Chapter 4

Minimizing Your Taxes When Investing

IN THIS CHAPTER

check Seeing how investments are taxed

check Understanding capital gains and dividend taxation

check Employing strategies to reduce investment taxation

check Considering tax issues when selling an investment

You should pay attention to tax issues when making investing decisions. Actually, let me rephrase that. Like plenty of other folks, you could ignore or pay half attention to taxes on your investments. Unless you enjoy paying more taxes, however, you should understand and consider tax ramifications when choosing and managing your investments over the years.

Tax considerations alone shouldn’t dictate how and where you invest your money. You should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the investment.

In this chapter, I explain how the different components of investment returns are taxed. I also present proven up-to-date strategies to minimize your investment taxes and maximize your returns. Finally, I discuss tax considerations when selling an investment.

Understanding Investment Taxes

When you invest outside tax-sheltered retirement accounts, the profits and distributions on your money are subject to taxation. (Distributions are taxed in the year that they are paid out; appreciation is taxed only when you sell an investment at a profit.) So the non-retirement-account investments that make sense for you depend (at least partly) on your tax situation.

Tracking taxation of investment distributions

The distributions that various investments pay out and the profits that you may make are often taxable, but in some cases, they’re not. It’s important to remember that it’s not what you make pretax on an investment that matters, but what you get to keep after taxes.

remember Interest you receive from bank accounts and corporate bonds is generally taxable. U.S. Treasury bonds, which are issued by the U.S. federal government, pay interest that’s state-tax-free but federally taxable.

Municipal bonds, which state and local governments issue, pay interest that’s federally tax-free and also state-tax-free to residents in the state where the bond is issued. (For more on bonds, see Chapter 9.)

Taxation on your capital gains, which is the profit (sales price minus purchase price) on an investment, is computed under a unique system. Investments held less than one year generate short-term capital gains, which are taxed at your normal marginal income tax rate (which I explain in the next section).

Profits from investments that you hold longer than 12 months are long-term capital gains. Under current tax law, these long-term gains are taxed at a maximum 20 percent rate, except for folks in the two lowest income tax brackets: 10 percent and 15 percent. For these folks, the long-term capital gains tax rate is 0 percent (as in nothing). Dividends paid out on stock are also taxed at the same favorable long-term capital gains tax rates under current tax law.

The Patient Protection and Affordable Care Act (informally referred to as Obamacare) increased the tax rate on the net investment income for taxpayers with adjusted gross income above $200,000 (single return) or $250,000 (joint return). Net investment income includes interest, dividends, and capital gains. The increased tax rate is 3.8 percent. During 2017, efforts were underway to possibly repeal and replace Obamacare and its associated taxes, but at the time of publication, no changes had been made.

Determining your tax bracket

Many folks don’t realize it, but the federal government (like most state governments) charges you different income tax rates for different parts of your annual income. You pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings.

Your federal marginal income tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income (see Table 4-1). Your taxable income is the income that is left after taking allowed deductions on your return.

TABLE 4-1 2017 Federal Income Tax Rates for Single and Married Households Filing Jointly

Singles Taxable Income

Married-Filing-Jointly Taxable Income

Federal Income Tax Rate (Bracket)

Less than $9,325

Less than $18,650

10%

$9,325 to $37,950

$18,650 to $75,900

15%

$37,950 to $91,900

$75,900 to $153,100

25%

$91,900 to $191,650

$153,100 to $233,350

28%

$191,650 to $416,700

$233,350 to $416,700

33%

$416,700 to $418,400

$416,700 to $470,700

35%

More than $418,400

More than $470,700

39.6%

remember Your actual marginal tax rate includes state income taxes if your state levies an income tax. Though this chapter focuses upon the federal income tax system and strategies to reduce those taxes, most of what is discussed also helps you reduce your state income taxes, which the vast majority of states levy. Each state income tax system is unique, so covering them all here is impossible. All but seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming — impose a state income tax. (New Hampshire and Tennessee have only a state income tax on dividend and interest investment income).

There’s value in knowing your marginal tax rate. This knowledge allows you to determine the following (among other things):

  • How much you could reduce your taxes if you contribute more money to retirement accounts
  • How much you would pay in additional taxes on extra income you could earn from working more
  • How much you could reduce your taxable income if you use investments that produce tax-free income (which might make sense only if you’re in a higher tax bracket — more on this later in the chapter)

For the latest on important changes to federal income tax rates and rules, please visit my website at www.erictyson.com.

Paying attention to the 2017 Congressional tax bill

As this book went to press in the fall of 2017, the president and his administration had been promising a significant tax bill that would likely reduce the number of individual tax brackets and reduce the taxes paid by non-high income earners. Also discussed was reforming and lowering corportate income tax rates to bring those in line with other developed countries.

It has been hard to assess the likelihood of such a tax bill passing, especially since it still hasn’t been introduced after early 2017 promises that a bill would have been passed and signed into law by now. For updates, please visit my website at www.erictyson.com.

Devising tax-reduction strategies

Use these strategies to reduce the taxes you pay on investments that are exposed to taxation:

  • Make use of retirement accounts and health savings accounts. Most contributions to retirement accounts gain you an immediate tax break, and once they’re inside the account, investment returns are sheltered from taxation, generally until withdrawal. Think of these as tax reduction accounts that will help you work toward achieving financial independence. See Chapter 2 for details on using retirement accounts when investing.

    Similar to retirement accounts are health savings accounts (HSAs). With HSAs, you get a tax break on your contributions up front; investment earnings compound without taxation over time; and there’s no tax on withdrawal so long as the money is used to pay for health-related expenses (as delineated by the IRS).

  • Consider tax-free money market funds and tax-free bond funds. Tax-free investments yield less than comparable investments that produce taxable earnings, but because of the tax differences, the earnings from tax-free investments can end up being greater than what taxable investments leave you with. If you’re in a high-enough tax bracket, you may find that you come out ahead with tax-free investments.

    tip For a proper comparison, subtract what you’ll pay in federal and state income taxes from the taxable investment income to see which investment nets you more.

  • Invest in tax-friendly stock funds. Mutual funds that tend to trade less tend to produce lower capital gains distributions. For mutual funds held outside tax-sheltered retirement accounts, this reduced trading effectively increases an investor’s total rate of return. Index funds are mutual funds that invest in a relatively static portfolio of securities, such as stocks and bonds. (This is also true of some exchange-traded funds.) They don’t attempt to beat the market; rather, they invest in the securities to mirror or match the performance of an underlying index. Although index funds can’t beat the market, the typical actively managed fund doesn’t, either, and index funds have several advantages over actively managed funds. See Chapter 10 to find out more about tax-friendly stock mutual funds, including some nonindex funds and exchange-traded funds.
  • Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. Even then, with investment real estate, you often can roll over the gain into another property as long as you comply with tax laws. Increases in value in small businesses can qualify for the more favorable longer-term capital gains tax rate and potentially for other tax breaks. However, the current income that small business and real estate assets produce is taxed as ordinary income.

remember Short-term capital gains (investments held one year or less) are taxed at your ordinary income tax rate. This fact is another reason why you shouldn’t trade your investments quickly (within 12 months).

Reducing Your Taxes When Selling Investments

I advocate doing your homework so you can purchase and hold on to good investments for many years and even decades. That said, each year, folks sell and trade lots of investments.

My experience in helping people get a handle on their investments suggests that too many investors sell for the wrong reasons (while other investors hold on to investments for far too long and should sell them).

In this section, I highlight important tax and other issues to consider when you contemplate selling your investments, but I start with the nontax, bigger-picture considerations.

Weighing nontax issues

Although the focus of this chapter is on tax issues to consider when making, managing, and selling your investments, I’d be remiss not to raise bigger-picture considerations:

  • Meeting your goals and preferences: If your life has changed (or if you’ve inherited investments) since the last time you took a good look at your investment portfolio, you may discover that your current holdings no longer make sense for you. To avoid wasting time and money on investments that aren’t good for you, be sure to review your investments at least annually.

    warning Don’t make quick decisions about selling. Instead, take your time, and be sure you understand tax and other ramifications before you sell.

  • Keeping the right portfolio mix: A good reason to sell an investment is to allow yourself to better diversify your portfolio. Suppose that through your job, you’ve accumulated such a hefty chunk of stock in your employer that this stock now overwhelms the rest of your investments. Or perhaps you’ve simply kept your extra money in a bank account or inherited stock from a dear relative. Conservative investors often keep too much of their money in bank accounts, Treasury bills, and the like. If your situation is like these, it’s time for you to diversify. Sell some of the holdings of which you have too much, and invest the proceeds in some of the solid investments that I recommend in this book.

    investigate If you think your employer’s stock is going to be a superior investment, holding a big chunk is your gamble. At minimum, review Chapter 8 to see how to evaluate a particular stock. Remember to consider the consequences if you’re wrong about your employer’s stock. Develop an overall investment strategy that fits your personal financial situation (see Chapter 5).

  • Deciding which investments are keepers: Often, people are tempted to sell an investment for the wrong reasons. One natural tendency is to want to sell investments that have declined in value. Some people fear a further fall, and they don’t want to be affiliated with a loser, especially when money is involved. Instead, step back, take some deep breaths, and examine the merits of the investment you’re considering selling. If an investment is otherwise still sound per the guidelines I discuss in this book, why bail out when prices are down and a sale is going on? What are you going to do with the money? If anything, you should be contemplating buying more of such an investment.

    Also, don’t make a decision to sell based on your current emotional response, especially to recent news events. If bad news has hit recently, it’s already old news. Don’t base your investment holdings on such transitory events. Use the criteria in this book for finding good investments to evaluate the worthiness of your current holdings. If an investment is fundamentally sound, don’t sell it.

Tuning in to tax considerations

When you sell investments that you hold outside a tax-sheltered retirement account, such as in an IRA or a 401(k), taxes should be one factor in your decision. If the investments are inside retirement accounts, taxes aren’t an issue because the accounts are sheltered from taxation until you withdraw funds from them.

Just because you pay tax on a profit from selling a non-retirement-account investment doesn’t mean you should avoid selling. With real estate that you buy directly, as opposed to publicly held securities like real estate investment trusts (REITs), you can often avoid paying taxes on the profit you make. (See Chapter 12 for more information.)

With stocks and mutual funds, you can specify which shares you want to sell. This option makes selling decisions more complicated, but you may want to consider specifying what shares you’re selling because you may be able to save taxes. (Read the next section for more information on this option.) If you sell all your shares of a particular security that you own, you don’t need to concern yourself with specifying which shares you’re selling.

Determining the cost basis of your shares

When you sell a portion of the shares of a security (such as a stock, bond, or mutual fund) that you own, specifying which shares you’re selling may benefit you tax wise. Here’s an example to show you why you may want to specify selling certain shares — especially those shares that cost you more to buy — so you can save on your taxes.

Suppose you own 300 shares of a stock, and you want to sell 100 shares. You bought 100 of these shares a long, long time ago at $10 per share, 100 shares two years ago at $16 per share, and the last 100 shares one year ago at $14 per share. Today, the stock is at $20 per share. Although you didn’t get rich, you’re grateful that you haven’t lost your shirt the way some of your stock-picking pals have.

The good tax folks at the Internal Revenue Service allow you to choose which shares you want to sell. Electing to sell the 100 shares that you purchased at the highest price — those you bought for $16 per share two years ago — saves you in taxes. To comply with the tax laws, you must identify the shares that you want the broker to sell by the original date of purchase and/or the cost when you sell the shares. The brokerage firm through which you sell the stock should include this information on the confirmation that you receive for the sale.

The other method of accounting for which shares are sold is the method that the IRS forces you to use if you don’t specify before the sale which shares you want to sell — the first-in-first-out (FIFO) method. FIFO means that the first shares that you sell are simply the first shares that you bought. Not surprisingly, because most stocks appreciate over time, the FIFO method usually leads to your paying more tax sooner. The FIFO accounting procedure leads to the conclusion that the 100 shares you sell are the 100 that you bought long, long ago at $10 per share. Thus, you owe a larger amount of taxes than if you’d sold the higher-cost shares under the specification method.

remember Although you save taxes today if you specify selling the shares that you bought more recently at a higher price, when you finally sell the other shares, you’ll owe taxes on the larger profit. The longer you expect to hold these other shares, the greater the value you’ll likely derive from postponing, realizing the larger gains and paying more in taxes.

When you sell shares in a mutual fund, the IRS has yet another accounting method, known as the average cost method, for figuring your taxable profit or loss. This method comes in handy if you bought shares in chunks over time or reinvested the fund payouts in purchasing more shares of the fund. As the name suggests, the average cost method allows you to take an average cost for all the mutual fund shares you bought over time.

Selling large-profit investments

No one likes to pay taxes, of course, but if an investment you own has appreciated in value, someday you’ll have to pay taxes on it when you sell. (There is an exception: You hold the investment until your death and will it to your heirs. The IRS wipes out the capital gains tax on appreciated assets at your death.)

Capital gains tax applies when you sell an investment at a higher price than you paid for it. As I explain earlier in this chapter, your capital gains tax rate is different from the tax rate that you pay on ordinary income (such as from employment earnings or interest on bank savings accounts).

Odds are that the longer you’ve held securities such as stocks, the greater the capital gains you’ll have, because stocks tend to appreciate over time. If all your assets have appreciated significantly, you may resist selling to avoid taxes. If you need money for a major purchase, however, sell what you need and pay the tax. Even if you have to pay state as well as federal taxes totaling some 35 percent of the profit, you’ll have lots left. (For “longer-term” profits from investments held more than one year, your federal and state capital gains taxes probably would total less than 20 percent to 25 percent.)

investigate Before you sell, do some rough figuring to make sure you’ll have enough money left to accomplish what you want. If you seek to sell one investment and reinvest in another, you’ll owe tax on the profit unless you’re selling and rebuying real estate (see Chapter 12).

tip If you hold several assets, to diversify and meet your other financial goals, give preference to selling your largest holdings with the smallest capital gains. If you have some securities that have profits and some with losses, you can sell some of each to offset the profits with the losses.

Handling losers in your portfolio

Perhaps you have some losers in your portfolio. If you need to raise cash for some particular reason, you may consider selling select securities at a loss. You can use losses to offset gains as long as you hold both offsetting securities for more than one year (long term) or hold both for no more than one year (short term). The IRS makes this delineation because it taxes long-term gains and losses on a different rate schedule from short-term gains and losses.

If you sell securities at a loss, you can claim up to $3,000 in net losses for the year on your federal income tax return. If you sell securities with net losses totaling more than $3,000 in a year, you must carry the losses over to future tax years. This situation not only creates more tax paperwork but also delays realizing the value of deducting a tax loss. Try not to have net losses (losses + gains) that exceed $3,000 in a year.

warning Some tax advisors advocate doing year-end tax-loss selling with stocks, bonds, and mutual funds. The logic goes that if you hold a security at a loss, you should sell it, take the tax write-off, and then buy it (or something similar) back. When selling investments for tax-loss purposes, be careful of the so-called wash sale rules. The IRS doesn’t allow the deduction of a loss for a security sale if you buy that same security back within 30 days. As long as you wait 31 or more days, you won’t encounter any problems.

tip If you’re selling a mutual fund or exchange-traded fund, you can purchase a fund similar to the one you’re selling to easily sidestep this rule.

Selling investments when you don’t know their original cost

Sometimes, you may not know what an investment originally cost you, or you received some investments from another person, and you’re not sure what he or she paid for them.

If you don’t have the original statement, start by calling the firm where the investment was purchased. Whether it’s a brokerage firm or mutual fund company, the company should be able to send you copies of old account statements, although you may have to pay a small fee for this service.

Also, increasing numbers of investment firms, especially mutual fund companies, can tell you upon the sale of an investment what its original cost was. The cost calculated is usually the average cost for the shares you purchased.

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