Posts from the ‘Personal Financial Planning’ Category

Investing In Mutual Funds.

Many of my clients are investors in mutual funds and others have expressed an interest in putting some of their investment money into mutual funds. A complex set of tax rules need to be considered when making decisions about when to invest, what type of  fund to invest in, dividend options, switching between funds within a mutual fund family, and selling shares.

What type of fund.There are literally thousands of mutual funds that you can choose from to invest in. The choice of fund generally narrows based on one’s investment preferences and goals, e.g., high current yield income, long-term appreciation,  or tax-free income. These considerations are generally the same as would be applied in making a direct investment in corporate stock, bonds, etc.

As among the choice of funds, if you have unused capital losses carried over from an earlier year, you might prefer to invest in a fund whose objective is capital appreciation rather than current income. Capital gain distributions by the fund can be offset  by the loss carryover so that in effect the distribution is tax-free. If your income puts you in a high tax bracket, you might want to select a fund seeking capital appreciation (to take advantage of the favorable rates on long-term capital gains), a fund  that invests in dividend paying stocks and that distributes dividends taxable at capital gains rates, or a tax-free bond fund.

However, it’s important to remember that regardless of the type of fund selected, distributions from any fund, even a so-called tax-free bond fund (discussed below), can have unanticipated tax consequences to the investor.

When to invest.A purchaser of mutual fund shares owns a proportionate share of all of the fund’s investment holdings, including, in addition to the stock and bonds that comprise the fund’s portfolio, any accrued but undistributed interest or  dividend income and capital gains earned by the fund. If you buy mutual fund shares shortly before a dividend distribution, you may be buying a tax liability. The share price you pay reflects this income right. Say for example that you buy 1,000 mutual fund  shares for $10 a share shortly before the fund declares and pays a dividend of $2 per share. As a result of the dividend, the per share price will drop to $8. More important, you will have to include the $2,000 ($2 × 1,000) dividend in your income (regardless  of whether you receive the dividend in cash or reinvest it in additional fund shares) even though there has been no increase in the overall value of your investment. If the investment had been delayed until after the dividend. the same $10,000 investment would have purchased 1,250 shares (at $8 per share) and this problem of phantom income would have been avoided.

Nature of fund distributions.A mutual fund or regulated investment company (the more formal name for these investment vehicles) is generally taxed as a conduit. They distribute all or most of their income to shareholders. These distributions  can take the form of dividends that are taxed at capital gains rates, capital gain distributions, tax-exempt-interest dividends, and distributions that represent return of capital. A mutual fund shareholder will receive a Form 1099-DIV from the fund showing  the total amount distributed and providing the information necessary to properly report those distributions on the shareholder’s income tax return. It’s worth noting that a fund that invests solely in tax-exempt municipal bonds may nonetheless generate taxable  income. If the fund has realized a profit on the sale or disposition of such bonds, the resulting capital gain will be distributed and taxed to the shareholders. Note also that a mutual fund does not pass its losses through to its shareholders, it just uses them to net against gains, with excess losses carried to other years.

The fact that the investor may choose to receive his distribution in additional shares in the fund (rather than in cash) does not affect the immediate tax consequences. A dividend reinvestment option is treated as if the investor had received the distribution  in cash and then used the cash to acquire additional shares. These new shares have a basis equal to their cost, i.e., the amount of the dividend that was used to purchase them.

An investor who makes specific direct investments in stocks or bonds can generally control when and to what extent to realize capital gains. This is not true to the same extent with mutual fund investments. If a fund’s investment portfolio has done well  in a given year, the fund may make a large distribution near the end of the year because of gains that it has realized. These will be taxed to the investor as ordinary dividend to the extent of short-term gains, and capital gain distribution to the extent  it represents long-term gains of the fund. Because the fund may wait until late in Dec. before announcing the amount that it is distributing, year-end tax planning can be more difficult for individuals with substantial mutual fund holdings.

So-called “index funds” offer a way to avoid most of the problems associated with capital gain distributions. Index funds generally invest in the stocks or bonds that make up some market index, e.g., the Standard and Poor’s 500. They remain fully invested  in the component elements of the underlying index so that the price of the fund tracks the movement of the index. These funds generally do not sell any of their holdings unless necessary to provide funds for shareholder redemptions or to adjust for changes  in the components of the index. As a result, these funds generally do not realize significant capital gains and their capital gain distributions are correspondingly low. Instead, appreciation in value is reflected in the price of the fund’s shares and is only  translated into capital gain when the investor chooses to sell.

Even if you do not invest in index funds, you should be able to minimize tax costs by checking several factors in the financial information made available by the fund in which you are considering investing. First, check the fund’s portfolio turnover rate  (the reciprocal of its average holding period for its stocks). The longer the fund tends to hold its investments the lower its turnover rate and the less likely it is for the fund to be distributing taxable gains to its shareholders. Next, check the fund’s  net realized gain. This is the amount of gain the fund has realized since its last distribution. Finally, check the unrealized appreciation in the fund’s holdings. This represents the gains the fund will realize as it sells its investments. By investing in  funds with low portfolio turnover and comparatively lower realized and unrealized gains, you should be able to minimize the tax cost of your mutual fund investments.

In order to properly determine basis, discussed below, proper recordkeeping with respect to reinvestment of fund distributions is very important.

Sale of fund shares.When an investor in a mutual fund sells some or all of his shares, gain or loss is recognized. The gain or loss is measured by the difference between the amount realized from the sale of the fund shares and the basis for  those shares. One difficulty with mutual fund investments is that certain transactions are treated as sales even though they might not normally be thought of as such. Another problem can arise in determining your basis for shares sold, particularly if you  are selling only a portion of your fund holdings and the shares were acquired at different times and at different prices.

What is a sale.No one is likely to dispute the fact that a sale occurs when an investor has all of his shares in a mutual fund redeemed and receives a check for the proceeds. Similarly, there is a sale if the investor directs the fund to redeem  the number of shares necessary for a specific dollar payout, e.g., sufficient shares to produce a payout of $5,000.

It may be less obvious that a sale occurs if you are merely swapping funds within a fund family, for example the surrender of shares of the X Income Fund for an equal value of shares of the X Growth Fund received in exchange. Even though no money passes  hands, this is treated as a sale of the X Income Fund shares.

Many mutual funds provide check writing privileges to their investors. This is often a convenient and speedy way to pay large bills (as compared to directing the fund to redeem shares and send you a check, which then must be deposited in your regular checking  account and clear before you can draw against it). However, each time you write a check on your fund account you are making a sale of shares in the fund. Do this 20 or 30 times a year and you are going to have a fairly complex capital gains schedule attached  to your income tax return.

Determining basis of shares sold.If an investor disposes of all of his shares in a particular mutual fund in a single transaction, determining basis is relatively easy. Simply add the basis of all the shares, i.e., the amount of actual cash  investments (including any commissions or sales charges) plus distributions by the fund which were reinvested to acquire additional shares less any distributions that represented a return of capital.

The calculation becomes more complex if the investor is disposing of only a portion of his interest in the fund and the shares were acquired at different times and at different prices. Taxpayers can use one of several methods to identify the shares sold  and determine their basis.

•         First-in first-out method. The basis of the earliest acquired shares is used as the basis for the shares sold. If the share price has been increasing over the period of ownership, the older shares are likely to have a lower basis and thus result in more  gain.
•         Specific identification method. You can specify to the fund at the time of the sale the particular shares to be disposed of, e.g., “sell 200 of the 300 shares I purchased on July 1, Year 1”. You must receive written confirmation of your specification  from the fund. This method often can be used to lower the resulting tax liability by directing the sale of the shares with the highest basis.
•         Average basis. IRS permits you to use the average basis for shares that were acquired at various times and that were left on deposit with the fund or a custodian agent. Under the single category method, you find the average cost of all of your shares regardless  of how long you owned them. In applying the long-term and short-term rules, shares are considered to be sold in the order in which they were acquired. This method gives the investor less flexibility in choosing which shares to dispose of, but is relatively  simple to apply.An investor can also use a somewhat more complex double category method which determines the average basis for two separate groups of shares, those held long-term and short-term holdings. As with the specific identification method, above,  the investor specifies from which category the shares are to be sold.

If you have any questions about the above, or any other topics, please do not hesitate to contact us.

Sincerely,

Mike Jackson, CPA
Minar Northey LLP

(206) 282-2666

mike@minarnorthey.com

 

Planning for College? You MUST READ THIS.

As a parent with college-bound children, you are concerned with setting up a financial plan to fund future college costs. If your children are already college age, your goal is to pay for current or imminent college bills. I’d like to address both of these  concerns by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. (Please note that the following suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make the suggestions  inappropriate.)

Planning for college expenses.In some cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $26,000 in 2012 in cash or assets to each child with no gift tax consequences. And  for 2012, if  your child isn’t subject to the “kiddie tax,” he or she is taxed on income from assets entirely at his or her lower tax rates—as low as 10% (or 0% for long-term capital gain).

However, where the kiddie tax applies, the  child’s  investment  income above $1,900 for 2012 is taxed at your tax rates and not the child’s rates. The kiddie tax applies if: (1) the child hasn’t reached age 18 before the close of the tax year or (2) the  child’s earned income  doesn’t  exceed  one-half  of his  or her support and the child is age 18 or is a full-time student age 19 to 23.

A variety of trusts or custodial arrangements can be used to place assets in your children’s names. Note, it’s not enough just to transfer the income, e.g., dividend checks, to your children. The income would still be taxed to you. You must transfer the  asset that  generates the income to their names.

Tax-exempt bonds.Another way to achieve economic growth while avoiding tax is simply to invest in tax-exempt bonds or bond funds. Interest rates and degree of risk vary on these, so care must be taken in selecting your particular investment. Some  tax-exempts are sold at a deep discount from face and don’t carry interest coupons. Many are marketed as college savings bonds. A small investment in these so-called zero coupon bonds can grow into a fairly sizable fund by the time your child reaches college  age. “Stripped” municipal bonds (munis) provide similar advantages.

Series EE U.S. savings bonds.Series EE U.S. savings bonds offer two tax-savings opportunities when used to finance your child’s college expenses: first, you don’t have to report the interest on the bonds for federal tax purposes until the bonds are  actually cashed in; and second, interest on “qualified” Series EE (and Series I) bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses.

To qualify for the tax exemption for college use, you must purchase the bonds in your own name (not the child’s) or jointly with your spouse. The proceeds must be used for tuition, fees, etc., not room and board. If only part of the proceeds are used for  qualified expenses, then only that part of the interest is exempt.

If your adjusted gross income (AGI) exceeds certain amounts, the exemption is phased out. For bonds cashed in during 2012, the exemption begins to phase out when joint AGI hits $109,250 for joint return filers ($72,850 for singles) and is completely phased  out if your AGI is at $139,250 ($87,850 for singles).

Qualified tuition programs.A qualified tuition program (also known as a 529 plan) allows you to buy tuition credits for a child or make contributions to an account set up to meet a child’s future higher education expenses. Qualified tuition programs  can  be established by state governments or by private education institutions.

Contributions to these programs aren’t deductible. The contributions are treated as taxable gifts to the child, but they are eligible for the annual gift tax exclusion ($13,000 for 2012). A donor who contributes more than the annual exclusion limit  for  the year can elect to treat the gifts as if they were spread out over a five-year period.

The earnings on the contributions accumulate tax-free until the college costs are paid  from  the funds. Distributions from qualified tuition programs are tax-free to the extent the funds are used to pay qualified higher education expenses. Distributions  of earnings that aren’t used for qualified higher education expenses will be subject to income tax plus a 10% penalty tax.

Coverdell education savings accounts.You can establish Coverdell ESAs (formerly called education IRAs) and make contributions of up to $2,000 for each child under age 18. This age limitation doesn’t apply to a beneficiary with special needs, defined  as an individual who because of a physical, mental or emotional condition, including learning disability, requires additional time to complete his or her education.

The right to make these contributions begins to phase out once your AGI is over $190,000 on  a joint return ($95,000 for singles). If the income limitation is a problem, the child can make a contribution to his or her own account.

Although the contributions aren’t deductible, funds in the account aren’t taxed, and distributions are tax-free if spent  on qualified education expenses. If the child doesn’t attend college, the money must be withdrawn when the child turns 30, and any earnings  will be subject to tax and penalty, but unused funds can be transferred tax-free to a Coverdell ESA of another member of the child’s family who hasn’t reached age 30. These requirements that the child or member of the child’s family not have reached 30 do  not apply to an individual with special needs.

The above are just some of the tax-favored ways to build up a college fund for your children. If you wish to discuss any of them, or other alternatives, please call.

Paying college expenses.You may be able to take a credit for some of your child’s tuition expenses. There are also tax-advantaged ways of getting your child’s college expenses paid by others.

Tuition tax credits.You can take an American Opportunity tax credit of up to $2,500 per student for the first four years of college—a 100% credit for the first $2,000 in tuition,  fees, and books, and a 25% credit for the second $2,000. You  can  take a Lifetime Learning credit of up to $2,000 per family for every additional year of college or graduate school—a 20% credit for up to $10,000 in tuition and fees.

The American Opportunity  tax credit is  40% refundable. That means that you can get a refund if the amount of the credit is greater than your tax liability. For example, someone who has at least $4,000 in qualified expenses and who would thus qualify for  the maximum credit of $2,500,  but who has  no tax liability to offset that credit against, would qualify for a $1,000 (40% of $2,500) refund from the government.

Both credits are phased out for higher-income taxpayers. The American Opportunity tax credit is phased out for couples with income between $160,000 and $180,000, and for singles with income between $80,000 and $90,000. The Lifetime Learning credit is phased  out (for 2012) for couples with income between $104,000 and $124,000, and  for  singles with income  between  $52,000 and $62,000. The phase-out range for the Lifetime Learning credit is adjusted annually for inflation.

Only one credit can be claimed for the same student in any given year. However, a taxpayer is  allowed  to claim an American  Opportunity  tax credit or a Lifetime Learning credit for a tax year and to exclude from gross income amounts distributed (both  the principal and the earnings portions) from a Coverdell education savings account for the same student,  as  long as the distribution  isn’t  used for the same educational expenses for which a credit was claimed.

Scholarships.Scholarships are exempt from income tax, if certain conditions are satisfied. The most important are that the scholarship must not be compensation for services, and it must  be used for tuition, fees, books, supplies, and similar items  (and not for room and board).

Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the Hope and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits.

In an exception to the rule that a scholarship must not be compensation for services, a scholarship received under a health professions scholarship program may be tax-free even if the recipient  is required to provide medical services as a  condition for  the award.

Employer educational assistance programs.If your employer pays your child’s college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that’s “outside of  the pattern of employment.” Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).

Tuition reduction plans for employees of educational institutions.Tax-exempt educational institutions sometimes provide tuition reductions for their employees’ children who attend that educational  institution, or cash tuition payments for children  who attend other educational institutions. If certain requirements are satisfied, these tuition reductions are exempt from income tax.

College expense payments by grandparents and others.If someone other than you pays your child’s college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that  person exceed the regular annual (per donee) gift tax exclusion of $13,000 for 2012. Married donors who consent to split gifts may exclude gifts of up to $26,000 for 2012.

However, if the other person pays your child’s school tuition directly to an  educational institution,  there’s an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf  the payments are made is irrelevant, but the payer would typically be  a grandparent.

The unlimited gift tax exclusion applies only to direct tuition costs. There’s no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Prepaid tuition payments may qualify for the unlimited gift tax exclusion under  certain circumstances.

Student loans.You can deduct interest on loans used to pay for your child’s education at a post-secondary school, including some vocational and graduate schools. (This is an exception to the general rule that interest on student loans is personal  interest and, therefore, not deductible.) The deduction is an above-the-line deduction (meaning that it’s available even to taxpayers who don’t itemize). The maximum deduction is $2,500. However, for 2012, the deduction phases out for taxpayers who  are married  filing  jointly with AGI between $125,000 and $155,000 (between $60,000 and $75,000 for single filers).

Some student loans contain a provision that all or part of the loan will be cancelled if the student works for a certain period of time in certain professions for any of a broad class of employers—e.g., as a doctor for a public hospital in a rural  area. The student won’t have to report any income if the loan is canceled and he performs the required services. There’s also no income to report if student loans are repaid or forgiven under certain federal or state programs for health care professionals.  These are exceptions to the general rule that if a loan or other debt you owe is canceled, you must report the cancellation as income.

Bank loans.The interest on loans used to pay educational expenses is personal interest which is generally not deductible (unless you qualify for the deduction for education loan interest, described above). However, if the loan is “home equity  indebtedness,” and interest on the loan is “qualified residence interest,” the interest is deductible for regular income tax purposes, although not for alternative minimum tax purposes. If interest is deductible as qualified residence interest, it  can’t be deducted as education loan interest.

Borrowing against retirement plan accounts.Many company retirement plans permit participants to borrow cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, the loan must carry an  interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there’s no deduction for the personal interest paid. Moreover, unless strict requirements are  satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that’s subject to regular income tax and an additional penalty tax.

Withdrawals from retirement plan accounts.IRAs and qualified retirement plans represent the largest cash resource of many taxpayers. You can pull money out of your IRA (including a Roth IRA) at any time to pay college costs without incurring the  10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 591/2 . However, the distributions are subject  to tax under the usual rules for IRA distributions.

Some qualified plans either don’t permit withdrawals or restrict them. For example, a 401(k) cash-or-deferred plan may allow distributions if the participant has an immediate and heavy financial need and lacks other resources to meet that need. IRS regs  name a college education as such a need. To the extent they represent previously untaxed dollars and earnings, amounts withdrawn from a retirement plan are fully subject to tax and are also hit by a 10% penalty tax if they are made before the participant reaches  age 591/2 . (Note, however, that you cannot roll over a 401(k) plan “hardship” distribution into an IRA to set up a later penalty-free withdrawal to pay college costs.)

A younger plan participant may avoid triggering the penalty tax by annuitization payouts from an IRA or a SEP. This method doesn’t work for 401(k) type plans. The strategy works because the penalty tax doesn’t apply if annual or more frequent withdrawals  are made in substantially equal payments over the life or life expectancy of the taxpayer (or the joint lives or joint life expectancies of the taxpayer and designated beneficiary).

Not all of the above breaks may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks.

If you have any questions about the above, or any other topics, please do not hesitate to contact us.

Sincerely,

Mike Jackson, CPA
Minar Northey LLP

(206) 282-2666

mike@minarnorthey.com

 

Investing In Municipal Bonds

We’ve been getting a lot of questions about investing in municipal bonds, so here’s an overview:

• Purchase of bond. If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you buy such a bond between interest payment dates, you will have to pay the seller  any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.
• Amortization of bond premium.If you buy a tax-exempt bond at a premium, you must amortize the premium over the term of the bond, or in some cases to an earlier call date. While no deduction is permitted for the amount of premium amortized in  each year, the effect of this is to reduce your basis in the bond by a corresponding amount. Thus, if you buy such a bond at a premium and hold it to maturity, you won’t recognize a loss when the bond is paid off.If you buy a tax-exempt bond at a discount,  see below.
• Exclusion of interest from taxable income.In general, interest you receive on a tax-free municipal bond isn’t includible in gross income (although, as discussed below, it may be includible for alternative minimum tax purposes). While this is  an attractive feature, keep in mind that a municipal bond is likely to pay a somewhat lower rate of interest than an otherwise equivalent taxable investment. What is really significant isn’t whether the interest is included in income, but rather what the after-tax  yield is.In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield (although alternative minimum tax consequences may also have to be taken into account). In the case of a taxable bond, the after-tax yield will be based  on the amount of interest you have left over after taking into account the increase in your tax liability on account of each year’s interest payments. This will depend on your effective tax bracket. In general, tax-free bonds are likely to be more attractive for taxpayers in higher brackets, since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, on the other hand, the tax benefit from excluding interest from income may not be  enough to make up for the lower interest rate generally paid on this type of bond.

  I can help you with the effective yield calculations necessary to make a meaningful comparison of different investments.

  Even though municipal bond interest isn’t taxable,  it must be shown on the return. This is because tax-exempt interest is taken into account when determining the amount of social security benefits that’s taxable, and may affect the alternative minimum tax computation as well as the earned income credit and  investment interest deduction, see below. (Requiring municipal bond interest to be shown on the return also alerts IRS to the potential disallowance of any interest expense incurred to carry the bonds, see below.)

• Tax-deferred retirement accounts. It generally doesn’t make sense to buy and hold municipal bonds in your regular IRA, Keogh, or 401(k) plan account. The income in these accounts isn’t taxed currently, but once you start making withdrawals,  the entire amount withdrawn is likely to be taxed. Thus, if you want to invest your retirement funds in fixed income obligations, it’s advisable to invest in higher-yielding taxable securities.
• Alternative minimum tax consequences.Even though interest on municipal bonds is generally excluded from income for purposes of the regular federal income tax, interest on certain “private activity bonds” is included in income for purposes  of the alternative minimum tax (AMT). There is an exception for private activity bonds issued in 2009 or 2010, and for certain tax-exempt housing bonds issued after July 30, 2008. Your broker can tell you whether the particular bond you are considering is  a private activity bond subject to this rule.The AMT is a separate tax system that applies if the tax determined under that system exceeds your regular income tax. Whether or not the AMT applies will depend on your overall tax picture; however, in general,  the effect of the AMT would be to prevent you from achieving too low an effective tax rate by means of tax-favored techniques such as investing in municipal bonds. I can help you determine how the AMT would apply to your situation, and how it would affect the after-tax yield if you were to invest in municipal bonds.
• Effect of exempt interest on taxation of social security benefits.In general, a portion of social security benefits is taxable if your adjusted gross income, subject to certain modifications, exceeds specified amounts. For this purpose, the  modifications to adjusted gross income include adding in tax-exempt interest. The effect of this rule is that, if you receive social security benefits, investing in municipal bonds could increase the amount of tax you have to pay with respect to the social  security benefit. While technically the municipal bond interest remains exempt from tax, the effect is the same as though a portion of that interest were taxable.I can help you with the calculations necessary to determine whether and how you would be affected  by these rules.
• Effect of exempt interest on earned income credit. If you are otherwise eligible to take an earned income credit, you will lose the credit completely if you have more than $3,100 in 2010 ($3,150 in 2011) of “disqualified income,” generally,  interest, dividend, nonbusiness rental, passive, and capital gain net income. Disqualified income includes tax-exempt income. Thus, municipal bond income could cause loss of the credit. However, in most cases, an individual who’s eligible for the earned income  credit will be in a low tax bracket, thus making municipal bonds an unattractive investment in view of their lower yield, as discussed above.
• No deduction for interest on obligations incurred in connection with tax-exempt investments. If you borrow money for the purpose of investing in municipal bonds, you can’t deduct the interest expense with respect to that borrowing. Moreover,  even if the proceeds of borrowing aren’t directly traceable to tax-exempt investments, interest deductions could be disallowed if IRS could establish that you continued the borrowing in effect (that is, you didn’t pay it off) for the purpose of acquiring or  carrying the municipal bonds. If you have otherwise deductible interest and invest in municipal bonds, the effect of this rule, by denying a deduction for interest paid, could be effectively to tax the municipal bond interest.
• Sale, call or redemption of bond. Normally, the sale, call before maturity, or redemption of a municipal bond is treated the same as a taxable bond. If you held the bond long enough, any gain is taxed at favorable rates. Capital losses can be  used to offset other capital gains. Up to $3,000 of any remaining losses can generally be applied against other income, with a carryover of any excess to later years.
• Market discount on disposition. Ordinarily, when you sell a bond which you bought in the market, any gain you realize is taxed at favorable capital gains rates (if you held the bond long enough). However, where you buy a bond with “market  discount,” gain not exceeding the portion of the discount that accrues during the period you hold the bond is instead treated, when you sell it, as ordinary income. This rule applies to tax-exempt municipal bonds bought after April 30, 1993. Because, depending  on your tax bracket, ordinary income may be taxed at a higher rate, the effect of this is to reduce the benefit of tax-exempt bonds relative to taxable bonds, in the case of bonds trading at a discount.
• Municipal bond funds. If you are looking for diversity and professional management for your municipal bond holdings, you may want to consider buying shares of a mutual fund that invests in tax-exempt municipal bonds. These funds may be broadly based or targeted to the bonds of a particular state. Some “high yield” (junk-bond) municipal bond funds are also available. A fund that’s invested at least 50% in tax-exempt obligations may distribute exempt-interest dividends to its investors. These dividends are treated essentially the same as municipal bond interest. To preclude a potential tax loophole, if an investor buys mutual fund shares, receives an exempt-interest dividend, and then sells the shares at a loss within six months after the purchase, the loss is disallowed to the extent of the exempt-interest dividend.

If you have any questions about the above, or any other topics, please do not hesitate to contact us.

Sincerely,

Mike Jackson, CPA
Minar Northey LLP

(206) 282-2666

mike@minarnorthey.com

 

How to Keep Life Insurance Proceeds Out of Your Estate

Few people realize that, even though they may have a modest estate, their families may owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a substantial death benefit. This is so because life insurance proceeds,  while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax.

The solution to this problem is to create an irrevocable life insurance trust that will own the policy and receive the policy proceeds on your death. A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as  well as in the estate of your surviving spouse. It also protects the trust beneficiaries from their own “excesses”, against their creditors, and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets. Here’s  how the irrevocable life insurance trust works.

You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the  trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won’t have to pay gift tax on the contributions.

The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee’s discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value  of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial  interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.

If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you.

If you have any questions about the above, or any other topics, please do not hesitate to contact us.

Sincerely,

Mike Jackson, CPA
Minar Northey LLP

(206) 282-2666

mike@minarnorthey.com