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Five Tips for the Tax-Smart Investor
What's the one thing that affects every single investor? Interest rates? Inflation? Financial outlook? Nah, the answer is taxes. Nobody likes them, but we will always have them. Even more annoying is how complicated tax laws have become - accountants specializing in tax must earn a degree on the subject and constantly educate themselves to keep up with the dynamic world of taxes and tax law.
Ccomplicating things further are the different factors that can affect an investor's tax situation. First of all, tax law can differ greatly depending on the country, state, region, or municipality in question. Second, personal circumstance plays a major role in how an investor must approach taxes. Because of the variable nature of taxes, the goal of this article is simply to give some good general tips for the average investor to bear in mind. These five tips are not all you have to know about taxes, but they will give you useful information that can help you save some money.
Tax-deferred programs are like free money.
Every time you trade a stock, you are vulnerable to capital gains tax; however, if you make your purchases through a tax-deferred account you can save a pile of money. Tax-deferred accounts come in many shapes and sizes. The most well known are IRA and SEP (Simplified Employment Pension) accounts. With these accounts, you are not taxed on the funds until you withdraw, at which point you are taxed according to your current income-tax bracket. Waiting to cash-in until after you retire may save you even more because your income will likely be lower.
In addition to a reduction in the amount of capital gains you are likely to pay, these types of plans often allow investments to compound tax-free, which can have huge ramifications. Tax-deferred accounts used to bear the old stigma that they were only retirement funds. This, however, is no longer the case. Here's an interesting fact: if you use the funds from your IRA to purchase your first house, you may be able to withdraw the funds penalty-free. What a deal!
Match your profits and losses in the same year.
In many cases, matching the sale of a profitable investment with the sale of a losing one (within the same year) is a maneuver that takes advantage of tax laws. Capital losses can be used against capital gains, and short-term losses can be deducted from short-term gains. Also, if you had a particularly bad year, you can carry $3,000 of your loss over to other years.
For example, say you invested $5,000 in each of two companies at the beginning of the year: the TSJ Sports Conglomerate and Cory's Tequila Company (CTC). The TSJ happens to have a splendid year as two of the franchises it owns win their respective sport's titles. The stock rises 40%, increasing your $5,000 to $7,000. Despite this enviable position, your investment in CTC was a bust; the company greatly reduced future expected earnings, and the stock took a tumble, decreasing by 40% to $3,000. Prior to the end of the year, you decide that both stocks should be sold. Instead of paying capital gains on your TSJ shares, you are able to claim also the loss you suffered from the CTC shares tanking. Because the gain and the loss wash, you are left with a tax bill of $0 for these transactions. Remember this is a very simplified example, but it demonstrates the practice of using a capital loss to offset a capital gain.
It should also be noted that there is a limit to the amount of loss with which you are allowed to offset gains. In most jurisdictions it is fairly low - in the $3,000 range.
Buy tax-free or tax-advantaged investments
Most portfolios allocate some resources to fixed-income securities. You may be surprised to hear that state and municipal bonds are exempt from federal taxes. Better yet, if you live in the municipality from which the bonds are issued, the bonds are also exempt from state taxes. Munis (as these bonds are known) are attractive because they provide a nearly guaranteed investment - technically, cities and states could go bankrupt, but it is very unlikely--and they offer a pretty decent rate of return once taxes are considered. Take for example a Treasury bond (federal government issued) that returns 6% annually: if you are taxed at a rate of 20%, that $60 on every $1,000 bond quickly turns into only $48, and that 6% return quickly becomes 4.8%. Contrast that to a muni paying 5.5% annually, tax free.
Outside of municipal bonds, there are several insurance instruments such as annuities, which also have a tax-exempt status. Tax-exempt securities are definitely something for savvy investors to consider, at least as a small portion of their portfolio.
Add broker commissions and fees to the cost of your stocks.
Stock trading isn't free: you always pay commissions and may also pay transferring fees if you change brokerages. These expenses should be added to the amount you paid for a stock. When you sell the shares, subtract the commission from the sale price of the stocks. Think of these costs as a tax write-off because they are direct expenses necessary for making your money grow.
It's certainly to your advantage to keep commission costs down, and with the advent of online brokerages and their low-cost fees, this has become increasingly easy to do. For more on this subject, check out this brokerage tutorial.
Hold onto your stocks for at least 12 months
Here is another fact that is sure to please the buy-and-hold investor: short-term capital gains (less than one year) are almost always taxed higher than long-term gains. The difference in tax rates can be 13% or more.
If a stock is held for less than a year, any capital gain is simply taxed at your income tax rate (which can be as much as 40%, depending on your situation). If you hold investments for more than one year, capital gains are likely taxed at a rate of around 20% (again, this is variable). The point is that if stocks are held for the long term, the rate at which capital gains are taxed is substantially lower.
Some jurisdictions also have something known as super long-term investments, or investments held for more than five years. These are taxed at an even lower rate. (To read more on compounding and capital gains, check out "A Long-Term Mindset Meets the Dreaded Capital Gains Tax.")
Conclusion
At the risk of sounding like a broken record, we should repeat that taxes are a very individual thing, with many factors affecting each person's situation. However, the five points above are universal enough for just about every investor to keep in mind when viewing his or her investments.
By Investopedia Staff, (Investopedia.com)
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