The one great thing about the low yields on fixed income investments today is that they've made the bonds you've owned for a while worth more than you paid for them. As you know, when interest rates fall, bond prices rise....and interest rates have been falling for quite a while now. That means that some of your fixed income investments may now be selling at a 'premium' and that can be very tax positive for you. The question is "Will you take advantage of it?"
Let me explain.
For the sake of this discussion, you need to understand that bonds in a taxable account are generally subject to only one type of taxation - ordinary income taxes. That's because most people keep their bonds till maturity. Now, if you're a high income taxpayer, the interest on those bonds could be taxed as high as 39.6% at the federal level. Let's just call it 40% to keep the math simple. When you own bonds that are worth a 'premium' though, if the bonds are sold, that premium is subject to a capital gain tax, not ordinary income taxes. Because capital gain can be taxed as low as 20%....and ordinary income is taxed at up to 40%....well, you can see the advantage of going one way vs. the other. The difference - the arbitrage - between those two rates is where this KILLER TAX SAVINGS IDEA comes into play.
Take a look at the situation with John and Mary Affluent. They have a portfolio of 20 year US Treasury bonds that they purchased in 1996 for $1,000,000. Back then, interest rates were higher and those bonds yield 6%...or $60,000/year. The bonds mature next year - in 2016 - and John and Mary have one last $60,000 payment (actually, two $30,000 payments) coming their way.
Because bond values go up when interest rates go down, the bond portfolio that John and Mary bought for $1,000,000 - which matures a year from now - is now worth $1,055,832. That value is based on a quick Google search which shows that a 1 year Treasury note only yields about 0.40% as of September 3rd, 2015.
So, think about the choices John and Mary have, the tax implications, and the net amount they receive based on their choice:
By the way, if John and Mary are working with someone that knows what he's doing, those CDs can be fully guaranteed by FDIC insurance.
If John and Mary have any capital losses in their portfolio from prior years....or even this year given the gyrations in the stock side of their investment portfolio (what a ride just a week ago)....they can apply those loses against the capital gain of the bond transaction and lower the taxes even further!
Now, why do I say that there is deadline to this idea? I say this because the Federal Reserve Open Market Committee is meeting in mid-September to talk interest rates. If they choose to increase rates, the premium in bond portfolios will begin to erode and this tactic loses its oomph.
In short, if you have a taxable bond portfolio with gains, look at this idea to see if it makes sense for you to do something about it before mid-September!
*If you live in a state that taxes capital gains (and Georgia does), the numbers in the above example go down a bit because we've turned interest income from federal government bonds that wasn't taxable at the state level into capital gain that is taxable at the state level.
**This strategy is probably not appropriate for municipal bonds because it turns interest that isn't taxable at the federal level into capital gain that is taxable at the federal level.
Entrepreneur, financial guy, husband and father of two great kids.