How? Let us take a look.

Why the real income you make comes after taxes come out

Taxes are a major, if not the largest expense for most people. They can take a bite out of any income you generate, in some states they run close to 50%.

Yields, the amount of pretax income generated per dollar of a given investment, are often presented as independent of taxes. Yet, yield in and of itself does not really tell you how much money you will receive. 

Taxes are a real expense for your wallet. The true income you earn comes after the tax man takes his “fair share”, not before. 

The good news is that awareness and prudent management around the different tax categories of income can help you. You can have significant influence over maximizing income after tax. Whether it’s investments that pay income, which could be friendly to your wallet or end up costing you some hefty taxes.

How we help others: a case study

Let us examine situations of how we have helped other people navigate through these complex issues. We cannot give you specific names, but the example below is fairly typical.

Hypothetical Martha and Fred are a family who seek additional income. The family pays meaningful taxes even without investment income. They own both taxable and qualified accounts. 

They might want to house sources of ordinary income in their tax-deferred/qualified accounts. The ordinary income generated would not count against their other taxable income. Additionally, they would not pay tax on income generated for that year. (However, a tax-deferred account would mean they eventually pay tax once they begin to take Required Minimum Distributions. Alternatively, if they were to take money out before age 70.5, they would also owe tax.)

Fred and Martha could place investments that generate qualified dividends in their taxable accounts.  Such income in a taxable account would not count against their AGI. Additionally, they would pay a lower tax rate under long-term capital gains rate rather than ordinary income tax.

Let us help you deal with the issues

Are you ready to deal with income and taxes? If you feel a little overwhelmed, we are here to help. 

Come schedule a free consultation so we can help you figure out the best ways to generate income after taxes.

Do not go broke by stretching for income! Read our white paper to learn the 3 common potholes you need to steer clear of.

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The post Not All Investment Income Is Created Equal Because of Taxes: Case Studies appeared first on AWM.

That is not true about income coming from investments. Many of your neighbors forget this fact to their detriment.

One of the major problems people often do not understand is taxes. You can reduce different types of income with different levels of taxation.

Be informed.

What are the issues?

Income comes in many forms. Wages and bonuses you earn, sales or income from hard assets, Social Security, and sudden wealth are examples.

For many people, especially those in or approaching retirement, income from their investments is a major way to fund their lifestyles.

Some people lump income into one big category. For those of us who pay taxes (hint: most people pay taxes!), this would be a mistake. The IRS and state tax authorities view income under several categories.

The table below illustrates the different categories of income from a tax perspective and typical sources of such income:

Introducing Different Tax Categories of Income

The table below sheds light on how tax laws might apply for each category of income. This includes both taxable and qualified accounts (typically IRA’s or other retirement accounts).

Different Tax Treatment for Sources of Income in Taxable and Qualified Accounts

Here is some additional color on the specific tax treatment of each of these categories:

1. Ordinary income

   1. Taxable accounts
      1. Income other than long-term capital gains. Wages, salaries, and dividends are examples.
      2. Ordinary income is taxed under the marginal tax bracket as defined by the IRS.
      3. A range of itemized deductions might be able to offset a portion of ordinary income.
   2. Taxes on ordinary income are not relevant when held in retirement accounts.

2. Qualified Dividends

   1. 1. Taxable accounts
         1. Taxed at the long-term capital gains tax rate (used for gains on the sale of investments held for greater than 1 year).
         2. No cost basis, but also favorable tax treatment due to (typically) lower long-term capital gains tax rate.
      2. Only offset on income tax returns is capital losses (selling assets below purchase price and writing off all or a portion of the difference).
      3. Taxes on qualified dividends are not relevant when held in retirement accounts.

3. K-1 Income Pass-through Income

   1. Tax considerations for taxable accounts

      1. Partnerships like LP’s and Master Limited Partnerships (MLP’s), both public and private, pay income that the IRS treats differently from ordinary income.

      2. Investors at the end of each year receive a form K-1. A good portion of your income should be tax-deferred. However, there are complexities:

         • Most income qualifies as “return of capital”, which is recorded for tax purposes not as income, but rather as a reduction of the cost basis of the shares the investor purchased.
         • If and when the investor sells the shares of the partnership, the investor will pay capital gains tax on the difference between the share price and the cost basis. Hence, the return of capital is considered “tax-deferred” into the future, not “tax-free”.
         • Unrelated business taxable income (UBTI) is “income regularly generated by a tax-exempt entity by means of taxable activities.” Not only is this income taxed, but it has the potential to bump up the investor’s marginal tax bracket if it causes the investor’s total income to exceed certain thresholds.
         • Taxable income from MLP’s might offer potential offset in the form of depreciation and other deductions. List these items on your K-1.

      3. You might have to file income tax forms in states where you do not live but where the MLP might do business.

         • According to the MLP Association: “Because of the pass-through structure of MLPs, unitholders in multistate MLPs may owe tax in each state in which the MLP earns income. The K-1 package provided to you by the MLP each year includes information on how much income has been allocated to you in each state.”
         • Apart from a couple of states, most states have low thresholds as to how much income triggers a state income tax filing.
         • You might want to discuss with your professional the need for additional state income tax filings, payments, and whether you want to put up with the burden going forward.
   2. Taxes could still be quite relevant even if held in retirement accounts (such as IRA’s).
      1. Retirement accounts (IRA’s) – if total UBTI on all your investments in an IRA exceeds $1,000 in a year, you must file a special form and pay tax on it.
      2. In addition, you will need to file a special form with your 1040 (Form 990-T).

    

One additional consideration specific to income generated from investments with a foreign domicile is withholding tax.

Some countries have tax treaties with the US and do not withhold additional tax from dividends. However, others do not. The situation varies by country.

The UK poses an interesting example for foreign investors. Sometimes, certain structures (such as UK corporations) are exempt from dividend withholding tax. Yet, other structures in the same country (such as UK REITs) are subject to dividend withholding tax.

How we can help you deal with the issues

We would be happy to schedule a free consultation so we can help you figure out the best ways to generate income after taxes.

Do not go broke by stretching for income! Read our white paper to learn the 3 common potholes you need to steer clear of.

Schedule Appointment

The post Not All Income Is Equal Because of Taxes: 3 Types of Income appeared first on AWM.

We believe fixed income is an expensive asset class, but that does not mean investors should totally discard its use in diversified portfolios.

Current yields in nominal and real terms are near historic lows.

Foreigners hold roughly 6.3 trillion of the 20 trillion dollars in total public debt of the United States or roughly 30%.[1]  Japan and China hold $1 trillion each and comprise the 2 largest foreign holders of Treasury debt.  For context, the US Federal Reserve holds roughly $2.5 trillion.[2]  Adding the numbers together, foreign nations and the Fed hold roughly 40% ($8.5 of $20 trillion) or 4 out of every 10 dollars of US Treasury debt.  Monitoring the actions of these debt holders is crucial to forecasting the direction of interest rates on Treasuries.

The US Federal Reserve has indicated its preference to tighten short-term interest rates and eventually reduce its position in US Treasuries gradually over time.[3]  Tighter domestic monetary policy might add greater volatility to bonds than the low levels of recent history.

China is another wild card in terms of future actions.

As the largest exporter to the US and the largest central bank in the world in terms of foreign reserves, China would appear to have a long-term interest in maintaining its current large position in US Treasury debt.  If China were to reduce its Treasury position, it might potentially induce a sell-off in the US Dollar and currency appreciation in the yuan, a situation that could hurt profits for Chinese exporters.  China’s large Treasury holdings possibly offer a hedge against the risk of rising trade protectionism from the US.

On the other hand, China might see political benefits in promoting greater use of its own currency in lieu of the US Dollar in foreign trade.  For example, China is preparing to trade futures contracts on oil and gold denominated in its local currency.  In theory, oil exporters such as Russia and Iran could bypass sanctions and trade in Yuan.[4]

Any reduction in China’s holdings in US Treasury debt potentially could add to bond market volatility.

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[1] http://ticdata.treasury.gov/Publish/mfh.txt  accessed on October 23, 2017.
[2] https://fred.stlouisfed.org/series/TREAST  accessed on October 23, 2017.
[3] http://www.businessinsider.com/fed-statement-balance-sheet-interest-rates-september-meeting-2017-9  accessed on October 23, 2017.
[4] https://asia.nikkei.com/magazine/20170914/Business/China-aims-for-dollar-free-oil-trade?page=2  accessed on October 23, 2017.

The post Views on Fixed Income: Fixed Income as Ingredient, Not Total Solution (Part Three) appeared first on AWM.

Bond yields are not simply priced in a vacuum.

Investors (usually) expect to collect some sort of coupon above the rate of inflation.  They want to protect their purchasing power.  However, as the chart below reveals, at times bond yields can fall below the rate of consumer price inflation.  Indeed, 10-year bond yields were actually below the rate of inflation until just before President Trump’s election.

Inflation is stable to increasing.

If we get economic stimulus and greater confidence on prospects for future economic growth, bond yields could rise.  When bond yields rise, bond investors suffer a loss on their principal.  Markets force the bonds to price at higher yields.

What happens if bond yields increase significantly in real purchasing power terms?  What if they were to rise 1% or 2%?  How could that impact returns on other investments such as stocks?

History over the last 55 years suggests that stocks in many, but not all, cases have posted positive annual returns when real bond yields have risen 1% or even 2% in the past year.  In other words, bond investments have tended to lose money, yet stocks in many cases were able to increase.

Over the last 55 years, stocks, as measured by the S&P 500, fared well even when real 10-year bond yields increased by 1% or more.  In fact, stocks appreciated more frequently and at higher rates under a moderate rise in interest rates.

Stocks still posted positive annual gains in most months when real bond yields rose an even more dramatic 2%.  However, stock returns on larger increases of 2% or more in real interest rates were muted and occurred less frequently than when interest rates rose less dramatically.

In other words, in a scenario of rising real bond yields, bond investors potentially have more to be concerned about than stock investors.  That does not imply, though, that stocks will necessarily do so well in the future, nor should investors discard all of their bond investments.  What it might suggest, though, is that investors should consider investing in diversified portfolios that include an appropriate mix of different investments.

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The post Views on Fixed Income: Stocks, Bonds, and Inflation (Part Two) appeared first on AWM.

Let’s take a walk down memory lane.  Where were you 10 years ago at this time?

Do you remember when banks used to offer 4% rates on money market accounts?  Today, bank depositors would be fortunate to get 1%.

Since the eve of the Great Recession in 2007, US Treasury yields have declined considerably from over 5% to levels around 2.4% currently.  Fears of permanent economic damage in terms of lower growth and deflation along with strong intervention via purchases of government bonds by the Federal Reserve have pushed long-term Treasury bond yields down to historically low levels.

Bonds have had a tremendous run with yields falling and prices strongly rallying since their peak in 1981.  Will the good times keep on rolling?  Or are we due for a reversion to the mean?

The strength of the US economy (or lack thereof) is one factor that could determine the direction of future bond yields.  Another factor is inflation, the rate at which prices on the goods and services consumers and businesses purchase increases.

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The post Views on Fixed Income: Simple History in Pictures (Part One) appeared first on AWM.