Investing your refund—it's all about taxes!

by Luke Norris

Let’s face it, future tax rates are as unpredictable as Kansas City’s weather. But one thing is certain— your investment strategy should be paralleled by a strong tax strategy.

As you build wealth for your retirement, especially amidst changing times in today’s economy, there are a few things to consider before you invest this year’s tax refund.

Since 1913, federal tax rates have fluctuated greatly. Following WWI, and as a part of the Revenue Act of 1917, taxes skyrocketed from a low 15 percent up to 77 percent. After falling as low as 20 percent during the late 1920s, tax rates again increased during WWII to a high of 94 percent in 1945 for those earning $200,000 or greater, and between 78 and 93 percent for those earning between $50,000 and $200,000. Tax rates remained high but slowly diminished over the next 40 years, before dropping in 1987 to 38 percent after the Tax Reform Act of 1986. As an investor today, you benefit from some of the lowest tax rates since the late 80s, with the highest tax rate at 35 percent. So where will the tax trends go next, and how will it affect you?

There’s some uncertainty whether the Alter-native Minimum Tax (AMT) will stay or go, but it definitely should be a factor in any investor’s strategy. The AMT began in 1970 and set a minimum tax rate of 25 to 27 percent for certain taxpayers, preventing them from claiming many types of deductions and decreasing their taxable income. Affected are higher income taxpayers who have what are known as “tax preference items,” which can include certain home mortgage interest, accelerated depreciation, miscellaneous itemized deductions, certain tax-exempt income, certain credits, and personal and dependent exemptions. Designed to ensure that the “extremely wealthy” pay a minimum amount of tax, the current AMT could impact one in every five families by the year 2010, and nearly every married taxpayer earning between $100,000 and $500,000.1

If you are like many Americans who will receive a tax refund this year, you are wondering how to invest it and advance your retirement savings. How can you make sure your tax and investment strategies are in line with your personal or family goals? First, always seek the advice of your financial partner and tax advisor for sound investment advice and specialized tax knowledge for your particular situation.

Making investments and planning for retirement is an important step in life. While most of us hear diversify, diversify, diversify, we might not think of that as investing in anything more than domestic, foreign, high-risk, or bonds. But in reality, decisions on where to invest may be influenced by the potential tax implications. Diversifying your investments between taxable, tax deferred, and tax-free vehicles are all things you should consider, and are among the easiest ways you can gain control of your retirement planning and financial future.

Here’s a hypothetical example. This year, you opt to put 100 percent of your retirement savings in tax-deferred vehicles with the intent of deferring your payment of federal income taxes until you need the money. If you currently are in the 25 percent bracket, you are saving 25 percent on your federal income taxes. Fast forward to when you begin withdrawing your money for retirement, and say the tax rate—due to any number of circumstances—has risen to 40, 50, or 60 percent as in decades past. In this scenario, the earlier decision to save 25 percent on your income taxes could result in the payment of more money overall. Granted a number of variables exist, including the time value of money, or even your future marginal rate due to additional income, but these types of scenarios should be considered when planning your strategy.

With the constant uncertainly surrounding future tax laws, it’s wise to pursue a more strategic approach to your investments, diversified over tax-deferred, taxable, and tax-free vehicles. Your risk tolerance, time frame to reach your goals, income, and asset balance all play a vital role in determining your contributions to each “tax flavor.”

 

Luke Norris leads business development for H&R Block's Virtual and Specialty Tax Services Group.
P | 816.854.4212
E | Luke.Norris@hrblock.com