Taxes are an important consideration when making investment decisions, particularly with the April 18 income tax filing deadline just a few weeks away.
President Donald Trump has said he would like to reduce individual and corporate tax rates, and Congress will also be considering a variety of tax reform proposals that could affect income, capital gains and estate taxes. Therefore, investors should pay attention to any tax decisions that might come out of Washington later this year.
In the meantime, there are several strategies to consider. If you are working for a company that offers a tax-qualified retirement plan, such as a 401(K) or a 403(b) plan, consider maximizing your contributions in 2017. Every dollar that you contribute to a plan is subtracted from your gross income. So if you are in a 25 percent tax bracket, for example, and contribute $1,000 this year, your 2017 income tax would be reduced by $250.
That’s a substantial reduction in taxable income this year, and assets can grow even more especially if your employer will match some or all of your contributions. Of course, you will eventually have to pay income tax on those funds. But typically you will withdraw them later in life when your income may be significantly lower than it is today.
If you are self-employed, you may gain a similar tax benefit from contributing to an individual retirement account (IRA) or a SEP-IRA. In any case, you should talk with your accountant or financial advisor about how to set aside money for retirement, while reducing your 2017 income tax obligations. In addition, you may still be able to make 2016 contributions to your retirement account, allowing you to make a smaller income tax payment to the U.S. Treasury on April 18.
Investing in municipal bonds is another strategy that can be fruitful for individuals in a high-rate tax bracket. Because the federal government wants to encourage investments in city, county and state projects, the interest paid by these “munis” is usually tax-free for investors. However, some bonds may be subject to the alternative minimum tax (AMT), but these bonds are clearly marked as such. Municipal bonds generate a steady income stream without the dramatic ups and downs of the stock market, assuming you hold them until maturity.
A financial advisor can help you compare municipal bonds with other types of taxable fixed-income investments, such as corporate or sovereign bonds. For instance, a muni with a 2.5 percent tax-free return might provide more after-tax income than a corporate bond with 3.5 percent taxable return.
If you sell stocks that have increased in value during 2017, you probably will be subject to a capital gains tax. Even though these rates are lower than personal income tax rates, you should talk with your advisor about the most appropriate ways to handle capital gains before you decide to sell. Depending on your holdings, it might make sense to sell two shares in stocks — one that has gone up in value and one that has gone down — in order to balance those tax gains and losses.
Real estate is another investment sector where tax considerations come into play. If you finance the purchase of an income-producing property, such as an apartment building, shopping center, office or warehouse, the loan payments are typically treated as business expenses. Maintenance, insurance, repairs and improvements to the property are also subtracted from the property’s annual income, reducing your tax liability. In addition, you may be able to depreciate the value of the building, furnishings and equipment, further reducing your tax liability.
Of course, taxes are only one of the many considerations that go into constructing a diversified investment portfolio. To take just one example, a municipal bond from a local government that is struggling to pay its bills may have a higher risk of default, than a taxable bond from a blue-chip Fortune 500 company.
As you look ahead to the coming months, stay focused on your personal goals, understand your risk tolerance, and consider the tax consequences of your investment decisions. Most importantly, talk with your advisor about constructing a diversified asset portfolio that can reduce many types of risk for your “nest egg,” while supporting your financial goals.
Andrew Menachem, CIMA, is a Wealth Adviser at the Menachem Wealth Management Group at Morgan Stanley in Aventura. This column appeared in Business Monday of the Miami Herald. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors. Follow Menachem on Twitter @AMenachemMS