.

FISCAL CLIFF COULD IMPACT INVESTMENTDECISIONS




QUESTIONS AND ANSWERS

LEGEND FINANCIAL ADVISORSAND

EMERGINGWEALTH INVESTMENT MANAGEMENTARE AT YOUR SERVICE

Legend Financial Advisors, Inc.®5700 Corporate Drive, Suite 350Pittsburgh, PA 15237-5829Phone: (412) 635-9210E-mail: [email protected]

CONTACT INFORMATION

EmergingWealth Investment5700 Corporate Drive, Suite 360Pittsburgh, PA 15237-5829Phone: (412) 548-1386

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