3 Tips To Help You This Tax Season

As an investor you take on risk in the hope of receiving sufficient reward to justify that risk. That is just basic investing; where there is no risk there is no reward. Another basic reality of investing is that governments love to tax any profit you happen to make. It may not seem fair that you take the risk and they get some of the reward (ok, it more than seems unfair) but, “that’s the cost of living in a civilized society” (or so say those that take your profits).

The reality of investment-related taxes means that tax planning is an important part of your investment planning. Careful planning can help you reduce that cost. This planning won’t help you avoid taxes you rightfully owe, but with a little care you might be able to shrink the tax bite a bit.

Tip #1 – Keep Good Records
Whenever cash moves into or out of an investment you get some sort of receipt (often a trade confirmation). Keep all of these irritating bits of paperwork. With them you can establish your cost basis (how much you paid for the investment). Whether you use a computer or a journal you can keep track of your taxable gains and losses throughout the year. Track your tax liability as the year progresses and you might avoid an unpleasant surprise come tax time.

Tip #2 – Take Advantage of Tax Breaks
Investment accounts that allow you to defer taxes or even take income deductions can be a good way to manage investment-related taxes. 401ks and deductible IRAs are a nice way to push those taxes off for many years. When buying mutual funds outside of a tax-deferred account, pay attention to portfolio turnover (the lower the better). Another approach is to focus on index-based investment. They often have little turnover so produce little gains in the course of the year. Annuities can provide some tax deferral as well, but they do have a drawback. Though you do not pay taxes on gains until you draw the money out those gains are all taxed as regular income, even if the increase is mostly capital gains (which would normally be taxed at a lower rate).

Tip #3 – Use Those Losses
Have you taken losses in the last couple of years? Keep track of them. Capital Losses (usually from losses on stocks and stock mutual funds, but there are many other sources) can reduce your taxable income up to $3,000 a year. Whatever you do not use in a given year will carry forward into the next. Here is the trick: these losses offset Capital Gains dollar for dollar until they are used up. For example: I recently spoke with a woman who was heavily invested in stock mutual funds before the crash. Near the bottom of the market she finally gave up and sold her investments, switching to more conservative income producing investments. She has $180,000 in carry-forward losses. Unfortunately, she can only use $3,000 a year to reduce her income. At that rate it will take her 60 years to use up those losses. However, if she invests in something that produces Capital Gains those losses can offset her Capital Gain income dollar for dollar. That makes a lot more sense (assuming that sort of investment makes sense for her situation).

Keep your eye on the investing ball, including the tax implications of your decisions. To find out how these ideas fit into your investing plans consult your tax professional.

About the author

Jim Heitman, CFP®

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