With the introduction of higher tax rates for some taxpayers in 2013 and ongoing tax-reform debate in Washington, it is essential for any comprehensive financial plan to include tax smart planning strategies.

Specific income thresholds will trigger the new 3.8% Medicare surtax, income phase-out of itemized deductions, or the highest marginal tax rate.

These five strategies may lessen the tax burden for clients.

1. Invest in municipal bonds for tax-free income
Municipal bonds become more attractive for taxpayers who are subject to the 3.8% Medicare surtax on investment income and who may also be in the highest marginal tax rate (39.6%). The tax equivalent yield — the yield an investor would require in a taxable bond investment to equal the yield of a comparable tax-free municipal bond — has increased for these taxpayers.

2. Use strategies to reduce or avoid taxable income
Contributing to a retirement plan or individual retirement account (IRA), funding a flexible-spending account (FSA), or deferring compensation income can reduce adjusted gross income. Maximizing use of tax deductions such as charitable contributions or mortgage interest can offset income as well. At the same time, taxpayers need to be mindful of transactions, like the sale of appreciated assets, which could increase income level.

3. Consider Roth IRA/401(k) contributions or conversions
Roth IRA strategies can be used to hedge against future tax rate increases. Younger investors or taxpayers in lower tax brackets should consider Roth accounts to create a source of tax-free income in retirement. Like all income from retirement accounts, Roth income is not subject to the 3.8% surtax and is not included when calculating income to determine if the surtax is applicable.

4. Allocate assets by tax status
In general, clients may want to consider placing a larger percentage of stock holdings outside of retirement accounts and more fixed-income holdings inside retirement accounts. Allocating a greater proportion of buy-and-hold or dividend-paying investments to taxable accounts may increase a client’s ability to benefit from a lower tax rate on qualified dividends and long-term capital gains.

5. Be mindful of irrevocable trusts and taxes
The income threshold — $12,150 for 2014 — which will subject income retained within an irrevocable trust to the highest marginal tax rate and 3.8% surtax is low. Trustees may want to reconsider the investment choices inside the trust, or distribute more income to beneficiaries in lower income tax brackets.

For more information and additional planning ideas, read our latest investor education piece, “Ten income and estate planning strategies for 2014.”

While all bonds have risks, municipal bonds may have a higher level of credit risk as compared with government bonds and CDs.


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