Tips for Reducing Your Investment Tax Liability
Face it — no matter how much you'd like to try, you won't be able to get around paying taxes on your successful investments. If you're smart with your investing strategies, you can significantly minimize the taxes you'll have to pay, however. As a savvy investor, it's important that you be aware of the upsides and downsides of your investment plans as they relate to potential tax liability. The following sections provide some tips for how to go about investing wisely while keeping an eye on your taxes.
You must keep purchase documents for every security you buy, especially if you've bought shares in the same company at different times. At sale time, you'll subtract the cost basis of your stock from your sale proceeds to determine the gain or loss. Your cost basis equals the amount you paid for the stock, plus commissions. Another key factor is the holding period, or length of time you owned the stock. That determines your tax rate, and the long-term holding rate is lower than the short-term tax bite.
Let's look at some numbers:
You pick up 100 shares of XYZ, Inc., in January 2009 for $1,000 including commissions. Your basis is $10 per share.
You buy another 100 shares in March 2009, this time for $2,000 including commissions; for those shares, the basis comes to $20 each.
Finally, in January 2010 you add another 100 shares to your holdings, this time for a total (including commissions) of $3,000, for a per-share basis of $30.
In October 2010, the stock hit $50 per share, so you decide to sell off some of your holdings and take a profit. If you tell your broker to sell 100 shares, he'll follow the IRS guideline called first-in, first-out (or FIFO). That means he sells the shares you bought in 2009. However, you can tell him to sell particular shares when that will be more advantageous to you in terms of taxes. Regardless of which shares you sell, your proceeds will be $5,000. But your total gains — and the tax rate on them — depend on which stocks you've sold. With the January 2009 shares, you'll have a $4,000 long-term gain. The March 2009 shares bring a $3,000 long-term gain, and the 2010 shares net you a $2,000 short-term gain.
Which shares you choose to sell will depend on your overall tax picture at the time. If you have short-term losses to offset, you may want to shed the most recently purchased shares. If you have no other capital transactions, you may choose the 2009 shares for the smallest addition to your tax bill. In any case, the bottom line is that as long as you have your records, the impact on your taxes is up to you.
Mutual funds are treated a bit differently than stocks in that they are taxed in three distinct ways: dividend distributions, capital gains distributions, and gains or loss from selling shares. Just like a stock sale, when you sell your fund shares for more money than you've put into them, you'll be faced with a capital gains tax bill. The reverse is true as well: When you sell your mutual funds shares at a loss, you get to declare that loss on your taxes, reducing the rest of your income. The total amount you deduct from the sales price is called the basis, and it can be complicated to figure out — which is why most fund companies and brokers keep track of it for you.
If you invest in any mutual funds (except municipal bonds), you'll pay taxes on all the capital gains and dividends your shares earn. Dividend distributions come from the regular dividend and interest paid out on the underlying securities that make up the fund portfolio. As these earnings are periodically passed on to investors, they have to be reported by investors on their own personal tax returns. Likewise, capital gains distributions come from sales of securities held within the fund, and they get passed through to investors with the same tax-advantaged characteristics. Investors have to pay taxes on these distributions even if they are automatically reinvested in the fund.
Just as interest earned on U.S. government securities doesn't generate state and local income taxes, interest on debt securities issued by states and municipalities don't get hit by the federal revenue squad. These debt securities are known as municipal bonds, or munis. They are exempt from federal income taxes (and often from state and local income taxes as well), and typically offer lower interest rates than bonds that are fully taxable. You can make up that earnings difference through their tax savings.
It would be handy if municipal bond investing were 100 percent tax free — but it isn't. Though the interest you earn on municipal bonds is federal income tax exempt, you still have the tax consequences from capital gains (or losses) that occur when you sell these bonds. If you sell a muni and get more than your basis, your profit counts as a fully taxable capital gain. On the other hand, if you sell it for a loss, you've got a deductible capital loss.
Once a virtual afterthought at the Wall Street party during the late 1990s, life insurance is in big demand these days, thanks to recent changes by Congress that merge some elements of stocks and bonds into life insurance and boost its appeal. If you choose a policy that pairs your investments with some type of life insurance policy (for instance, whole life, universal life, or single-premium life), it will gain you tax-favored status.
Here's how it works: Instead of paying for insurance, a portion of your premiums go into investments that can build cash value. These investment earnings are protected from the IRS.
You don't have to die to get these tax benefits, either. You are allowed to borrow against your policy's cash value. They are very special loans because you don't have to pay them back, ever. Loans still outstanding at the time of death get deducted from the insurance proceeds due to your beneficiaries. Even though you will have to pay interest on that loan, policy earnings can counter it.
A stronger investment-insurance hybrid, annuities also sport big tax advantages. With annuities, you know your heirs will inherit at least as much money as you have put into the annuity, even if it's lost some money. But the real allure of annuities is the tax-free earnings accumulation that goes on until you start withdrawing funds.
If you cash out your annuity before you hit retirement age, beware. Most annuity contracts hit you with steep surrender charges if you withdraw funds during the first several years (the exception being immediate annuities). And if you're younger than the legal retirement age, 59½, you could be facing a 10 percent tax penalty.
An annuity contract prevents the taxman from taking your earnings, which differs from bank CDs and mutual funds. No taxes are due until you start taking funds out, which usually begins in retirement, which you can get either in steady periodic payments or in a single lump sum. Funds in an annuity have the same tax-deferred growth advantage as the money invested in an individual retirement account. But you aren't able to deduct amounts that are in an annuity, unlike an IRA.
Even aside from potential tax penalties, annuities don't come cheap. There are myriad fees associated with these instruments: surrender charges (usually very high fees — think 8 or 9 percent — for taking your money out before your contract allows); mortality and expense fees (charged based on customer risk characteristics); and administrative and management fees. Except for surrender charges, these are annual fees — and they typically run 0.50 to 0.75 percent higher than similar mutual fund fees.