Basics of Financial Investing – Part 3

Tax-Sheltered Accounts

You may not have thought about it this way, but you have an (uninvited) investment partner. This partner demands a share of all your winnings but refuses to cover more than a very small part of your losses. Your uninvited partner is, of course, the tax man. You are allowed to keep only that part of your portfolio’s return that is left over after your taxes have been paid. The tax man insists on taking his cut whether you like it or not.

You may be surprised to realize just how much of your investment income goes out the door in the form of taxes. An important part of your investment education involves understanding the impact of taxes on your gross investment income and thus the portion of your investment income that you are permitted to keep. Having such an understanding enhances your ability to assess the advantages of those types investments that allow you to shelter part or all of your investment income from tax liability. Such an understanding also enhances your ability to analyze the trade-offs between fully taxed and tax-sheltered investment income as it applies to your own particular situation. The higher your taxable income, the higher your income tax rate (tax bracket). The higher your tax rate, the more important tax considerations become to your investment decision-making.

Calculate your marginal tax rate so that you can accurately assess the impact of taxes on your investment income.

Clearly the taxes that you pay on your investment income have an adverse effect on your return. To understand how much taxes reduce the return on your investments, you need to understand the difference between your marginal and average tax rates. Your average tax rate is rather easy to calculate and easy to understand. If, for example, you pay $12,000 in income and Social Security taxes on an income of $60,000, your average tax rate is 20 percent ($12,000/$60,000 = .20). Thus a fifth of all that you earn goes to the government. You work all day Monday to pay your tax bill. The rest of the week, you are working for yourself. As interesting as this average tax-rate number may seem to be, it is irrelevant for most investment analysis. Your average tax is a blend of several tax rates that you pay under our progressive rate tax system. You do not actually pay the average rate on any specific piece of your income. The marginal tax rate is the rate that enters into most after-tax return calculations. Suppose you were to earn one more dollar of income. Your marginal tax rate is the part of that additional dollar of income that must be paid as taxes. Unless your investment income is a very large part of your total income, your non-investment income from wages, salary, and so on is the income level that largely determines your marginal tax rate.

If you are fortunate enough to earn a handsome income from your job, you should be able to derive a significant amount of investable funds from that income. Your high level of base income does, however, have a downside. Such an income level will place you in a relatively high tax bracket. The higher your tax bracket, the less you get to keep of any additional taxable income that you receive.

If, in addition to your salary, you derive some taxable income from your investments, that investment income becomes part of your overall or adjusted gross income. The amount of tax you must pay is largely determined by the size of your adjusted gross income. Under most circumstances, your investment income (which is a component of your adjusted gross income) can and generally should be viewed as extra income coming on top of your primary sources of income (e.g., wages, salaries, pensions, etc.). Thus your marginal or incremental tax rate is the rate that applies to your investment income.

Suppose you unexpectedly receive a sum of money that is over and above your normal income. It is extra money that you could either spend or invest. The funds might source from an unusually large tax refund, bonus from your employer, inheritance, lottery winnings, or whatever. The funds are discretionary. They are not needed to meet ordinary living expenses. If you spend this unexpected windfall, the money will be gone. If you invest these funds, you will both retain ownership of the investment asset and earn an income on it. But that investment income is very likely to be taxable. Knowing how much your tax liability would increase if you earned that extra amount of investment income would help you decide what to do with the money. This is where your marginal tax rate enters the analysis. The ratio of that extra tax liability to the extra investment income is your marginal tax rate. If, for example, you earn an additional $1,000 in interest income and your tax liability increases by $250, your marginal tax rate would be 25 percent.

To determine your marginal or incremental tax rate, you need to be able to answer the following question: If you earned an additional dollar of income, how much would your tax bill increase? You might think that the answer is easy to determine. If your income level put you in, say, the 25 percent tax bracket, the answer would seem to be 25 percent. You may well be correct, or at least approximately so.

The issue may, however, be much more complex. First, the tax code has embedded within it a series of hidden taxes. At certain income levels, allowances for exemptions and itemized deductions begin to be phased out. If applicable, these phaseouts will have the effect of increasing your marginal tax rate above the bracket rate. So, above certain income levels, an extra dollar of income has the effect of increasing your taxable income by more than a dollar because it reduces the amount that you can subtract from your adjusted gross income to arrive at your taxable income. In addition, several deductions come into play only to the extent that their amount exceeds a percentage of your income (e.g., medical expenses, miscellaneous deductions). As your income level rises, this threshold rises with it. The effect of earning additional income may be to lower the amount of any deductions that you might otherwise be able to use to reduce that portion of your income that is taxable.

If, for example, an extra dollar of income increases your taxable income by $1.10 and you are in the 25 percent tax bracket, the increase in your tax liability is 27.5¢ (1.1 x 25 = .275), or 27.5 percent of your additional income. Also, for an increasing number of taxpayers, the alternative minimum tax (AMT) may be triggered by the receipt of additional income of one type or another. If applicable, this AMT can increase your marginal tax rate substantially. Finally, you should not neglect the impact of state and local taxes. They can add 5 to 15 percent to the earner’s marginal tax rate. The marginal tax rate that you calculate for yourself needs to take all of these factors (phaseouts, AMT, state and local taxes) into account.

Note, however, that your marginal tax rate will always be less than 100 percent. Even with all the bells and whistles of the federal tax system and the impacts of state and local taxes, you will still be allowed to keep at least a portion of any of the extra income that you earn. Some people mistakenly believe that if they were to earn a bit more, the extra income would put them into a higher tax bracket, thereby causing them to pay more in additional taxes than they would earn in extra income. This perverse result cannot occur. Even when earning an extra dollar puts you into a higher tax bracket, you pay that higher rate only on the last increment of income. The tax code is structured such that your first increment of taxable income is taxed at the lowest statutory rate. Then you move on to the next lowest bracket for the next level of income, and so on with higher levels of income. When your income places you in a higher tax bracket, only the income above the threshold that defines the beginning of that bracket is taxed at the higher rate. Suppose, for example, that your current level of income places you at the top of the 25 percent tax bracket and then you earn an extra $1,000. If your additional income pushes you into the 28 percent tax bracket on the last $1,000 of income, you would pay $280 in tax on that amount. The rest of your income would be taxed at lower rates.

You can compute your marginal tax rate in either of two basic ways. One approach starts by ascertaining your tax position to see if any hidden taxes apply. You would then take account of the impact of each of these provisions and add it to the basic tax rate. You would also determine if the AMT applied and what the impact was for state and local taxes (including an assessment of the deduction that such tax payments may allow on your federal taxes, if you itemize).

The second and far easier way to determine your marginal tax rate is to input your tax information into one of the computerized tax software programs such as TurboTax. You would then add a hypothetical dollar to your taxable income and determine the impact. If, for example, a dollar of additional income would increase your tax liability by 35 cents, your corresponding marginal tax rate is 35 percent. Having a marginal tax rate of 35 percent would mean that you are allowed to keep only 65 cents of each additional dollar of fully taxable income. You would need to utilize the computerized tax software for both the federal and any applicable state and local income taxes to determine your overall marginal rate.

All of this may seem more complicated than necessary. You can take a shortcut under certain circumstances. If your income is below the level where the hidden taxes emerge (currently around $150,000 if you are married filing jointly) and if you do not qualify for the alternative minimum tax (check your last tax return to see if you had to pay the AMT taxes), then you can probably just take the federal and state brackets in which your income level places you and add them together. If you itemize your deductions (rather than taking the standard deduction), you would be able to reduce the net cost to you of your federal income tax by the tax benefit of the state income tax deduction. So, if your federal rate was 25 percent and your state rate was 6 percent, you would reduce the 6 percent by one-fourth and add the result to your federal rate. In this case, your marginal tax rate would be 25 percent plus three-fourths of 6 percent, or 4.5 percent. The total becomes 29.5 percent. That would mean that not quite 30 percent of every extra dollar earned on your investments goes out in the form of taxes. That is, if the investment income is in the form of ordinary income, you must pay a tax equal to about 30 percent of that investment income. So, for example, an investment that produced a fully taxable 10 percent return before tax would yield 7 percent (.7×10% = 7%) after tax.

The accompanying table will provide you with some guidance in determining the level of your marginal tax rate. You simply estimate your taxable income (look at your most recent tax return and adjust the income number if necessary) and find the place where that income falls in the table. Note, however, that these are the rates for taxpayers who are married filing jointly (separate tables apply for different filing statuses) and ignores all the bells and whistles (ATM, phaseouts of exemptions and deductions, state and local taxes). Moreover, the IRS adjusts these threshold levels each year in order to offset the impact of inflation. So in subsequent years the dividing lines for each bracket will be increased as the price level rises.

Realize that not all investment income is fully taxed. Invest accordingly. Investment income in the form of interest, rent, royalties, and short-term capital gains (and some dividends) is fully taxed at the investor’s marginal tax rate. Long-term capital gains (realized) and most dividends are subject to special tax treatment that limits the rate to no more than 15 percent. The interest income on municipal bonds is tax-free (with very few exceptions). Unrealized capital gains are not subject to tax as long as the gains remain unrealized. Thus, depending upon the income source, your after-tax investment income may be equal to either 100 percent, 85 percent, or (1-MTR) percent of your before-tax investment income (where MTR = the marginal tax rate that applies to your ordinary income). If, for example, your marginal tax rate is 35 percent, an investment offering a 10 percent before-tax return would produce a 10 percent after-tax return if tax-free, 8.5 percent if taxed at 15 percent, and only a 6.5 percent after-tax return if fully taxed. Clearly, taxes can have a major impact on (after-tax) returns.

Tax Rates for Married Filing Jointly

Taxable Income Rate
0–$14,600 10%
$14,601–$59,400 15%
$59,401–$119,950 25%
$119,951–$182,800 28%
$182,801–$326,450 33%
over $326,450 35%

Utilize retirement and related accounts in order to shelter as much income as you are allowed to shelter.

A number of different government-authorized programs (e.g., IRA, Keogh, 410Ks, ESOP) allow investors to put tax-sheltered income into a qualified retirement savings account. In particular, employer pension plans, 401Ks, ESOPs, regular IRA accounts, and Keogh accounts all allow the participant to contribute a percentage of his or her income, up to some maximum overall dollar amount, into a qualifying tax-sheltered account. Both the contributions that are set aside, and any income earned on those contributions, are sheltered from current federal income tax liability. No tax is due on either the income used to fund the payment or any investment income earned on the account until the funds begin to be withdrawn from the account (as retirement income). Funds may be withdrawn (without a penalty tax) beginning at age 591⁄2 and must begin to be withdrawn by age 701⁄2. Such withdrawals will be taxed as ordinary income.

These retirement tax shelters allow a substantial tax liability to be put off, possibly for many years. As a result, you are able to earn a compounding return on an appreciably larger sum of money than would be available if only after-tax dollars were available to be invested.

To see just how advantageous these retirement tax shelters can be, consider the following illustration: Suppose that you are in the 35 percent tax bracket and put $10,000 a year into a tax-sheltered retirement plan. In the first year your $10,000 contribution would reduce your tax liability by $3,500 (.35 x $10,000). Any return earned on the money put aside is also tax-sheltered. If you earn 10 percent on the money, your initial $10,000 contribution will return $1,000 in its first year. Thus your total tax savings in the first year is $3,500 on that year’s $10,000 contribution. Assuming the investment income is otherwise fully taxable, you would also save $350 in taxes on your investment income. The total tax savings in the first year would come to $3,850 ($3,500 + $350 = $3,850). In the second year, your tax savings would again be $3,500 on the second $10,000 contribution, but an additional $735 on your investment income (35% of 10% of $21,000), for a total tax savings of $4,235. In the third year, your account grows to $33,100 and the tax savings is again $3,500 on that year’s $10,000 contribution, and now saves about $1,160 in taxes on that year’s investment income. So by the third year, the tax savings would offset almost half ($3,500 + $1,160 = $4,660) of the amount put aside. Again we see the impact of compounding, this time coupled with the addition of a tax shelter. Continue the calculation for a few more years and the annual tax savings will approach, and eventually more than offset, the amount being put aside. Indeed, by the eleventh year you would have accumulated more than $173,000, and all but $64 of that year’s contributions would be offset by tax savings.

Bear in mind that the tax savings from such tax shelters is only a deferral. All of the money accumulated in the account will be subject to taxation at ordinary income tax rates when it is withdrawn. Moreover, this calculation assumes a 35 percent tax rate on all investment income and a 10 percent fully taxable return on all monies invested. These assumptions are rather aggressive. Results would vary for other assumptions. Still the basic point is valid. Over time, a tax-sheltered account will tend to shelter a higher and higher percentage of the annual contribution. Follow the program for long enough, and the annual tax savings (deferral) will more than offset the annual contribution.

Each type of retirement program has differing requirements for eligibility and maximum annual contributions. Qualified company plans are made available at the option of the employer. The plans may or may not require an employee contribution and may or may not allow for additional employee contributions beyond the minimum. Employees who have the resources should take full advantage of the tax shelter provided by their employer’s retirement plan. To do so, they should put the maximum allowed amount into these plans.

Individual retirement accounts (IRAs) are designed to encourage retirement savings by employees having modest levels of earned income, particularly those whose employer does not provide their employees with a pension plan. Employees with higher income levels and their own company-sponsored plans do not qualify for an IRA.

Unlike the aforementioned plans, the so-called Roth IRA requires contributions of after-tax dollars, but imposes no tax liability on retirement money that is withdrawn from the plan. All of the other tax-sheltered plans provide a tax shelter for income going in to fund the plan. The Roth IRA plans shelter money coming out. As with the regular IRA, the Roth IRA is available only to those having modest income levels or no available employer plan. Anyone who earns self-employment income can set up a Keogh plan. If you are also an employee covered by your employer’s pension plan, you are still eligible to contribute to a Keogh on any self-employment income that you earn. Unlike IRAs, eligibility for Keoghs is not limited by one’s income level. You can set up and contribute to a Keogh account no matter how high your income, just as long as some of your income is derived from self-employment sources.

After-Tax Cost of Contributions To a Retirement Account

Year Beginning Portfolio Value Yearly Contribution Investment Income Ending Value Tax Savings Net After-Tax Cost
1 $0 $10,000 $1,000 $11,000 $3,850 $6,150
2 $11,000 $10,000 $2,100 $23,100 $4,235 $5,765
3 $23,100 $10,000 $3,310 $36,410 $4,660 $5,340
4 $36,410 $10,000 $4,641 $51,051 $5,124 $4,876
5 $51,051 $10,000 $6,105 $67,156 $5,637 $4,363
6 $67,156 $10,000 $7,716 $84,872 $6,207 $3,799
7 $84,872 $10,000 $8,487 $103,750 $6,470 $3,530
8 $103,750 $10,000 $11,325 $124,579 $7,463 $2,537
9 $124,579 $10,000 $13,458 $148,037 $8,210 $1,790
10 $148,037 $10,000 $15,804 $173,841 $9,031 $969
11 $173,841 $10,000 $18,384 $202,225 $9,934 $64

Non–company sponsored plans, including Keoghs and both regular and Roth IRAs, must be carefully set up according to rather complex sets of government-established rules. Almost all such accounts are organized under a master plan established by a financial institution such as a bank, brokerage firm, or insurance company. The funds deposited in one of these institution-sponsored master plans may be invested in a variety of ways. Some plans allow the individual to manage the money directly. Others provide a menu of options such as several types of stock, bond, and money market funds. Maintain a diversified retirement account. Don’t let the value of the investments in any single stock, particularly your employer’s stock, dominate your portfolio.

Those retirement/investment plans that encourage you to purchase your employer’s stock (e.g., ESOPs) can place a large part of or even all your investment portfolio at serious risk. While seeking the advantages of a tax shelter, you should not lose sight of the importance of diversification. If your employer fails (e.g., Enron, WorldCom, UAL, Kmart, Adelphia, etc.), your job is very likely to be put at risk. In addition to losing your job, you could lose all of the money that you had invested in the company’s stock. Accordingly, you should limit your investment in any one company to a relatively modest percentage of your total net worth (e.g., no more than 10%).

Allocate investments whose income is heavily taxed (e.g., bonds) to retirement accounts, while investments whose income that is taxed at lower rates (e.g., stocks) should be allocated to non-retirement accounts. One caveat regarding these various types of retirement accounts: the tax reduction act of 2003 reduced the maximum tax rate on long-term capital gains and qualifying dividends to 15 percent. The tax rate is even lower for those in very low tax brackets. To qualify for the 15 percent rate on dividends, the income that funded the payment must be subject to the corporate income tax. The maximum statutory tax on ordinary income tops out at 35 percent. The effective top rate is somewhat higher as a result of the impact of hidden taxes. Accordingly, funds withdrawn from a retirement account (except for the Roth IRA) may be subject to a relatively high tax rate (your MTR). Investment income in the form of long-term capital gains and qualifying dividends, in contrast, is subject to the relatively low 15 percent rate, and even lower in some cases. Therefore, under some circumstances, particularly when one is already close to retirement, the tax-deferral advantage of having the income sheltered in a retirement account may be rather modest. One effective way to deal with this situation is to hold investments whose income is subject to high tax rates anyway (e.g., corporate and U.S. government bonds) in your retirement accounts while maintaining non-retirement accounts for more tax-advantaged types of income (e.g., municipal bonds, whose interest income is tax-free, and stocks whose income is in the form of dividends and capital gains).

Never let tax considerations override sound investment decisions.

Sheltering income from taxes is financially advantageous, as is postponing tax payments. But, you should never lose sight of your underlying investment objective: to maximize after-tax return while avoiding undue risk. A poorly performing investment that lowers your tax bill is still a poorly performing investment.

Managing your investment portfolio in ways that will reduce your tax liability is easy. Lose money on an investment and you will probably lower your tax liability in the process. If you are in a very high tax bracket, every dollar you lose may be able to save you as much as $0.50 in federal and state income taxes (the maximum amount in investment losses that you can deduct from ordinary income is $3,000 per year). But losing a dollar to save fifty cents in taxes still loses you a net of fifty cents. You would have been much better off if you had put the money in a safe deposit box, made a 0.0 percent return, and not saved anything in taxes. Better still, if you had made a modest positive return of, say, 6 percent and had to pay half of it in taxes, you still would have a positive after-tax return of at least 3 percent. So, whenever you look for tax savings, make sure that the end result is an attractive expected after-tax return. Many investments that are touted for their tax advantages are, in fact, very poor investments. Don’t let the alleged tax advantages of an investment blind you to the overall picture. An attractive fully-taxed return is almost always higher than an unattractive tax-sheltered return.

Do not contribute funds to a tax-sheltered plan that you may need to extract prior to the point of allowed withdrawals.

While some emergency exemptions exist, most tax-sheltered plans do not allow penalty-free withdrawals until the owner reaches a specified minimum age. For IRAs and Keoghs, the minimum age to begin withdrawals without incurring a tax penalty is 591⁄2. You must begin your withdrawal program by age 701⁄2.

If you absolutely must withdraw funds from a retirement account prior to reaching the allowed age for withdrawals, you will be assessed a 10 percent penalty tax (unless the withdrawal qualifies under one of the allowed emergency exceptions). Thus, in addition to the regular tax liability that is incurred on funds withdrawn from a retirement account, another 10 percent penalty tax is assessed. If you end up having to withdraw funds and pay a penalty, you almost certainly would have been better off not to have put the money into the account in the first place.

Certain types of assets cannot be purchased or held in a retirement account. If you want to invest in such assets, retain a portfolio of investments outside of your retirement accounts.

While most types of investments, including stocks, bonds, and mutual funds, can be held in a retirement account, several other types of investments and investment strategies are not allowed. For example, collectibles, futures contracts, options, and mortgaged real estate are not permitted in most types of retirement accounts. Similarly, the use of margin leverage and short selling are not generally permitted to take place in retirement accounts.

So, if you want to buy any of the types of assets or undertake any of the types of transactions that are prohibited in a retirement account, you will need to have sufficient funds to do so in a non-retirement account. It is, of course, perfectly okay to have both a retirement account (or even a set of different retirement accounts) and to have a fully taxed non-retirement account in which you do things that you cannot do with retirement funds.

Variable annuities also offer some modest tax benefits. Utilize these annuities, however, only once you have taken maximum advantage of tax-sheltered retirement accounts.

Variable annuities, which are sold by insurance companies, also provide a degree of tax-sheltering. Like mutual and closed-end funds, variable annuities pool resources from a large group of investors into a common portfolio. The net performance of the annuity portfolio is then attributed to the annuity holder's pro rata to their share of ownership. Unlike the other types of funds (e.g., mutual funds), the realized return earned by a variable annuity is not paid out to the holders each year. All of the annuity’s income is reinvested in the annuity itself. Also, unlike other types of funds, that internal return on the annuity is not subject to tax on an annual basis. Rather than having to use a portion of the investment’s return to pay taxes, the total investment income is available for reinvestment. As a result, all of the investment income is compounded. The income from an annuity becomes taxable only when the funds are withdrawn. While this deferral-of-income-tax-on-earnings feature makes annuities somewhat attractive on a tax basis, variable annuities do not either allow contributions into the account with before-tax dollars, as is the case for most other types of retirement accounts, or, as is the case with Roth IRAs, allow tax-free withdrawals. Accordingly, these other types of savings vehicles tend to be much more tax efficient than are variable annuities, which shelter only the income on earnings but not the contributions themselves.

As a general rule, you should first contribute the maximum amount allowed to fully tax-sheltered accounts. Only if you still have additional funds available to invest should you consider moving on to something like a variable annuity. The tax advantages of variable annuities are small compared to those of fully tax-sheltered accounts. Moreover, the net return on the variable annuity is reduced by a couple of factors. First, you must purchase some life insurance protection as part of the product in your annuity account. Second, as with a load mutual fund, the annuity’s sales force and portfolio managers will take out their sales and management fees. As a result, the net return to you will be appreciably less than the gross return on the fund’s investments.

Be very wary of limited partnership tax shelters.

Financial promoters assemble and market a variety of types of investment vehicles in the form of limited partnerships (LPs). Limited partnerships, like corporations, restrict the investor’s exposure to the amount invested. If a corporation or an LP goes bankrupt, the creditors are not able to seek recovery of their losses from the business’s shareholders or limited partners. Unlike corporations, however, LPs are not subject to the corporate income tax.

Corporations must pay taxes on their profits, and their shareholders are taxed on their dividends and capital gains. In this way the income of corporations is taxed twice. The LP’s income flows through the LP untaxed at the partnership level. That income then becomes reportable on the LP investor’s tax return. Thus the LP investor’s investment income is taxed only once.

Many of these limited partnership investments are designed to produce tax benefits under certain circumstances. An LP can be structured to accumulate untaxed value internally while producing reportable tax losses up front. Recall that you are taxed only on realized income. Unrealized income is not taxed just as long as it remains unrealized. Accordingly, such shelters undertake a strategy designed to accumulate unrealized value enhancements while recognizing expenses and losses as incurred. On paper, the LP is throwing off losses that the LP owners may be able to use to reduce their tax liabilities. Thus the tax liability on capital gains and other types of income that the investor has in other parts of his or her portfolio may be offset by the losses that the tax shelter reports for tax purposes. So, for example, an investor with real estate that produces rental income may be able to offset the tax liability on that income with the losses from such a shelter.

Many LP tax shelters assemble portfolios of rental real estate as their investment vehicle. Such tax shelters generally rely upon timing differences in the recognition of expenses and income to create tax benefits for their limited partners. They seek to recognize for tax reporting purposes substantial expenses early in the life of the LP while realizing very little in the form of taxable income until the LP is near its scheduled time for liquidation. By deducting accelerated depreciation, interest expense, operating expense, and amortizing the partnership setup expenses, a limited partnership that invests in real estate may be able to report a loss for tax purposes (expenses in excess of rental income) in its early years. Because many of the reported expenses are non-cash write-offs (depreciation, amortization, etc.), the partnership may still generate a positive cash flow. Nonetheless, these reported losses flow through to the tax returns of the LP investors. As the owned property appreciates, the value of that internal buildup becomes an unrealized gain. No tax is due on that gain until the point at which the property is sold. Once the property is sold, the net gain becomes taxable income to the investor but generally at the lower rate applicable to long-term capital gains. All of the above sounds attractive on paper; the scheme does, however, have a number of potential problems and drawbacks.

First, the promoters who put these deals together grab hefty selling fees from the investors’ money as it goes in. Fees will also be charged by the organizers who set up the partnership, the brokers who sell the partnership units, and the brokers who handle the purchase of the assets that are put into the partnership’s portfolio. For every dollar you invest in such a partnership, 20 percent or 30 percent, or even more, may stick to the fingers of the promoters and others in the form of fees and expenses. In other words, as little as 70 or 80 cents of each dollar put into the fund may actually be used to pay for the portfolio’s assets. A further set of fees will be incurred at the partnership’s termination. At a minimum, brokerage fees will be charged on the asset sales, and the managers are likely to collect a success fee as well. When you buy a security or mutual fund, in contrast, at least 94 percent of what you pay (load fund) goes to buy the asset and 6 percent or less (no load fund) goes to pay commissions and other sales fees.

Second, the managers of the partnership’s assets usually pay themselves generous management fees. They will charge the partnership an annual fee that is usually equal to 1 to 2 percent of the assets under management. In addition, a success fee will be assessed on the partnership’s income. The typical success fee extracts 20 percent of any gains above some threshold return (e.g., 6%). Thus we see that the promoters and managers take a hefty share of the return while placing little or none of their own money at risk. Unless the project turns out exceptionally well, these fees will reduce the investor’s return to a rather ordinary level or worse. By comparison, an actively managed mutual fund usually charges a management fee of 0.75 percent and incurs expenses of about another 0.5 percent per year for a total of about 1.25 percent. For index funds the fees and expenses are even lower, averaging about 0.5 percent annually. Moreover, mutual funds do not assess success fees.

Third, once limited partnership ownership units are purchased from the promoters, they become very difficult and costly to resell. Most such partnerships are structured to exist for a lengthy period. Ten years is a typical life for a limited partnership fund. At the termination of this pre-specified time period, the partnership’s assets are liquidated and (after paying the managers their fees) the net proceeds are distributed to the partners. The units are not meant to be trading vehicles. Those who wish to sell their units prior to the windup of the partnership will encounter a very illiquid marketplace. Ownership transfers of partnership units normally require permission from the general partner and/or the partnership group. The potential purchasers of the units almost always demand a very steep discount in order to induce them to buy into an ongoing limited partnership venture. Frequently, a discount of 50 percent from the LP manager’s estimated valuations is needed to attract a buyer. Accordingly, you should never invest in one of these LP deals unless you are confident that you can leave your invested funds with the partnership until its termination. Only at termination is the full value of the underling assets (less fees due at termination) likely to be realized.

Fourth, many partnerships are sold with forward-looking payment schedules. Each investor agrees to pay a certain amount into the LP up front and then to contribute up to a defined amount of additional capital to the partnership when called upon to do so in the future. Failure to make the additional capital contributions can result in a forfeiture of all of the money that the unit-holder had already invested in the partnership. Never invest in such an LP fund unless you are sure you will be able to make all of the forward payments as they come due.

Fifth, the tax code in place (or thought to be in place) when the partnership was set up may be changed, thereby taking away some or all of the tax benefits contemplated by the plan. Similarly, the IRS may issue new regulations that remove or reduce the contemplated tax advantages. Avoid investing in limited partnership tax shelters that seem especially aggressive in their pursuit of tax advantages.

Sixth, the use of the losses thrown off by such funds is restricted. Only certain types of gains and income can be offset by the losses of these types of partnerships. Make sure you have enough of the type of income that the fund’s projected losses can offset before you invest.

Take advantage of the 15 percent tax rate on dividends, but make sure that your dividends qualify.

The tax reduction act of 2003 lowered the maximum tax rate on dividends from the rate applied to ordinary income (up to 35 percent) to 15 percent. This 15 percent rate on dividends compares favorably with the maximum of 35 percent (or more) on most other types of income (e.g., interest income). As a result, the after-tax return on qualifying dividends is considerably closer to the before-tax return than that for bond interest (other than municipal bond interest). For example, someone in the 35 percent tax bracket would derive an after-tax return of 6.5 percent from a bond paying a 10 percent coupon. A stock with a 10 percent dividend yield would, in contrast, produce an after-tax return of 8.5 percent, a full two percentage points higher.

Drawbacks To Limited Partnership Tax Shelters

  1. High sales fees assessed by the organizer/promoter
  2. Substantial management fees including success fees charged
  3. Difficult and costly to sell prior to LP windup
  4. Forward payments must be made by the investor, if called
  5. Tax law changes could take away contemplated advantages
  6. Use of reported tax losses is severely limited

By no means do all dividends receive this favorable tax treatment. To qualify for the 15 percent rate, the corporation paying the dividend must also have paid U.S. corporate income taxes on the funds from which the dividend payments were derived. Under this provision, four sources of dividends do not qualify for the advantageous treatment. First, REITs are exempt from paying corporate income taxes as long as they distribute all of their income to their shareholders. Since REITs pay no corporate income tax, REIT investors must pay the full tax rate on their dividends. Second, most preferred shares are technically debt instruments. As debt instruments, the preferred stock issuer is allowed to deduct the dividend payments, technically interest payments, from their own taxable income. Since the preferred stock issuer does not pay taxes on the money used to make the dividend payment, the preferred shareholder must pay taxes at the higher rate that applies to ordinary income. In addition, the dividend distributions from many types of mutual funds do not qualify for the lower tax rate. For example, the dividend payment of money market and bond mutual funds, whose own income is in the form of interest payments, are taxed as ordinary income. Finally, dividends paid by foreign-based corporations that are not subject to the U.S. corporate income tax do not qualify.

Accordingly, before you purchase a stock or mutual fund for its high dividend yield, determine whether the dividend qualifies for favorable tax treatment. Dividends that qualify are worth substantially more to the recipient than those that do not.

Categories: Finance

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