OCEAN CITY – The point of your investment decisions is, by definition, to produce the returns you need to meet your long-term financial goals. But unless you’re also managing investments for tax efficiency, you may be paying more than your fair share of federal tax. This is especially true for the growing number of households that in 2007 could become subject to the Alternative Minimum Tax (AMT).
The AMT is a provision of the IRS tax code enacted in the 1960s to curb the use of tax deductions by the wealthiest citizens. Although the goal was to ensure that everyone paid at least some income tax, the AMT has never been adjusted for inflation. As a result, roughly 23 million filers with rising incomes may face higher payments in the 2007 tax year.
Because the AMT’s provisions are graduated based on income, you can minimize their impact by working with your financial advisor and your tax attorney to incorporate tax-advantaged investment accounts, tax-efficient investments and other strategies into your portfolio. But whether you are a candidate for the AMT or not, boosting the tax efficiency of your investments will put you in the best position to keep your long-term financial strategy intact.
"When it comes to the AMT, you can lose out on a lot of tax deductions. This makes planning your investments more complex," says Scott Cooper, Managing Director with Merrill Lynch’s Private Banking and Investment Group. Many of the deductions we generally take for granted — such as home equity loan interest and state and local taxes are no longer available under the AMT’s provisions. Because certain taxable events trigger the AMT, as many as 30 percent of taxpayers earning between $75,000 and $100,000, 64 percent of those earning between $100,000 and $200,000, and 87 percent of those earning between $200,000 and $500,000 will have to follow its guidelines.
Some common strategies to reduce your exposure to the AMT include paying your state and local taxes early so that they are deducted in the previous tax year. You can also spread out the sale of a stock over several years to reduce the capital gains, which can trigger the AMT. There are also certain investments, such as "private activity bonds" — a type of municipal bond — which are not taxable under the regular tax code but are under the provisions of the AMT.
Because tax laws are intricate and constantly changing, it is crucial for your financial advisor and tax advisor to work together, especially if your investments and tax situation are complex.
"Often you can realize the greatest tax efficiencies by setting a strategy in advance — sometimes years in advance — and adapting it as circumstances require," notes Christopher Wolfe, Chief Investment Officer for Merrill Lynch’s Private Banking and Investment Group. But to take that sort of long-term approach requires an in-depth knowledge that you are more likely to get from a coordinated team of specialists.
Of course, it’s important to remember that while tax efficiency is a major consideration in your investment decisions, it’s not the only piece of the puzzle. No decision should be made on the basis of a single factor – including its tax implications.
"It’s an old saying, but it bears repeating," Cooper says. "Don’t let the tax tail wag the investment dog."
(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)