How to Keep Congress’ Hands Off Your Money

Let me tell you how it will be
There’s one for you, 19 for me
’Cause I’m the taxman, yeah, I’m the taxman

Should 5% appear too small
Be thankful I don’t take it all
‘Cause I’m the taxman, yeah I’m the taxman

If you drive a car, I’ll tax the street
If you try to sit, I’ll tax your seat
If you get too cold, I’ll tax the heat
If you take a walk, I’ll tax your feet

Don’t ask me what I want it for
If you don’t want to pay some more
’Cause I’m the taxman, yeah, I’m the taxman

Now my advice for those who die
Declare the pennies on your eyes
’Cause I’m the taxman, yeah, I’m the taxman
And you’re working for no one but me. – The Beatles

Is there any day better than April 15 in the United States when taxes are due?!

Uh, yeah, pretty much every other day.

We all have to pay our taxes to ensure that firefighters and soldiers get paid. But it burns me up that our taxes also ensure that Rep. Alexandria Ocasio-Cortez and Sen. Mitch McConnell get $174,000 and $193,400 per year, respectively. And that doesn’t include their plush benefits. Talk about not getting what we’re paying for!

But this isn’t a political rant. It’s a piece on taxes and how to make sure less of your money goes to AOC and McConnell and more stays in your pocket.

While investing is critical for creating a comfortable retirement and building wealth, it can have significant tax consequences. Here are several tax-savvy moves you can make to keep more of your money.

Tax-Deferred Accounts

You should definitely establish tax-deferred or tax-free accounts. These include IRAs, Roth IRAs, 401(k)s and 529 plans.

There are limits on how much you can contribute to each. As a general rule of thumb, any investment you make that is intended to provide for retirement (or education if it’s a 529 plan) and generates income should go into a tax-deferred account if possible.

That way, the income produced by the investment is shielded from taxes.

But you may not be able to simply stuff all of your income-producing investments in a tax-deferred account. As I mentioned, they have limits.

An IRA has a maximum contribution of $6,000 ($7,000 if you’re age 50 or older). The most you can contribute to a 401(k) is $19,000 ($25,000 if you’re age 50 or older).

If you need to prioritize which investments will go in your tax-deferred accounts, consider this guide in order.

1. Interest-bearing investments – Interest on bonds or other loan types are taxed at your ordinary income tax rate, which is likely higher than dividend or capital gains tax rates.
2. Short-term trading – Pursue this in an IRA or 401(k) ONLY if your retirement is paid for regardless of what’s in your retirement account. Short-term trading carries a lot of risk, and you don’t want to lose your nest egg if it’s your main source of funds in retirement. But if you’re wealthy and have the resources to maintain your lifestyle regardless of what’s in your IRA or 401(k), then using the account for short-term trading may make sense if you’re a successful trader. Short-term capital gains are taxed at ordinary income tax rates. If you can protect them from those higher rates, you’ll keep more of the profits. However, if you are not a successful trader and you take losses, you will not be able to write them off the way you would if the positions were held in a taxable account.Therefore, you should use your tax-deferred accounts for short-term trading only if you are confident that you can turn a profit and afford any losses.
3. Covered calls and naked puts – If you sell covered calls, the premium is considered a short-term capital gain once the option expires, and it is taxed at your ordinary income tax rate. If you can protect those premiums from taxes, you should. Additionally, if your stock is called away and it’s a short-term capital gain, you’ll avoid the higher taxes. The same goes for a naked put. The premium is taxed as a short-term capital gain at expiration, so you will pay your ordinary income tax rate on your puts. Keep in mind, though, that if a stock is put to you and you sell it for a loss, you will not be able to deduct the loss from your taxes if it takes place in a tax-deferred account.
4. Dividend stocks – Dividends are taxed at the lower 15% rate for most investors. Though the rate is not high, you still want to protect your dividends from tax, especially if you’re reinvesting them for the future. If you reinvest dividends in a taxable account, you’ll owe taxes on those dividends even though you won’t receive cash for them. Plus, as compounding works its magic over the years, the dividends could be quite substantial – so you’ll want to shield them from taxes if you can.

Also, keep in mind that there are a few types of stocks you should not hold in tax-deferred accounts.

1. Master limited partnerships (MLPs) – Most MLPs’ distributions (they’re called distributions, not dividends) are mostly return of capital, which is not taxed. Instead, it lowers your cost basis. So if you bought a stock at $25 and received a $1 distribution that was all return of capital, you would not pay any tax on the $1 distribution, and your cost basis would now be $24. If in three years you sold the stock at $30, you’d pay taxes on $6 in capital gains rather than $5. However, you’d be collecting tax-deferred income until you sold the stock. Because the distribution is tax-deferred already, there is no reason to allow it to take up valuable space in a tax-deferred account. You might as well hold a less tax-efficient investment in that account.Additionally, some MLPs’ distributions consist of something called unrelated business taxable income, or UBTI. If you earn $1,000 or more in UBTI and the investments are held in tax-deferred accounts, you may have to pay taxes and penalties on the income – so it’s safer to keep MLPs in taxable accounts.
2. Foreign dividend payers – Most foreign governments take taxes directly out of your dividends before you receive them. If the stock is held in a taxable account, you will receive a foreign tax credit from the IRS; however, if the stock is held in a tax-deferred account, the foreign tax authority will still take its share of taxes out of your dividend, but you will not qualify for the foreign tax credit.

For more tax-saving tips, be sure to check out my videos series Sticking It to the Tax Man on Wealthy Retirement’s Facebook page.

Good investing,

Marc