What does your tax-inefficient portfolio really cost you?

The majority of investors are still in a very favorable tax environment for long term capital gains. Until January 2013, all investors faced the lowest capital gains rate in the post-war period at 15%.

Today, investors in the top tax bracket (married filers with income over $450,000) face a 20% capital gains rate and a 3.8% surcharge on investment income, making this an effective 23.8% federal tax rate. Most other individual taxpayers still pay at the 15% rate (although those with significant investment income may be subject to the 3.8% surcharge as well).  Even with this increase, rates are lower than they have been for most of the last 50 years.

However it would be naive to assume that these tax rates, either the 15% or the 23.8%, are the only tax costs faced by investors.  Long-term capital gains are taxed at a favorable rate (compared to ordinary income rates), but they are still included in Adjusted Gross Income (AGI). Many less obvious calculations that can create an unfavorable tax situation are based around AGI.

The tax reform passed in early 2013 to avoid the revenue side of the “fiscal cliff” included the reinstatement of the phaseout of personal exemptions and itemized deductions (also known as “PEP and Pease”), for married taxpayers with AGI over $300,000. Capital gains from an investment portfolio that push a taxpayer’s income over this $300,000 limit will end up costing much more than the 15% long term capital gain rate as tax-reducing deductions are slowly eliminated from their return.

Additionally, eligibility for traditional IRA deductions and Roth IRA contributions are affected by AGI, meaning that a tax-inefficient portfolio could prevent a taxpayer from making retirement account contributions.

Below is a short list of further preferential tax treatments that can be reduced, eliminated or phased out as a result of high AGI:

  • Child Tax Credit;
  • Education Credits (Lifetime Learning Credit and American Opportunity Credit);
  • Deductible spousal IRA contributions;
  • Education loan interest deductions;
  • Adoption Tax Credit;
  • Passive loss deduction;
  • Eligibility of itemized deductions for medical expenses (must be above 10% of AGI in 2013);
  • Dependent care credit (partial reduction);
  • Mortgage insurance premium deduction;

In summary, it is short sighted to assume that the only cost of capital gains generated from your investment portfolio is the stated capital gain rate. Investors should consider the full ramifications of a portfolio that regularly (and unnecessarily) kicks out capital gain distributions as a result of tax-inefficient mutual funds and other investments.

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