Archives for March 2013

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Tax Planning Tip: Pay Attention to Timing

A common misconception about tax planning is that it consists primarily of making sure to claim all the deductions and credits for which you are eligible. That’s important, no doubt. But there are often additional savings to be had from figuring out the best time to claim your deductions. And the same goes for income.

Of course, you often have no choice in the matter. For example, if you receive a certain amount of wages this year, you cannot simply choose to include those wages in next year’s taxable income rather than this year’s.

But sometimes you do have a choice. And when the timing is up to you, you should put some serious thought into it.

Capital Gains and Losses

Capital gains and losses provide many opportunities for timing strategies, because you get to choose when you sell your investments.

Most obviously: It’s often a good idea to wait until a gain is a long-term capital gain before realizing it, thereby allowing you to take advantage of the lower tax rate. And if you’re selling your home for a gain, if it all possible, you’ll want to wait until you’ve qualified for the exclusion.

Less obviously: As we recently discussed, it is often advantageous to separate capital gains and losses into different years if doing so a) doesn’t cause any other problems and b) allows the losses to offset ordinary income rather than long-term capital gains.

Bunching Itemized Deductions

If in most years you fall just short of being able to itemize your deductions, there may be an opportunity to achieve savings by bunching up your deductions every other year.

For example, if you are married filing jointly and your normal itemized deductions include $6,000 of state and local income taxes, plus a $5,000 charitable contribution to your favorite non-profit, the $11,000 total isn’t going to do you any good. You would just claim the standard deduction ($12,200 for 2013) instead.

However, what if, in 2013, instead of making your normal $5,000 charitable contribution, you kept that money in your checking/savings and made the donation in January of 2014? In that case, you could claim the standard deduction in 2013, and in 2014 you would be able to benefit from itemizing because you’d have $16,000 of itemized deductions ($6,000 state and local income taxes, plus two $5,000 charitable contributions).

And you could run through the same routine every two years: no donations in odd-numbered years and double contributions in even-numbered years.

Changes in Tax Brackets

Whenever you find yourself in a higher-than-normal tax bracket (e.g., due to a large bonus that is unlikely to be repeated next year), you should check to see if there are any deductions that you can accelerate into this year. For example:

  • If you have any healthcare procedures that you’ve been putting off, and you do not ordinarily max out your HSA or FSA, now would be a good time to bump up those contributions and go ahead and get the procedure done, or
  • If you itemize, consider making next year’s charitable contributions this year.

And conversely, in years in which you’re in an unusually low tax bracket, it’s worth considering what opportunities you have for recognizing income this year that would otherwise be recognized in a later year. For example:

  • Roth conversions often make sense in years in which your taxable income is temporarily-low (e.g., after retiring but before Social Security kicks in).
  • Or, if you’re ordinarily in the 25% tax bracket or above, and you temporarily find yourself in the 15% tax bracket or below, that would be a good time to realize some long-term capital gains to take advantage of the 0% tax rate.

For More Information, See My Related Book:


Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Tax on “Net Investment Income” (What Does the IRC Say?)

A reader writes in, asking:

I’m finding conflicting information about how the new 3.8% tax on net investment income is calculated. The lists for what types of income are included vary depending upon where I’m reading…WSJ, Forbes, etc. Even IRS articles don’t agree with each other!!

Whenever you’re getting conflicting information about a tax topic, I think the best approach is to go right to the source: the Internal Revenue Code (IRC).

While the IRC isn’t exactly fast-paced reading, I think you’ll find that it’s not (quite) as bad as you might have expected if you’re willing to be patient and take your time as you read it.

Finding the Appropriate Code Section

If you don’t know what you’re doing, it can be difficult to find the relevant code section for a specific topic. The method that works best for me is to use Google to do a site-specific search of Cornell University’s website (my favorite place to read code sections).

On Cornell website, all the Internal Revenue Code URLs start with “”. So, to look for the code section about the tax on net investment income, I would start with the following Google search:

site: net investment income

Section 1411 is the first result. A quick glance tells us that we’re in the right place.

Making Sense of Legalese

As mentioned above, reading a section of the IRC is an exercise in patience. Fortunately, if you’re willing to go line-by-line, you can typically get a good enough grasp on the material to answer your specific question.

So let’s get back to our specific question: What is included in net investment income?

Section 1411 begins with the following statement:

“Except as provided in subsection (e)”

Darn. A cross-reference right off the bat. So we scroll down to subsection (e) and find:

“(e) Nonapplication of section
This section shall not apply to—
(1) a nonresident alien, or
(2) a trust all of the unexpired interests in which are devoted to one or more of the purposes described in section 170 (c)(2)(B).”

OK. That’s not so bad. Assuming you’re not a nonresident alien or dealing with a trust in some way, we can ignore this subsection and get back to our reading at the top of the page.

“In the case of an individual, there is hereby imposed […] for each taxable year a tax equal to 3.8 percent of the lesser of—
(A) net investment income for such taxable year, or
(B) the excess (if any) of—
(i) the modified adjusted gross income for such taxable year, over
(ii) the threshold amount.”

The structure of that statement isn’t particularly hard to understand. But it does leave the reader wondering about the definitions for “net investment income,” “modified adjusted gross income,” and “the threshold amount.”

And guess what? Subsection (b) consists of a definition of the threshold amount. Subsection (c) consists of a definition of net investment income. And subsection (d) consists of a definition of modified adjusted gross income. It’s almost as if this code section was written with the intention of being understandable!

So, to answer our reader’s question, let’s skip right to the part that defines net investment income:

The term “net investment income” means the excess (if any) of—
(A) the sum of—
gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),
(ii) other gross income derived from a trade or business described in paragraph (2), and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

So unless you’re deriving income from a trade or business, net investment income includes: interest, dividends, annuities, royalties, rents, and capital gains.

And a little bit later, in paragraph (5), we read the following:

The term “net investment income” shall not include any distribution from a plan or arrangement described in section 401(a)403(a)403(b)408408A, or 457(b).

You probably recognize 401, 403, and 457 as dealing with employer-sponsored retirement plans. Section 408 deals with IRAs, and 408A deals with Roth IRAs. In other words, net investment income does not include distributions from IRAs, Roth IRAs, or most employer-sponsored retirement plans.

For More Information, See My Related Book:


Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

What is a Closed-End Fund?

I think the best way to explain closed-end funds is to compare them to regular (open-end) mutual funds and to exchange-traded funds (ETFs).

With traditional (open-end) mutual funds, shares are created (or eliminated) everyday when investors put money into (or take money out of) the fund. And all of these buy and sell transactions occur at the fund’s “net asset value” (NAV), which is the per-share price of the underlying net assets.

With a closed-end fund, the number of shares is constant. That is, when a new closed-end fund is started, the fund company creates a fixed number of shares, and they sell those shares via an IPO — much like a normal stock.

If you want to buy or sell shares of a closed-end fund, you have to do it on an exchange (buying shares from existing shareholders or finding somebody to sell your shares to) rather than doing the transaction directly with the fund company. In this way, closed-end funds are much like ETFs.


As with ETFs, when buying or selling a closed-end fund, the price you get is simply whatever price you can get somebody else to agree to — which could be more or less than the NAV of the fund.

With ETFs, these discounts and premiums relative to NAV are typically very small. That’s because, while you cannot create or eliminate shares, certain other parties can. Large financial institutions referred to as “authorized participants” can create or eliminate ETF shares by exchanging an appropriate number of shares of the underlying holdings with the fund company.

Because they have the ability to create and redeem shares, when authorized participants notice that the ETF’s market price is significantly above or below the fund’s NAV, they can engage in a bit of arbitrage (by creating or redeeming shares at NAV with the fund company, then buying or selling them on the open market). This process generally keeps the market price for the ETF very close to the fund’s NAV.

This process does not occur, however, with closed-end funds because the number of shares is fixed. As a result, closed-end funds are more likely to trade at significant discounts or premiums relative to their NAV.

Generally speaking, these discounts or premiums are not going to be to the individual investor’s advantage. Typically, it will be the larger investors with their better access to data and automated systems who are better able to take advantage of discounts and premiums.

Opportunities for the Fund Manager

One advantage of the closed-end structure is that, because the fund manager doesn’t have to worry about selling holdings to raise cash for share redemptions, he/she can invest in illiquid holdings.

It also means, however, that the fund manager can use leverage to ratchet the risk and expected return of the portfolio upward — again, because he/she doesn’t need to worry about selling holdings at an inopportune time in order to satisfy share redemptions. Frankly, I do not think this is a good thing for most investors. Most investors have plenty of control over their desired risk level just by changing their asset allocation — no need for leverage. (Borrowing money does come at a cost, after all.)


At least according to one study, closed-end domestic stock funds have slightly lower expense ratios, on average, than open-end domestic stock funds. But when it comes to mutual fund costs, “average” isn’t exactly a high standard to hold yourself to. Most closed-end funds that I’ve seen have expense ratios that are well above what I would be willing to pay for exposure to a given asset class.

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