Cleaning Up: Lindsay Lohan Somehow Forgot to Add the IRS to Her “List”

Although Lindsay Lohan is supposedly in recovery from her various addictions, she reportedly owes the IRS over $140,000 for unpaid 2010 taxes. What could Lindsay's advisors have done differently to make sure the federal government didn't come so high on her list of people she's wronged?

The first mystery is how she amassed such a huge liability. Per IMDB, she only had one small acting job in 2010: the movie “Machete," a low-budget film where Lindsay presumably was paid little if any compensation.

Certainly, whatever she earned from this would have been offset by medical expense deductions for rehab.

We can only come to one conclusion on the source of Lindsay’s income during 2010: investment income.

As a CPA and Personal Financial Specialist (as well as co-founder of Total Rebalance Expert®), I know a thing or two about tax-efficient investing, and I think Lindsay needs professional help from a tax-aware financial advisor!

With proper management, the tax costs of investing can be minimized.
There are three basic types of investment income generally reported on tax returns: interest income, dividend income and capital gains. Let’s look at how Lindsay’s taxable income could be reduced.

Managing the IRS interest

It might seem like a no-brainer to choose municipal bonds or tax-free money markets rather than pay tax on interest. However, for those in a low tax bracket, this doesn’t make sense.

Since municipal interest pays less than taxable interest, this strategy tends to benefit only those in the highest tax bracket. Based on Lindsay’s large tax liability, she is most likely in a high tax bracket, so municipal interest could be a good answer.

A better solution would be to place interest-generating investments in her IRA or other retirement plan. Since these accounts are tax deferred, Lindsay would pay no current tax on the interest income.

Down the road, assuming she reaches a ripe old age, distributions from Lindsay’s IRA would be subject to ordinary tax rates. No problem here: that interest would be taxed at ordinary rates anyway!

Dividends are another issue. Qualified dividends are taxed at low capital gain rates while nonqualified dividends are taxed as ordinary income.

Any equities producing a large quantity of nonqualified dividends might be better held in a retirement account.

Although qualified dividends are taxed at lower rates, this tax will still need to be paid each year. Tax can only be avoided by offsetting this income with capital losses.

From an economic standpoint, investors like Lindsay want their portfolios to grow. From a tax standpoint, investors -- again, like Lindsay -- would rather not pay Uncle Sam! The solution to this problem is two-fold: tax deferral and tax avoidance.

Tax deferral, or postponement, is accomplished by harvesting tax losses. When there is a dip in the market, positions worth less than original cost can be sold to recognize a tax loss.

To stay fully invested while avoiding wash sale treatment, a similar investment can be bought as a “place holder.” By creating losses for tax purposes, capital gain income -- including capital gain distributions -- and up to $3,000 in ordinary income per year can be offset.

And, to the extent all losses are not utilized in one year, they can be carried forward to offset gains in future years. Continued loss harvesting can go a long way toward reducing Lindsay’s tax bite year after year.

It’s true that this strategy just postpones the pain, but had Lindsay taken advantage of tax loss harvesting, she might have avoided a large part of her tax assessment.

And, if she holds on to her investments until she dies, the basis step-up results in permanent tax avoidance for her heirs.

Tax-smart portfolio allocation

Finally, by allocating Lindsay’s investments among her different accounts, she could permanently cut her tax bill.

Holding appreciating equities in IRAs or other retirement accounts rather than taxable accounts could transform long-term capital gain tax into ordinary tax, essentially causing twice as much tax on the growth. Thus, equities should generally be held in taxable accounts.

Putting high-return investments in Lindsay’s Roth IRA gives the biggest bang for the buck, eliminating tax permanently on these holdings.

These strategies could be overwhelming for Lindsay to carry out herself. They could also be complicated for her advisor. By utilizing state-of-the-art automation for rebalancing and account aggregation, the process can be simplified.

(Benefits of rebalancing software are quantified in the White Paper “Return on Technology Investment” available as a free download at www.trxpert.com.)

The more the advisor can simplify the processes, the better the client -- Lindsay -- can legally cut down her tax liability.

And Lindsay needs all the help she can get.

Sheryl L. Rowling, CPA/PFS is a co-creator and CEO of Total Rebalance Expert®, the most tax-efficient rebalancing software.  She is also the head of Rowling & Associates.  Sheryl has been providing fee-only tax and financial planning advice since 1979. Sheryl was named one of the nation’s top 250 financial advisers by Worth magazine, received recognition as one ofAccounting Today’s 100 Most Influential People, and was named a FIVE STAR Wealth Manager by San Diego Magazine. Contact her at Sheryl@trxpert.com

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