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Am I tax diversified?

Am I tax diversified?

Posted on 12/01/2014

Am I tax diversified?

Guest Columnist, Nagendra Singh, EA

 A popular segment on Jim Cramer’s television show Mad Money is “Am I diversified?” An audience member calls in with their five stocks and Jim gives them the thumbs up or thumbs down regarding their portfolio diversification. Known as the only free lunch in the [investment] business, the goal of portfolio diversification is to mitigate our financial loss when a market downturn occurs.

 Is that the only risk we can diversify away? How else do we lose money made on our investments? Last year, capital gains rates rose and a new net investment income tax was implemented. There are now more ways than ever before to lose your investment gains to the tax man. Can some tax diversification mitigate our tax loss to Uncle Sam every April 15th? I think so.

 The plan is to pair up our least tax-efficient investments with the best tax advantage investment accounts: 

  • In my non-qualified accounts where I pay tax every year as I go, I hold
    • master limited partnerships where the payout is generally a non-taxable return of basis
    • individual municipal bonds that pay out tax-free interest
    • municipal bond funds for the same tax-free interest
    • individual growth stocks which generally pay no dividends

It is true that when I sell any of these investments, there will be a capital gains tax to pay but thankfully that is at a lower fixed capital gains rate. 

  • In my qualified accounts where the tax is deferred until I retire, I hold
    • corporate bonds (individually and through mutual funds) which consistently pay out interest that would normally be taxed at the highest interest rate
    • dividend paying stocks (individually and through mutual funds) where the dividends may qualify for a lower fixed tax rate or may not qualify and

 Your biggest concern may not be market downturns, when you consider the top federal tax rate on investment income is now 43.4%. In the non-qualified account I outlined above, the top tax rate would be only 23.8%. That 19.6% savings achieved from proper tax diversification is now the second free lunch.

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