Don’t let this out to anyone on the Senate Finance Committee, but rich old people who set up their portfolios a certain way get away with murder on their tax returns.
No, the portfolio does not have to be tucked away in the Cayman Islands. It can be invested through a U.S. brokerage account in mainstream funds like Vanguard Total Stock Market, familiar blue chips like Microsoft and very liquid energy partnerships like Kinder Morgan Energy Partners.
To illustrate, let’s invent a retired couple who live outside Boston. They own a $2 million home, have $7 million stashed away at their broker and haul in $200,000 a year in dividends, interest, Social Security and distributions from publicly traded partnerships. They have $30,000 in deductions, including $20,000 for property tax and $5,000 for a donation.
Type this example into Intuit’s TurboTax program and the federal income tax bill that comes out is $17.
How is that possible? The main reason is the government’s gentle treatment of most stock dividends. The usual rate is 15%, but a couple enjoys a 0% rate up to the point where their taxable income hits $70,700.
Another reason is that, in our hypothetical case, three-fourths of the couple’s $3 million bond portfolio is invested in municipal bonds. Also contributing: a foreign tax credit, untaxed distributions from energy partnerships and a $3,000 capital loss writeoff.
Do dream tax returns like this one occur in real life? Yes, says Rick Welsch, a partner at Wegner CPAs in Madison, Wis. “We’ve seen a number of returns where individuals have a fair amount of assets generating income qualifying as dividends and capital gains, and the return has a very low or no federal income tax.”
The citizens of Wisconsin and Massachusetts do not get away scot-free: They have local taxes, whose deductibility on federal returns depresses their federal taxes. Our Boston-area example has, besides the property tax, a $4,998 tab for state income tax. If the couple moved to Florida or Texas their federal tax would go up, but they’d still be a bit better off because their local taxes would go down by a larger amount.
Welsch worked up two Wisconsin examples for us, based on real taxpayers, with numbers changed enough to make them anonymous. Case I is a couple living off $216,000 a year, including $75,000 of municipal bond interest, $6,000 of taxable bond interest, $70,000 of dividends, $25,000 of taxable pensions and $40,000 of Social Security. Their federal tax bill is $198.
Case II is a widow with a $166,000 income from dividends, bond coupons, a private pension and Social Security. Her federal tax bill: $261.
The high life for portfolio investors is more common among senior citizens but not limited to them. The results would be similar for a self-employed consultant who stuffs most of her earned income into tax-sheltered retirement and health savings accounts, while paying the rent by cashing in bits of stock. There would also be light income tax on a playboy living off a $5 million stash inherited from his uncle.
If you want to join this party, follow these steps:
– Look for companies paying dividends that qualify for the reduced tax rate. The category includes most U.S. corporations (but not real estate investment trusts) and a surprising number of foreign corporations.
– Claim the foreign tax credit. Example: The dividend yield on Total, the French oil company, is over 4% even after French withholding, which offsets your U.S. tax.
– Sell losers from your stock portfolio and let winners ride. Losses of up to $3,000 a year can shelter ordinary income.
–Defer Social Security and IRA distributions until age 70. Live off non-IRA assets.
– Once you pass 65, consider buying energy partnerships like Kinder Morgan and Enterprise Products. Their taxable income, low or nil in early years, rises sharply after a decade or two. But the deferred taxes are erased on inherited shares.
Our model portfolio for the Bostonians includes $2.5 million in U.S. stocks yielding 2%, $1 million in foreign stocks yielding 3.3% in cash plus 0.33% in foreign tax credits, $1.25 million in Massachusetts bonds, $1 million in tax-exempt bonds from other states, $750,000 in 20-year Treasurys yielding 2.8% and $500,000 in partnerships yielding 5%.
It’s not hard to get yields like these. The U.S. stock portfolio could be mostly invested in a diversified ETF like Vanguard Total Stock Market (VTI) or Schwab U.S. Broad Market (SCHB). It would be helpful to include individual positions in stocks with somewhat higher than average dividends, like McDonald’s (MCD) and Microsoft (MSFT).
Candidate foreign stocks with dividends and tax credits can be found in the portfolios of European stock funds. Total S.A., for example, trades on the New York Stock Exchange under the ticker TOT. You can crib ideas for energy partnerships from funds, too; a common holding is Kinder Morgan (KMP).