Tax Issues

Tax efficient placement of investment assets

Larry posted (52528) the link to an article by the TIAA-CREF Institute on the tax efficient placement of investment assets. The paper is titled “Maximizing Long-Term Wealth Accumulation”. The paper discusses “the advantages of placing equities in taxable accounts and taxable bonds in tax-deferred acounts in order to maxmize tax efficiency.”

The idea of placing equities in taxable accounts and bonds in tax-deferred accounts is not new. The reason for this recommendation is due to the differential tax treatment of capital gains and interest income. In a taxable account, capital gains (long term) are taxed at a maximum of 15% while interest income are taxed at the income tax rate of up to 35%.

Now consider the fact that tax-deferred accounts are always taxed at the income tax rate of up to 35% at withdrawal, regardless of whether the gains come from capital gains or interest income. What this means is that if we keep equities in the tax-deferred account, the more valuable capital gains rate actually gets “converted” into income tax rate, an undesirable situation. On the other hand, there is no such disadvantage if bonds are kept in the tax-deferred account since interest income is taxed at income tax rate anyway. Therefore, bonds are ideally placed in the tax-deferred account and equities in the taxable account.

Placing equities in the taxable account also has some other benefits, like ability to perform tax-loss harvesting, foreign tax credit, and the eventual stepped-up basis for the heirs

Impact of AMT on tax exempt funds

In an earlier post, I wrote about the regressive tax brackets when evaluated under the AMT structure. In this post, we will consider how these AMT brackets affect the yield of various flavors of tax exempt money market funds, looking specifically at the case of an investor domiciled in California.

There are many different types of money market funds; they are listed below in the following broad types:

  1. Fully taxable at local, state and federal level, e.g. Vanguard’s Prime money market fund.
  2. Taxable only at federal level, e.g. Vanguard’s Treasury money market fund.
  3. Taxable only at local, state level, taxable at federal level if you are subject to AMT, e.g. Vanguard’s tax-exempt money market fund. (Note: The portion of the interest earned that comes from your state of residence is tax-exempt)
  4. Taxable only at federal level if you are subject to AMT, otherwise it is fully tax-exempt, e.g. Vanguard’s California tax-exempt money market fund (for California residents).
  5. Fully tax-exempt, e.g. Fidelity’s California AMT-free money market fund.

The following table summarizes the situation:

2006-08-18-mmf-types.png

The reason why certain tax-exempt funds are subject to AMT is because they contain private activity bonds (e.g. bonds to build a shopping mall). Tax-exempt funds hold these bonds because they tend to have better yield.

Let’s calculate the net yield, with the effect of AMT considered, for an investor with the following tax situation:

State tax bracket 9.3% (California)
Federal tax bracket 28%
AMT bracket 32.5%

1) For a fully taxable fund, e.g. VG Prime MMF yields 5.10%
Net yield (no AMT) = 5.10% * (1 – 0.28 – 0.093*(1-0.28)) = 3.33%
Net yield (with AMT) = 5.10% * (1 – 0.325 – 0.093) = 2.97%

2) For a federal-taxable-only fund, e.g. VG Treasury MMF yields 4.69%
Net yield (no AMT) = 4.69% * (1 – 0.28) = 3.38%
Net yield (with AMT) = 4.69% * (1 – 0.325) = 3.17%

3) For a state-taxable-only fund, e.g. VG Tax exempt MMF yields 3.38%
This MMF has about 12.6% in CA and 17% subject to AMT
Net yield (no AMT) = 3.38% * (1 – 0.093*(1-0.126)) = 3.11%
Net yield (with AMT) = 3.38% * (1 – 0.093*(1-0.126)) * (1-0.17*0.325) = 2.93%

4) For a state-specific tax-exempt fund, e.g. VG CA tax exempt MMF yields 3.31%
This MMF has 100% in CA and about 18.2% subject to AMT
Net yield (no AMT) = 3.31%
Net yield (with AMT) = 3.31% * (1-0.182*0.325) = 3.11%

5) For a state-specific TE and AMT-free fund, e.g. Fidelity’s CA AMT-free MMF yields 3.19%
This MMF has 100% in CA and 0% subject to AMT
Net yield (no AMT) = 3.19%
Net yield (with AMT) = 3.19%

Interestingly, assuming my calculations are correct, Fidelity’s CA AMT-free fund turns out to be the best for an investor subject to AMT, despite the lower expenses of VG’s CA TE MMF.

The after-tax yields with and without AMT for the above scenario, and other scenarios for an investor in California are given below:

2006-08-18-after-tax-480×368.png

Note 1: The yields quoted are read from the respective website as of 2006-08-17.
Note 2: Most equivalent-yield calculators available on the web DO NOT take into account of AMT.

Update Nov 06, 2006
It appears that under California tax law, a mutual fund must have at least 50% of the income derived from California before that portion can be considered as state tax free. Under this scenario, the yield for the type 3 “state-taxable-only” money market fund is actually lower than the number shown in the tables above.

Regressive tax brackets under AMT

The alternative minimum tax or AMT has been affecting more and more Americans in recent years. Originally designed as an alternative tax for the very rich who avoided paying tax by claiming various deductions, it is now becoming more and more of a middle and upper-middle class tax. The main reason is because the income thresholds for AMT are not indexed for inflation, quite unlike the regular income tax brackets.

Most people must have heard that the AMT tax brackets are ‘only’ 26% for incomes below $175k or 28% for incomes beyond $175k. This is not quite true. AlvinSch on Diehards forum has raised the issue a few times that AMT brackets are in fact regressive if your income is within the range of $150k and $400.2k (was $382k in 2005, see CNN article: “How the new tax law affects you”, May 17, 2006).

The reason why the effective AMT brackets are not 26% and 28% is because the effect of a phase-out of the personal AMT exemption for incomes above $150k by a quarter of a dollar for every additional dollar earned is ignored. The effect of the phase-out is to increase the tax rate by a quarter of 26% or 28% for incomes in the phase-out range.

Overall, the effective AMT brackets for a couple filing jointly for tax year 2006, taking the phase-out exemption into account, is as follows:

  • below $62.55k : 0%
  • $62.55k to $150k : 26%
  • $150k to $220.04k : 26% + 26%/4 = 32.5%
  • $220.04k to $400.2k : 28% + 28%/4 = 35%
  • beyond $400.2k : 28%

As we can see, the AMT brackets are regressive and actually lower for the very rich with incomes beyond $400.2k.

Notes:

1) The income of $220.04k is the point at which AMT changes from 26% to 28%. This number, call this Y, occurs when your ordinary income, reduced by personal exemption, is $175k. The calculation to derive Y is as follows:

Y – E = 175000 where E is the personal exemption.

Y is above $150k and E is therefore subjected to the phase-out:

E = 62550 – 0.25(Y-150000)

Combining,

Y – (62550 – 0.25(Y-150000)) = 175000, giving Y = $220,040.

2) The number of $400.2k is the point at which the personal exemption completely disappears. This number is given by $150k + $62.55k/0.25 = $400.2k.