Income Taxes and Investing
One day the Pharisees set out to trap Jesus with a question. They asked, “Tell us then, what is your opinion? Is it right to pay taxes to Caesar or not?” (Matthew 22:17). Jesus took a minute and asked them to shoe him the coin and tell him whose picture was on the coin. “Caesar’s,” they replied.
Jesus astounded them with his answer by saying, “Give to Caesar what is Caesar’s, and to God what is God’s” (Matthew 22:21).
The United States Tax Code places the burden of determining how much is “Caesar’s” on each individual citizen. Unfortunately, many Christians with good intentions proclaim they gladly pay their taxes. Sometimes this kind of attitude camouflages the fact that too much tax is being pain unnecessarily.
How much tax is enough is a philosophical issue. It came before the courts in 1947 in Commissioner v. Newman, when Justice Learned Hand wrote, “Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everyone does so, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands: Taxes are enforced extractions, not voluntary contributions. To demand more in the name of morals is mere cant.” So from both the words of Jesus and tax court, we can proceed to review the U.S. income tax system and hold the philosophical premise that while we should pay our taxes, we should not pay any more tax than required.
There are few absolutes in the world of investment planning. There is one axiom, however, that comes pretty close to an absolute: Never make an investment exclusively on the basis of tax implications. There are few exceptions to this rule. One exception might be IRC Section-42 (affordable housing program) and the tax credits it offers. Other possible exceptions might be certain types of qualified energy programs. But as an operating rule of thumb, investments should be made for their economic potential, with income tax considerations as an ancillary part of the decision process.
Another helpful general rule is that there is usually a corollary between tax benefits and loss of liquidity. For example, an investment in an annuity usually enjoys tax-deferred status on any subsequent gain. However, any distribution from that annuity prior to age fifty-nine-and-a-half will be treated as earnings-out-first, and the gain will be subject to a 10% tax penalty. So much for liquidity.
Numerous investments offer enticing income tax advantages. When properly arranged, for example, annuities and life insurance encounter no income tax on the gain in the contract cash value until there is a distribution. This tax advantage is referred to as tax deferral. Municipal bonds are generally free of federal income tax, and may also be free of state income tax. The dividends on these investments are then said to be tax exempt. As pointed out, an investment in a properly managed Section 42 affordable-housing program may offer tax credits. Tax credits are the most powerful tax advantage, since each dollar of credit by one dollar your tax liability.
One of the most common mistakes in this area is to equate a tax benefit with the underlying investment. For example, some people say they would not invest in an IRA again, because it had a poor rate of return. In fact, the portion of the tax code that authorizes Individual Retirement Accounts (IRAs) distinctly lists the types of investments that may qualify for this special tax advantage. A mutual fund might be categorized as tax exposed (meaning any dividends, interest, or capital gains would be taxable in the year they are earned), or tax deferred, in the case of an IRA. It might even be offered as a “separate account” in a variable annuity or a variable universal life contract, and qualify as tax deferred as a result. Be careful that you don’t mistakenly assume that any special tax advantage that an investment receives is synonymous with the underlying investment itself.
There are any number of legitimate ways to mitigate, defer, or even eliminate taxes. Congress continuously engages in “social engineering,” attempting to get the country to behave one way or another by giving certain investment strategies distinct tax advantages. The number of changes that have been made to the Individual Retirement Account (IRA) in the last 25 years and to other tax-driven programs such as Section 529 College Savings Plans, UTMA, and UGMA is hard to keep up with. Check with your accountant, or go online and obtain the current limits and guidelines.
Speak with a Recommended Financial Professional about income taxes and investing >