What Is the Capital Gains Tax?

Capital gains are the profits realized from the sale of capital assets such as stocks, bonds, and property. The capital gains tax is triggered only when an asset is sold, not while the asset is held by an investor. However, mutual fund investors could be charged capital gains on investments in the fund that are sold by the fund during the year.

There are two types of capital gains: long term and short term; each is subject to different tax rates. Long-term gainsare profits on assets held longer than 12 months before they are sold. The American Taxpayer Relief Act of 2012 instituted a 20% long-term capital gains tax rate for taxpayers in the 39.6% income tax bracket and extended both the 0% capital gains tax rate for individuals in the 10% and 15% tax brackets and the 15% capital gains tax rate for all other tax brackets. Short-term gains (on assets held for 12 months or less) are taxed as ordinary income at the seller’s marginal income tax rate.

The taxable amount of each gain is determined by a “cost basis” — in other words, the original purchase price adjusted for additional improvements or investments, taxes paid on dividends, certain fees, and any depreciation of the assets. In addition, any capital losses incurred in the current tax year or previous years can be used to offset taxes on current-year capital gains. Losses of up to $3,000 a year may be claimed as a tax deduction.

If you have been purchasing shares in a mutual fund over several years and want to sell some holdings, instruct your financial professional to sell shares that you purchased for the highest amount of money, because this will reduce your capital gains. Also, be sure to specify which shares you are selling so that you can take advantage of the lower rate on long-term gains. The IRS may assume that you are selling shares you have held for a shorter time and tax you using short-term rates.

Capital gains distributions for the prior year are reported to you by January 31, and any taxes that must be paid on gains are due on the date of your tax return.

Higher-income taxpayers should be aware that they may be subject to an additional 3.8% Medicare unearned income tax on net investment income (unearned income includes capital gains) if their adjusted gross income exceeds $200,000 (single filers) or $250,000 (married joint filers). This is an outcome of the Patient Protection and Affordable Care Act.

What Is the Estate Tax?

The estate tax is a tax on property that transfers to others upon your death. Estate taxes are assessed on the total value of your estate — your home, stocks, bonds, life insurance, and other assets of value — that is over the applicable exemption amount. Everything you own, whatever the form of ownership and regardless of whether the assets have been through probate, is subject to estate taxes.

Also referred to as the “death tax,” the federal estate tax was first enacted in this country with the Stamp Act of 1797 to help pay for naval rearmament. After several repeals and reinstatements, the Revenue Act of 1916 put the current estate tax into place. Despite its long history, this tax remains controversial.

Estate taxes are calculated on the net value of your estate, which includes all your assets less allowable debts, expenses, and deductions (such as mortgage debt and administrative expenses for the estate). The applicable estate tax exemption is subtracted, and the resulting taxable value is multipled by the applicable estate tax rate to determine any taxes due.

The most common exception to the federal estate tax is the unlimited marital deduction. The government exempts all transfers of wealth between a husband and wife from federal estate and gift taxes, regardless of the size of the estate.(The surviving spouse must be a U.S. citizen to qualify for this exemption.) However, when the surviving spouse dies, the estate is subject to estate taxes and, unless the appropriate portability preparations have been made, only the surviving spouse’s applicable exemption can be used.

The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually increased the federal estate tax exemption until finally repealing the federal estate tax altogether for the 2010 tax year only. The 2010 Tax Relief Act reinstated the federal estate tax with a $5 million exemption (indexed for inflation after 2011) through December 31, 2012. The  2010 estate tax provisions were made permanent by the American Taxpayer Relief Act of 2012, although the top federal estate tax rate was raised to 40%. The applicable exemption amount in 2014 is $5.34 million.

Check with your tax advisor to be sure that your estate is protected as much as possible from estate taxes upon your death.

* Executors for estates of decedents who died in 2010 had the option of electing to use the 35% rate, $5 million exemption, and “stepped up” basis of inherited assets for income tax purposes or zero estate tax liability with “carry over” basis of inherited assets for income tax purposes.

What Is the Gift Tax?

The federal gift tax applies to gifts of property or money while the donor is living. The federal estate tax, on the other hand, applies to property conveyed to others (with the exception of a spouse) after a person’s death.

The gift tax applies only to the donor. The recipient is under no obligation to pay the gift tax, although other taxes, such as income tax, may apply. The federal estate tax affects the estate of the deceased and can reduce the amount available to heirs.

In theory, any gift is taxable, but there are several notable exceptions. For example, gifts of tuition or medical expenses that you pay directly to a medical or educational institution for someone else are not considered taxable. Gifts to a spouse who is a U.S. citizen, gifts to a qualified charitable organization, and gifts to a political organization are also not subject to the gift tax.

You are not required to file a gift tax return unless any single gift exceeds the annual gift tax exclusion for that calendar year. The exclusion amount ($14,000 in 2014) is indexed annually for inflation. A separate exclusion is applied for each recipient. In addition, gifts from spouses are treated separately; so together, each spouse can gift an amount up to the annual exclusion amount to the same person.

Gift taxes are determined by calculating the tax on all gifts made during the tax year that exceed the annual exclusion amount, and then adding that amount to all the gift taxes from gifts above the exclusion limit from previous years. This number is then applied toward an individual’s lifetime applicable exclusion amount. If the cumulative sum exceeds the lifetime exclusion, you may owe gift taxes.

The 2010 Tax Relief Act reunified the estate and gift tax exclusions at $5 million (indexed for inflation), and the American Taxpayer Relief Act of 2012 made the higher exemption amount permanent while increasing the estate and gift tax rate to 40% (up from 35% in 2012). Because of inflation, the estate and gift tax exemption is $5.34 million in 2014. This enables individuals to make lifetime gifts up to $5.34 million in 2014 before the gift tax is imposed.

How Much Money Can I Put into My IRA or Employer-Sponsored Retirement Plan?

IRAs and employer-sponsored retirement plans are subject to annual contribution limits set by the federal government. The limits are periodically adjusted to compensate for inflation and increases in the cost of living.

IRAs
For the 2014 tax year, you can contribute up to $5,500 to all IRAs combined (the limit will be adjusted annually for inflation). If you have a traditional IRA as well as a Roth IRA, you can only contribute a total of the annual limit in one year, not the annual limit to each.

If you are age 50 or older, you can also make a $1,000 annual “catch-up” contribution.

Employer-Sponsored Retirement Plans
Employer-sponsored retirement plans such as 401(k)s and 403(b)s have a $17,500 contribution limit in 2014; individuals aged 50 and older can contribute an extra $5,500 each year as a catch-up contribution.

If you are currently contributing to an IRA or an employer-sponsored retirement plan, it may be wise to check the contribution limit each year in order to put aside as much as possible.

Distributions from traditional IRAs and most employer-sponsored retirement plans are taxed as ordinary income and may be subject to an additional 10% federal income tax penalty if taken prior to reaching age 59½. If you participate in both a traditional IRA and an employer-sponsored plan, your IRA contributions may or may not be tax deductible, depending on your adjusted gross income.

What Is a Required Minimum Distribution?

A required minimum distribution (RMD) is the annual amount that must be withdrawn from a traditional IRA or a qualified retirement plan (such as a 401(k), 403(b), and self-employed plans) after the account owner reaches the age of 70½. The last date allowed for the first withdrawal is April 1 following the year in which the owner reaches age 70½. Some employer plans may allow still-employed account owners to delay distributions until they stop working, even if they are older than 70½. RMDs are designed to ensure that owners of tax-deferred retirement accounts do not defer taxes on their retirement accounts indefinitely.

You are allowed to begin taking penalty-free distributions from tax-deferred retirement accounts after age 59½, but youmust begin taking them after reaching age 70½. If you delay your first distribution to April 1 following the year in which you turn 70½, you must take another distribution for that year. Annual RMDs must be taken each subsequent year no later than December 31.

The RMD amount depends on your age, the value of the account(s), and your life expectancy. You can use the IRS Uniform Lifetime Table (or the Joint and Last Survivor Table, in certain circumstances) to determine your life expectancy. To calculate your RMD, divide the value of your account balance at the end of the previous year by the number of years you’re expected to live, based on the numbers in the IRS table. You must calculate RMDs for each account that you own. If you do not take RMDs, then you may be subject to a 50% federal income tax penalty on the amount that should have been withdrawn.

Remember that distributions from tax-deferred retirement plans are subject to ordinary income tax.

Waiting until the April 1 deadline in the year after reaching age 70½ is a one-time option and requires that you take two RMDs in the same tax year. If these distributions are large, this method could push you into a higher tax bracket. It may be wise to plan ahead for RMDs to determine the best time to begin taking them.

What Are the Tax Benefits of Charitable Trusts?

Americans give freely to support the causes they value, from churches, education, and the arts to medical research. Fortunately, current tax laws encourage and even reward philanthropy. Beyond the basic tax deductions for charitable giving, setting up one or both of the following types of trusts could provide financial advantages in addition to the personal satisfaction that comes from giving.

Charitable Remainder Trust
When money, securities, property, or other assets are placed in a properly structured charitable remainder trust, the grantor or the grantor’s beneficiaries receive payment of a specified amount at least annually. When the trust expires, the designated charity receives the assets that remain.

For the grantor, there are a few potential tax benefits: (1) Assets placed in the trust may qualify for an income tax deduction on the estimated present value of the remainder interest that will eventually go to charity. (2) At death, trust assets are not subject to estate taxes because they are no longer part of the grantor’s taxable estate. (3) Any appreciated assets in the trust are also exempt from current capital gains tax.

Charitable Lead Trust
A charitable lead trust is an estate conservation tool that uses the grantor’s assets to provide income to a charity. At the end of the trust period, the remaining assets are paid to the grantor or the grantor’s beneficiaries. This type of trust could potentially reduce the estate tax due upon death, most notably on highly appreciated assets, because they are not subject to current capital gains tax.

Keep in mind that donations to both types of charitable trusts are irrevocable. This means that the assets cannot be withdrawn once the trust is formed. Also bear in mind that not all charitable organizations are able to use all possible gifts. It is prudent to check first. The type of organization selected can also affect the tax benefits that may be received.

When structured properly, these tools could possibly be used to benefit the charities of your choice and also help to reduce your tax obligations at the same time.

The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of an experienced estate planning professional and your legal and tax advisors before implementing such strategies. Trusts incur upfront costs and ongoing administrative fees.

When Must Taxes Be Paid on IRA and Employer-Sponsored Retirement Funds?

Traditional IRAs and most employer-sponsored retirement plans are tax-deferred accounts, which means they are typically funded with pre-tax or tax-deductible dollars. As a result, taxes are not payable until funds are withdrawn, generally in retirement.

Withdrawals from tax-deferred accounts are subject to income tax at your current tax rate. In addition, withdrawals taken prior to age 59½ may be subject to a 10% federal income tax penalty.

If you made nondeductible contributions to a traditional IRA, you have what is called a “cost basis” in the IRA. Your cost basis is the total of the nondeductible contributions to the IRA minus any previous withdrawals or distributions of nondeductible contributions. The recovery of this basis is not seen as taxable income.

Exceptions are the Roth IRA and the Roth 401(k) and Roth 403(b). Roth accounts are funded with after-tax dollars; thus, qualified distributions (after age 59½ and the five-year holding requirement has been met) are free of federal income tax.

Traditional IRAs, most employer-sponsored retirement plans, and Roth 401(k) and 403(b) plans are subject to annual required minimum distributions (RMDs) that must begin after the account owner reaches age 70½. (The first RMD must be taken no later than April 1 of the year after the year in which the owner reaches age 70½.) Failure to take an RMD triggers a 50% federal income tax penalty on the amount that should have been withdrawn. Roth IRA owners never have to take RMDs; however, the designated beneficiaries of IRAs and employer-sponsored retirement plans do have to take RMDs.

When you begin taking distributions from your retirement accounts, make sure to pay attention to any required beginning dates and the appropriate distribution amount in order to avoid unnecessary penalties.

What Happens If I Withdraw Money from My Tax-Deferred Investments Before Age 59½?

Withdrawing funds from a tax-deferred retirement account before age 59½ generally triggers a 10% federal income tax penalty; all distributions are subject to ordinary income tax. However, there are certain situations in which you are allowed to make early withdrawals from a retirement account and avoid the tax penalty.

IRAs and employer-sponsored retirement plans have different exceptions, although the regulations are similar.

IRA Exceptions

• The death of the IRA owner. Upon your death, your designated beneficiaries may begin taking distributions from your account. Beneficiaries are subject to annual required minimum distributions.
• Disability. Under certain conditions, you may begin to withdraw funds if you are disabled.
• Unreimbursed medical expenses. You can withdraw the amount you paid for unreimbursed medical expenses that exceed 10% of your adjusted gross income in a calendar year. Individuals older than 65 can claim expenses that surpass 7.5% of adjusted gross income through 2016.
• Medical insurance. If you lost your job or are receiving unemployment benefits, you may withdraw money to pay for health insurance.
• Part of a substantially equal periodic payment (SEPP) plan. If you receive a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary, you may take payments over a period of five years or until you reach age 59½, whichever is longer, using one of three payment methods set by the government. Any change in the payment schedule after you begin distributions may subject you to paying the 10% tax penalty.
• Qualified higher-education expenses for you and/or your dependents.
• First home purchase, up to $10,000 (lifetime limit).

Employer-Sponsored Plan Exceptions

• The death of the plan owner. Upon your death, your designated beneficiaries may begin taking distributions from your account. Beneficiaries are subject to annual required minimum distributions.
• Disability. Under certain conditions, you may begin to withdraw funds if you are disabled.
• Part of a SEPP program (see above). If you receive a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary, you may take payments over a period of five years or until you reach age 59½, whichever is longer.
• Separation of service from your employer. Payments must be made annually over your life expectancy or the joint life expectancies of you and your beneficiary.
• Attainment of age 55. The payment is made to you upon separation of service from your employer and the separation occurred during or after the calendar year in which you reached the age of 55.
• Qualified Domestic Relations Order (QDRO). The payment is made to an alternate payee under a QDRO.
• Medical care. You can withdraw the amount allowable as a medical expense deduction.
• To reduce excess contributions. Withdrawals can be made if you or your employer made contributions over the allowable amount.
• To reduce excess elective deferrals. Withdrawals can be made if you elected to defer an amount over the allowable limit.

If you plan to withdraw funds from a tax-deferred account, make sure to carefully examine the rules on exemptions for early withdrawals. For more information on situations that are exempt from the early-withdrawal income tax penalty, visit the IRS website at www.irs.gov.

What Is Tax Deferral?

“Tax deferral” is a method of postponing the payment of income tax on currently earned investment income until the investor withdraws funds from the account. Tax deferral is encouraged by the government to stimulate long-term saving and investment, especially for retirement.

Only investment vehicles designated as “tax deferred,” such as IRAs, plans covering self-employed persons, and 401(k)s, allow taxes to be deferred. In addition, many insurance-related vehicles, such as deferred annuities and certain life insurance contracts, provide tax-deferred benefits.

There is a substantial benefit to deferring taxes as long as possible, because this allows the entire principal and any accumulated earnings to compound tax deferred. The compounding effect can be dramatic over an extended period of time and can make a big difference in the accumulation of a retirement nest egg.

Additionally, investments in tax-deferred vehicles are often made when you are earning a higher income and subject to a higher tax rate. When you reach retirement and begin taking distributions from your tax-deferred accounts, it is possible that your tax bracket will be lower.

One note of caution: When formulating your tax plan, recognize that all withdrawals from tax-deferred plans are taxed as ordinary income. Early withdrawals (prior to age 59½) may be subject to a 10% federal income tax penalty. Once again, the government is encouraging a long-term outlook.

How Can I Benefit from Tax-Advantaged Investments?

For many people, tax-advantaged investing is an excellent way to reduce their taxes. And while many of the traditional tax-advantaged strategies have been eliminated, there are still alternatives left that can help you reduce your taxes. Some are described below.

Real Estate Partnerships
Two of the most common types of real estate partnerships are low-income housing and historic rehabilitation. The federal government grants tax credits to those who construct or rehabilitate low-income housing or who invest in the rehabilitation or preservation of historic structures.

Participating in a real estate partnership has many advantages. These partnerships may provide opportunities for tax-advantaged income and long-term capital appreciation.

The tax credits generated by these partnerships can be used to offset your income tax liability on a dollar-for-dollar basis. This can make them much more valuable than tax deductions, which help reduce your taxable income, not the tax you pay. These credits are subject to certain limitations, and the rehabilitation tax credit begins to phase out for taxpayers with adjusted gross income (AGI) greater than $200,000 ($100,000 if married filing separately) and is completely phased out when AGI reaches $250,000 ($125,000 if married filing separately).

Oil and Gas Partnerships
Energy partnerships can provide shelter through tax deductions taken at the partnership level. These include deductions for intangible drilling costs, depreciation, and depletion.

The deductions may be limited; check with a tax advisor to see whether you could benefit from oil and gas partnerships.

Suitability
There are risks associated with investing in partnerships. Key among these is that they are long-term investments with an indefinite holding period and no, or very limited, liquidity. There is typically no current market for the units/shares, and a future market may or may not be available. If a market becomes available, it may result in a deep discount from the original price. At redemption, the investor may receive back less than the original investment. The investment sponsor is responsible for carrying out the business plan, and thus the success or failure of the venture is dependent on the investment sponsor. There are no assurances that the stated investment objectives will be reached. This type of investment is considered speculative. You want to ensure that the investment is not disproportionate in relation to your overall portfolio and that it is consistent with your investment objectives and overall financial situation. In order to invest, you will need to meet specific income and net worth suitability standards, which vary by state.

These standards, along with the risks and other information concerning the partnership, are set forth in the prospectus, which can be obtained from your financial professional. Please consider the investment objectives, risks, charges, and expenses carefully before investing. Be sure to read the prospectus carefully before deciding whether to invest.

The alternative minimum tax is another concern. Make sure to consult a tax advisor to evaluate your exposure to the AMT.

As long as they are suitable for your situation, these tax-advantaged investing strategies could be used to help reduce your income tax liability. A financial professional can help you determine whether such investments would be appropriate for you.

What Tax Deductions Are Still Available to Me?

Tax reform measures are enacted frequently by Congress, which makes it hard for U.S. taxpayers to know which deductions are currently available to help lower their tax liability. In fact, a former head of the IRS once said that millions of taxpayers overpay their taxes every year because they overlook one of the many key tax deductions that are available to them.¹

One of the most overlooked deductions is state and local sales taxes.²

Taxpayers may be able to take deductions for student-loan interest, out-of-pocket charitable contributions, moving expenses to take a first job, the child care tax credit, new points on home refinancing, health insurance premiums, home mortgage interest, tax-preparation services, and contributions to a traditional IRA.

Of course, some tax deductions disappear as adjusted gross income increases. And some deductions are subject to sunset provisions, which your tax professional can help you navigate.

Another key deduction is unreimbursed medical and dental expenses.

Remember that you may only deduct medical and dental expenses to the extent that they exceed 10% of your adjusted gross income (AGI) and were not reimbursed by your insurance company or employer. Individuals older than 65 can claim qualified expenses that exceed 7.5% of AGI through 2016.

In addition to medical and dental expenses, certain miscellaneous expenses — primarily unreimbursed employee business expenses — can be written off if they exceed 2% of AGI, subject to the limitation on itemized deductions that exceed certain thresholds. Some of the expenses that qualify for this deduction are union dues, small tools, uniforms, employment agency fees, home-office expenses, tax preparation fees, safe-deposit box fees, and investment expenses. Your tax advisor will be able to tell you exactly what’s deductible for you.

The end of the year is the time to take one last good look to determine whether you qualify for a tax credit or deduction or whether you’re close to the cutoff point.

If you’re not close, you may opt to postpone incurring some medical or other expenses until the following year, when you may be able to deduct them.

On the other hand, if you’re only a little short of the threshold amount, you may want to incur additional expenses in the current tax year.

With a little preparation and some help from a qualified tax professional, you may be able to lower your income taxes this year. You just have to plan ahead.

What Tax-Advantaged Alternatives Do I Have?

A strong savings program is essential for any sound financial strategy.

We take Benjamin Franklin’s saying to heart, “A penny saved is a penny earned,” and we save our spare cash in savings accounts and certificates of deposit.

Investors who’ve accumulated an adequate cash reserve are to be commended. But as strange as it sounds, it is possible to save too much. Although this may not sound like much of a problem, it can be if you save too much of what you should be investing.

You see, many investors simply put their savings into the most convenient and stable financial instrument they can find. Often that turns out to be certificates of deposit (CDs). The benefits of CDs are that they are FDIC insured (up to $250,000 per depositor, per federally institution) and generally provide a fixed rate of return.

Unfortunately, placing all your savings in taxable instruments like certificates of deposit can create quite an income tax bill.

In an effort to help provide stability, some investors inadvertently produce a liability. It’s a bit like turning on all the taps in your house just to make certain the water is still running. Sure, you’ll know that the water is still running, but a lot of it will go down the drain. The solution is simply to turn off some of the taps.

A number of financial instruments can help you to defer or eliminate income taxes. By shifting part of your cash reserves to some of these instruments, you can keep more of your money working for you and turn off the taps that hamper your money’s growth.

You can consider a number of tax-advantaged investments for at least a portion of your savings portfolio.

One possibility is a fixed annuity contract. A fixed annuity is a retirement vehicle that can help you meet the challenges of tax planning, retirement planning, and investment planning. Fixed annuity contracts accumulate interest at a competitive rate. And the interest on an annuity contract is usually not taxable until it is withdrawn. Most annuities have surrender charges that are assessed in the early years of the contract if the owner surrenders the annuity before the insurance company has had the opportunity to recover the cost of issuing the contract. Also, annuity withdrawals made prior to age 59½ may be subject to a 10% federal income tax penalty. The guarantees of fixed annuity contracts are contingent on the claims-paying ability of the issuing insurance company.

Another tax-exempt investment vehicle is a municipal bond. Municipal bonds are issued by state and local governments and are generally free of federal income tax. In addition, they may be free of state and local taxes for investors who reside in the areas in which they are issued.

Municipal bonds can be purchased individually, through a mutual fund, or as part of a unit investment trust. You must select bonds carefully to ensure a worthwhile tax savings. Because municipal bonds tend to have lower yields than other bonds, the tax benefits tend to accrue to individuals with the highest tax burdens. If you sell a municipal bond at a profit, you could incur capital gains taxes. Some municipal bond interest could be subject to the federal alternative minimum tax. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk. Bond mutual funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.

A number of other tax-advantaged investments are available. Consult with your financial professional to determine which types of tax-advantaged investments may be appropriate for you.

What Is the Most Tax-Efficient Way to Take a Distribution from a Retirement Plan?

If you receive a distribution from a qualified retirement plan such as a 401(k), you need to consider whether to pay taxes now or to roll over the account to another tax-deferred plan. A correctly implemented rollover can avoid current taxes and allow the funds to continue accumulating tax deferred.

Paying Current Taxes with a Lump-Sum Distribution
If you decide to take a lump-sum distribution, income taxes are due on the total amount of the distribution and are due in the year in which you cash out. Employers are required to withhold 20% automatically from the check and apply it toward federal income taxes, so you will receive only 80% of your total vested value in the plan.

The advantage of a lump-sum distribution is that you can spend or invest the balance as you wish. The problem with this approach is parting with all those tax dollars. Income taxes on the total distribution are taxed at your marginal income tax rate. If the distribution is large, it could easily move you into a higher tax bracket. Distributions taken prior to age 59½ are subject to an additional 10% federal income tax penalty.

If you were born prior to 1936, there are two special options that can help reduce your tax burden on a lump sum.

The first special option, 10-year averaging, enables you to treat the distribution as if it were received in equal installments over a 10-year period. You then calculate your tax liability using the 1986 tax tables for a single filer.

The second option, capital gains tax treatment, allows you to have the pre-1974 portion of your distribution taxed at a flat rate of 20%. The balance can be taxed under 10-year averaging, if you qualify.

To qualify for either of these special options, you must have participated in the retirement plan for at least five years and you must be receiving a total distribution of your retirement account.

Note that these special tax treatments are one-time propositions for those born prior to 1936. Once you elect to use a special option, future distributions will be subject to ordinary income taxes.

Deferring Taxes with a Rollover
If you don’t qualify for the above options or don’t want to pay current taxes on your lump-sum distribution, you can roll the money into a traditional IRA.

If you choose a rollover from a tax-deferred plan to a Roth IRA, you must pay income taxes on the total amount converted in that tax year. However, future withdrawals of earnings from a Roth IRA are free of federal income tax after age 59½ as long as the account has been held for at least five tax years.

If you elect to use an IRA rollover, you can avoid potential tax and penalty problems by electing a direct trustee-to-trustee transfer; in other words, the money never passes through your hands. IRA rollovers must be completed within 60 days of the distribution to avoid current taxes and penalties.

An IRA rollover allows your retirement nest egg to continue compounding tax deferred. Remember that you must begin taking annual required minimum distributions (RMDs) from tax-deferred retirement plans after you turn 70½ (the first distribution must be taken no later than April 1 of the year after the year in which you reach age 70½). Failure to take an RMD subjects the funds that should have been withdrawn to a 50% federal income tax penalty.

Of course, there is also the possibility that you may be able to keep the funds with your former employer, if allowed by your plan.

Before you decide which method to take for distributions from a qualified retirement plan, it would be prudent to consult with a professional tax advisor.

Is There Such a Thing as a Tax-Free Investment?

The simple answer to this question is “yes.” There are two main types: (1) municipal bonds and municipal bond mutual funds and (2) tax-free money market funds.

Municipal bonds are issued by state and local governments in order to finance capital expenditures; typically, municipal bond funds invest in municipal bonds. Municipal bonds are generally free of federal tax because the interest from bonds issued by a state, municipality, or other local entity is exempt from federal taxation.

As an added benefit, most states will allow a state tax exemption if the owner of the bond resides in the state of issue. However, if you purchase a bond outside your area of residency, it may be subject to both state and local taxes.

If you buy shares of a municipal bond fund that invests in bonds issued by other states, you will have to pay income tax. In addition, while some municipal bonds that are in the fund may not be subject to ordinary income tax, they may be subject to federal, state, or local alternative minimum tax. If you sell a tax-exempt bond fund at a profit, there are capital gains taxes to consider. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.

Municipal bonds come in a variety of forms and should be selected by strict criteria based predominantly on the state’s or municipality’s ability to service the debt. It’s important to remember that the principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

Tax-free money market funds invest in short-term notes of state and local governments and can provide a high amount of liquidity. Money market funds can be invested in a wide range of securities, so it is important to analyze your options carefully before investing.

Money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Although money market funds attempt to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in such a fund.

If you decide to invest in either type of tax-exempt security, consider the different options carefully. You can purchase individual bonds, which come in denominations of $1,000. Or you might consider investing in a municipal bond mutual fund, a portfolio of bonds in which you can invest for as little as $500. Municipal bonds can also be purchased through a unit investment trust, a closed-end portfolio of bonds with minimums of $1,000.

Often tax-exempt securities are the most favorable for those in higher tax brackets, so it’s important to determine whether buying them would be an advantageous move for you. To decide whether municipal bonds or money market funds would be an asset to your portfolio, calculate the taxable equivalent yield, which enables you to compare the expected yield of the tax-exempt investment with its taxable equivalent.

For instance, if you are in the 28% federal income tax bracket and invest in a municipal bond yielding 5%, this is equivalent to investing in a taxable investment yielding 6.94%. If you are in the 35% tax bracket and invest in the same bond, it would be the equivalent of investing in a taxable investment yielding 7.69%.

Also be aware that tax-exempt income is included in the formula for determining taxes on Social Security benefits. In some instances, it may be necessary to limit your tax-exempt income by shifting to other tax-advantaged investment areas.

If they’re in line with your investment objectives, tax-exempt securities can be an excellent means of reducing taxable income. Check your options with your tax advisor.

How Can I Keep More of My Mutual Fund Profits?

Provisions in the tax code allow you to pay lower capital gains taxes on the sale of assets held more than one year. The long-term capital gains tax rate is 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets but increases to 20% for individuals in the 39.6% tax bracket. Lower-bracket taxpayers (0% and 15% brackets) pay zero tax on long-term capital gains.*  Short-term gains — those resulting from the sale of assets held for one year or less — are still taxed at your highest marginal income tax rate.

This means that if you’ve been buying shares in a stock or mutual fund over the years and are considering selling part of your holdings, your tax liability could be significantly affected by the timing of your sale.

The main pitfall for most investors is the IRS “first-in, first-out” policy. Simply stated, this means the IRS assumes that the first shares you sell are the first shares you purchased. Thus, the first shares in become the first shares out. As a result, if the value of your shares has appreciated, more of the money you receive from the sale will be considered to be taxable as a capital gain.

Fortunately, there is an alternative. When you place a sell order, instruct your broker or mutual fund transfer agent to sell those shares that you purchased for the highest amount of money. This will reduce the percentage of the proceeds of the sale that can be considered capital gain and are therefore taxable.

In order for this strategy to work, you must specify exactly which shares you are selling and when they were originally purchased. Ask your broker to send you a transaction confirmation that identifies by purchase date the shares you want to trade. This will enable you to reduce your taxable gain and maximize your deductible losses when you fill out your tax return.

In some cases, you may be better off selling the first shares you purchased, even if this results in a larger gain. If the first shares are subject to the 15% long-term capital gains rate, but the recently purchased shares are subject to the higher short-term rate, the correct choice may not be obvious. Always consult a tax professional.

By carefully reviewing your brokerage statements, you can determine which shares you paid the most for. You can then specify exactly which shares you’d like to sell. A word to the wise: Make this request in writing. If the IRS calls the transaction into question, the burden of proof is on you.

Finally, the IRS also allows you to calculate your tax basis by taking the average cost of all your shares. On an appreciating asset, this should result in a lower tax liability than the first-in, first-out rule would dictate. Be aware, though, that if you elect to average, you must continue to average for any subsequent sales.

Using either system, you may end up with a lower tax liability from the sale of your shares than the IRS would assume using the first-in, first-out rule.

The value of stocks and mutual funds fluctuates so that shares, when sold, may be worth more or less than their original cost.

Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

* Taxpayers with modified adjusted gross incomes over $200,000 ($250,000 for married taxpayers filing jointly) are subject to an additional 3.8% Medicare tax on net investment income (unearned income) as a result of a provision in the Patient Protection and Affordable Care Act.

How Can I Upgrade My Insurance — Tax-Free?

Responding to the changing needs of consumers, the life insurance industry has developed some alternatives that go much further in satisfying a variety of financial needs and objectives than some of the more traditional types of insurance and annuities.

Advancements
Modern contracts offer much more financial flexibility than traditional alternatives do. For example, universal life and variable universal life insurance policies allow policy owners to adjust premiums and death benefits to suit their financial needs.

Modern contracts can also provide much more financial control. Whereas traditional vehicles, such as whole life insurance and fixed annuities, provide returns that are determined by the insurance company, newer alternatives enable clients to make choices that help determine returns. For example, variable annuities and variable universal life insurance allow investors to allocate premiums among a variety of investment subaccounts, which can range from conservative choices, such as fixed-interest and money market portfolios, to more aggressive, growth-oriented portfolios. Returns are based on the performance of these subaccounts.

There are contract limitations, fees, and charges associated with variable annuities and variable universal life insurance, which can include mortality and expense risk charges, sales and surrender charges, investment management fees, administrative fees, and charges for optional benefits. Withdrawals reduce annuity contract benefits and values. Variable annuities and variable universal life insurance are not guaranteed by the FDIC or any other government agency; they are not deposits of, nor are they guaranteed or endorsed by, any bank or savings association. Any guarantees are contingent on the claims-paying ability of the issuing company.

Withdrawals of annuity earnings are taxed as ordinary income and may be subject to surrender charges plus a 10% federal income tax penalty if made prior to age 59½. The investment return and principal value of an investment option are not guaranteed. Because variable annuity subaccounts fluctuate with changes in market conditions, the principal may be worth more or less than the original amount invested when the annuity is surrendered.

The cash value of a variable universal life insurance policy is not guaranteed. The investment return and principal value of the variable subaccounts will fluctuate. Your cash value, and perhaps the death benefit, will be determined by the performance of the chosen subaccounts. Withdrawals may be subject to surrender charges and are taxable if you withdraw more than your basis in the policy. Policy loans or withdrawals will reduce the policy’s cash value and death benefit and may require additional premium payments to keep the policy in force.

There are differences between variable- and fixed-insurance products. Variable universal life insurance offers several investment subaccounts that invest in a portfolio of securities whose principal and rates of return fluctuate. Also, there are additional fees and charges associated with a variable universal life insurance policy that are not found in a whole life policy, such as management fees. Whole life insurance offers a fixed account, generally guaranteed by the issuing insurance company.

A Dilemma
So what should you do if you want to cash out of your existing insurance policy or annuity contract and trade into one that better suits your financial needs, without having to pay income taxes on what you’ve accumulated?

One solution is the “1035 exchange,” found in Internal Revenue Code Section 1035. This provision allows you to exchange an existing insurance policy or annuity contract for a newer contract without having to pay taxes on the accumulation in your old contract. This way, you gain new opportunities for flexibility and tax-deferred accumulation without paying taxes on what you’ve already built up.

The rules governing 1035 exchanges are complex, and you may incur surrender charges from your old policy or contract. In addition, you may be subject to new sales and surrender charges for the new policy or contract. It may be worth your time to seek the help of a financial professional to consider your options.

Variable annuities and variable universal life insurance are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity and variable universal life contract and the underlying investment options, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.