Tax Sins of Commission and Omission

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Investors often cut into their take-home returns by paying more in taxes than they actually need to. Here with me to discuss some common tax-related pitfalls, as well as some overlooked tax maneuvers, is John Pitlosh, he is an investment advisor with Investor Solutions LLC.

John, thank you so much for being here.

John Pitlosh: Thanks for having me.

Benz: You have outlined some pitfalls for us that investors frequently fall into, and the first one you noted was not fully understanding some of the tax ramifications of different investments.

So on your shortlist were MLPs (master limited partnerships), gold ETFs. Let's talk about some of the implications there and how investors maybe don't fully understand the tax implications of those vehicles.

Pitlosh: We find that a lot of investors watch CNBC, and they see MLPs are doing great or gold is the must-have, and they're looking to purchase these assets, without really understanding how these things are packaged and what the tax ramifications are of actually owning these investments. And we find that a lot of clients that do hold these can be pretty surprised when it comes April and ... their CPA bill is a lot more expensive than they were thinking.

So, for example, MLPs, which are master limited partnerships that invest in a lot of oil and gas infrastructure. We've had several people come to us that have these MLPs in their IRAs, and one of the pitfalls that they have is that they have an unusual tax that's called a UBTI tax, which is a tax that's "unrelated business taxable income," and most people think they can put their MLP in their IRA and forget about it, not to worry about all the tax complications of a partnership. But ... they can find out that they end up having a tax bill for something in their IRA, and that can be very surprising to them.

Benz: So if that UBTI exceeds a certain level, then they will owe taxes on that amount.

Pitlosh: If it's over $1,000.

Benz: And then gold, let's discuss the wrinkle there. I think you are talking about the gold bullion ETFs?

<TRANSCRIPT>

Pitlosh: Right. So, a lot of times people sell these thinking the capital gain is the standard capital gain, and ... some of these investments are taxed at the different rates. So, gold bullion, for example, is taxed at I believe it's a 28% capital gains rate, which is different than the normal 15%.

Benz: So, it's taxed as a collectible, not quite as attractive from a tax standpoint.

Now, another thing I want to touch on with you, John, is the new cost basis regulations that are going into effect on a staggered basis over the past few years and continuing into 2012. Let's discuss the default methods that a lot of financial institutions are using for tracking cost basis, and you say that sometimes going with that default can cost investors money?

Pitlosh: I think it was a couple of years ago when the same legislation I believe that TARP was put in, this act was used to help raise revenue and make sure people are reporting their capital gains properly.

So, what they did in this law was that they actually shifted the reporting responsibility for new purchases on certain types of investments from individuals over to the brokers that are actually holding the assets for clients. So, what happens in this situation is, you are having a lot of people that are no longer in control of their cost basis [reporting], and they can't necessarily make it up because the 1099 they're getting at the end of year already lists cost basis for certain assets.

Benz: So, I know a lot financial providers have been sending out these election forms or sending them to clients via e-mail, and you're given a chance to say, "Well, here is how I want you to track my cost basis." And I know with a lot of mutual fund companies, for example, they simply use the average method, when in fact another method might give the investor a little more control over the tax situation.

Pitlosh: Right. And also some firms even use FIFO, which is first-in, first-out. And if you have an old position or something that has grown a lot over time, or even in a short period, and you only sell a portion of the position, the first thing that you bought is what would get taxed.

So, a lot of times you want to defer the tax as much as possible, and you want to be able to avoid average and FIFO, if possible, so you can ... identify your own lots that fit your tax situation for a particular year in the best light under taxes.

Benz: Would you say for many investors that specific share identification method is the one that you would use to give yourself the most control over the tax position in various holdings?

Pitlosh: Absolutely. I think it depends how they call it. I think Schwab, for example, defaults to a highest cost basis, but ... you want to have the most control possible. So if you can do specific identification, that's usually the best route.

Benz: OK. One other thing on your list of pitfalls to avoid is not properly accounting for dividend distributions when you are keeping track of your own cost basis. So, even though financial providers will be tracking this stuff for you for new securities, you're still in charge of tracking your own cost basis for things you held prior to these rules. What should investors know about properly accounting for those dividends when tracking their own cost basis?

Pitlosh: A lot of people just need to keep good records. I can't tell you how many times I've worked with clients that have mutual funds from probably 10 different places, and three different brokers, and it's changed over time, and they've had dividends and capital gains reinvested back into their mutual funds over decades in some cases.

And what can happen in that situation is that they think about the position that they bought as they put $10,000 into something 10 years ago, and in fact they've been paying taxes on the capital gains and dividends that are being reinvested every year, and that [should be] increasing their cost basis. But if they haven't tracked that cost basis from broker-to-broker, the brokers haven't changed or they haven't been sharing information, they've lost a lot of that tax benefit that they've already paid for.

Benz: So keep your own records, just keep a simple spreadsheet or something like that, where you are tracking those reinvested dividends and capital gains.

Pitlosh: So, the new laws will help things going forward, but it hasn't cleared everything up in the past.

Benz: Now, I want to discuss some sins of omissions. So, some frequently overlooked tax maneuvers that investors don't avail themselves of.

At the top of your list is not donating appreciated securities to charity. When you want to make a charitable contribution, you think that investors should often look to securities that maybe they wanted to unload anyway. What's the big benefit there?

Pitlosh: The benefit is that you're basically giving something that has appreciation in it, and you're giving it to a 501(c)(3) charity that, whenever they sell the stock, they are not being taxed on it. So, nonprofits ... are not taxed on capital gains. So, the real benefit here is you are able to pass off your gains without having to pay the taxes on it, and the benefit to you is that you get the full deduction within the guidelines in terms of what you can deduct on your itemized deduction.

Benz: Right, and you get to do a little bit of good, too.

Another thing on your list is health savings accounts. I know that these accounts are very popular with some of our Morningstar.com users. Maybe you can just quickly run through why you think they can be advantageous in certain situations?

Pitlosh: Unless you are using health-care services on a regular basis and you need a low deductible plan, the ability to save for the future on a pretax rate can make a huge difference over time. So, to me, putting money into a pre-tax health savings account up to whatever the limit is, is just kind of a no-brainer. I'm surprised to see how many clients that don't use their health-care provider at all other than maybe an annual checkup or getting their glasses, they really don't take advantage of this, and they really should.

Benz: So, people who don't have a lot of medical expenses, who have the option to choose one of these high-deductible health-care plans, might find it very advantageous because they will lower their premiums and also have this health savings account as an additional savings vehicle, potentially?

Pitlosh: Exactly, and if you look at in 2013 the itemized deduction for medical expenses, the floor on that's going to go from 7.5% all the way up to 10%.

Benz: You also had a couple of items related to Roths; one is taking non-deductible IRAs and thinking about doing some conversions to Roths. What's the big advantage there?

Pitlosh: The advantage here is that for high-income earners that don't have IRA accounts already, most of their assets ... all of their qualified assets are tied up in the 401(k) or 403 (b) or something like that. You're able to ... anybody can contribute to a non-deductible IRA, and the benefit of doing that is that they can ... contribute to a Roth conversion in kind of a backdoor way.

Benz: And then another one on your short list is the Roth 401(k). So for people who have that option within their 401(k) plan, they might take a look at that. Who do you see as the chief candidates for a Roth 401(k) versus traditional contributions?

Pitlosh: Really, I see it as people that are needing to diversify their tax attributes for their investments. So, in terms of a long-term savings strategy, it really is beneficial for the high-income earner that doesn't have an easy way of contributing to a Roth. But also I think everybody should put at least a little bit into something like that, just so you are more prepared for whatever retirement is going to hold.

Benz: Just to get that tax diversification?

Pitlosh: Right.

Benz: How about people who are just starting out in their careers? I often talk to young folks who are wondering, while we have both of these options in our plan, which is the better one for me? I know it's hard to give one-size-fits-all recommendations, but what kind of counsel do you typically give in such a situation?

Pitlosh: If it's a younger new worker, a Roth is generally better, but some people want the tax deduction, and it can make sense in certain situations as well.

Benz: Maybe no easy answers on that front. Well, John, thank you so much for sharing all these ideas. It's obvious that there are lots of ways that investors can enhance their take-home returns by staying attuned to some of these opportunities and avoiding some of the pitfalls.

So, thank you so much for joining us.

Pitlosh: Sure. Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.