3 Tax Blunders the IRS Can’t Wait for You to Make

You must pay taxes. But there’s no law that says you gotta leave a tip.” – Morgan Stanley advertisement

I received a jury duty summons last week. It actually said, “Congratulations. You’ve been selected for jury duty…” I’m not so sure congratulations were in order, but I’m the rare person who doesn’t mind jury duty.

Sure, it’s an inconvenience and completely disrupts my schedule. But the only other time I had jury duty, I was seated on a case and found the process fascinating.

Call me old-fashioned, but I do believe in our duty as citizens to serve on a jury of our peers.

When it comes to taxes, I have a similar mindset (now you’re probably not calling me old-fashioned, but just plain crazy – or worse).

[ad#Google Adsense 336×280-IA]I don’t enjoy paying taxes, but understand that they are necessary if we’re to have roads, schools, a robust military, corporate welfare, public welfare, subsidies… OK, maybe the last three aren’t quite so necessary, but you get the point.

But just because I understand that taxes are necessary doesn’t mean I don’t do everything in my power to keep my tax bill as low as legally possible. I’ll pay what I’m required to under the law, but not a penny more.

Shockingly, there are many people who pay more than what they’re required to pay. If you want to join them and be among those who are leaving a tip, so to speak, for Uncle Sam, follow these steps.

Step 1: Ignore your 401(k) – If you are offered a 401(k) plan at work and don’t use it, you’re paying the government more than you should. The contribution to a 401(k) comes right off of your taxable income, and it grows tax-deferred.

Let’s say you make $50,000 a year and contribute $3,000 to your 401(k). Your taxable income is now $47,000. So your $3,000 grows tax-deferred and you’ll save roughly $1,000 on taxes because your income has been lowered by $3,000.

And if your employer does any kind of matching and you’re not taking advantage of it, that’s just leaving free money on the table. Many employers match $0.50 on the dollar up to 3%.

Using the $50,000 salary example… If you contribute $3,000 and your employer matches $1,500, you now have $4,500 to grow tax-deferred. But if you’d rather leave $1,500 of free money in the street and pay $1,000 more in taxes, be sure to ignore your 401(k).

Step 2: Don’t Use an IRA to Shield Your Income-Producing Assets – If you have investments such as stocks, bonds or mutual funds that generate income, you will pay taxes on that income unless it’s in an IRA.

IRAs are another way to allow your investments to grow tax-deferred. But many people don’t use them the right way. They simply throw whatever investments they have into the IRA in order to avoid paying taxes on them.

But there are annual maximums as to how much you can contribute to an IRA – $5,500 for ages 50 and younger; $6,500 over 50 years old. So there are many investors who have both IRAs and taxable accounts and don’t think about which investments are in which accounts.

If an investor owns growth stocks that he or she doesn’t anticipate selling for a while, those are better off in the taxable account. The investor does not pay taxes on an appreciating stock price – only when the stock is sold.

But a stock or other asset that generates annual income is a different story. That income is taxed.

For example, a long-term investor owns shares of Facebook (Nasdaq: FB) and TECO Energy (NYSE: TE). Facebook does not pay a dividend. TECO pays a 5.1% dividend yield. So for every $1,000 worth of TECO, the investor will receive $51 in dividends. If the investment is not in a tax-deferred account, the IRS gets 15% to 20% of that dividend depending on the investor’s tax bracket.

So if you’d rather not give the tax man a chunk of your investment income every year, keep those investments in an IRA and, even better, reinvest the dividends so you can allow the investments to compound tax-deferred.

Step 3: Forget About Master Limited Partnerships (MLPs) – A master limited partnership is a stock that differs from ordinary shares in a few important ways. When you own an MLP, you are a partner in the business, not simply a shareholder.

As a result the dividends are called distributions, and they are extremely tax-friendly. Usually the vast majority of these distributions are considered a return of capital. That means you will not pay taxes on the portion of the distribution that is considered a return of capital.

Instead it lowers your cost basis by the amount of the return of capital.

Let’s compare a regular dividend-paying stock and an MLP.

If you own $10,000 worth of Lockheed Martin (NYSE: LMT), you receive a 3.9% dividend yield or $390. If the stock is held in a taxable account you will pay $58.50 in federal taxes on the dividend if you’re in the 15% dividend tax bracket. So you’d net $331.50.

Compare that to Magellan Midstream Partners, (NYSE: MMP), an MLP with a 3.6% yield. On a $10,000 investment you’d receive $360 per year. Let’s assume that the distribution is 90% return of capital (the 2013 numbers won’t be released until next year, but 90% is a safe assumption). In that case, only $36 of the $360 would be taxable. At 15%, the investor would pay $5.40.

Even though the MLP pays a lower cash distribution, the net of $354.60 would be higher than Lockheed Martin’s, with the higher dividend yield.

It is important to understand that the return of capital lowers the cost basis. If you paid $10,000 for your Magellan units, your cost basis would be lowered by $354.60. Your new cost basis would be $9,646.40.

The return of capital turns into a capital gain (assuming you sell for a profit) at some point in the future. But for now, you get to keep the income, tax free.

Because MLPs are already a tax-deferred strategy, it is best to keep them in a taxable account, not an IRA.

Although the tax-deferred strategies of MLPs are attractive, be careful not to get too overweight with MLPs as they are mostly in the energy sector.

There are lots of other ways to pay more than your fair share of taxes. But these are the simplest steps you can take to ensure that Uncle Sam is digging into your pockets more than you have to legally allow.

— Marc

Source: Wealthy Retirement