The idea behind investing is to make a profit. I fully support the idea. But I'm a tax accountant, and I know that Uncle Sam's appetite for tax revenue can affect how much money you actually realize from your investments.
And I know one other thing: Uncle Sam wants you to make money from your investments and throws more than a few bones at you as incentives.
So, to use the tax code to make your investments work harder for you, I offer seven ways you can use Uncle Sam to maximize your gains, minimize your losses and, when necessary, reap the biggest deductions.
Time your sales for the lowest tax
Short-term capital gains are taxed at your regular income rates -- as high as 35%. That's a big, 20-percentage-point difference. On a gain of $10,000, that means $2,000 more in your pocket.
To qualify as long term, a security must be held for more than 12 months.
Say you bought 1,000 shares of Microtax on Jan. 2, 2009 at $50. If you sell before Jan. 2, 2010, you will be taxed at the higher rate on any gain.
Let's say 2009 was a great year. (Somebody had to make money; go with me on this.) And let's say that, by early December, the price is $150. You're looking at a pretax gain of $100,000. But you expect the stock price to crater soon. And you want to get out before it does. What happens if you sell now?
You're in short-term capital gain purgatory. You'd pay as much as $35,000 to protect your gain. With proceeds of $150,000, you'd be left with $115,000.
But what if you wait? Your best guess is that the stock won't fall to below $140 until the New Year. That drop would cost you $10,000. But, what's now a $90,000 gain would be taxed at no more than 15%. That's $13,500 off your $140,000 proceeds, leaving you $126,500.
Does it pay to wait? You bet: You end up with $11,500 more than if you sold before year's end.
Or you could buy a put option -- the right to sell at a given price -- and insure your gain.
Time your stock buys to avoid wash sales
This is a nasty trap for the unwary.
How to avoid it? Easy. Pay close attention to the calendar. Don't buy until the 31st day.
Time your mutual fund buys carefully
That date is called the date of record (or record date). If you're found on the books on the date of record, you pay the tax on the whole year's gain.
So, if you buy the fund on Dec. 1, and the date of record is Dec. 10, you're going to have to eat the tax on the full year's gains. That's only half the hit. When you bought on Dec. 1, the price you paid probably included most of the gain. So, you're actually paying tax on gain that you bought and already paid for.
So here's Schnepper's rule:
- Before you buy any fund, ALWAYS find out its date of record. Then carefully time your buy. A few days' wait can save you a substantial tax hit.
Don't automatically fund your IRA
Let's say you're in the top tax bracket now, and you expect to be so at retirement. Any distribution from your IRA or other qualified retirement plan is going to be ordinary income that's taxed at today's maximum 35% rates. Current tax rates are now the lowest I can remember. With exploding deficits creating a continuous need for new revenue, I can see tax rates moving only higher. President Barack Obama has promised higher rates for those in the top tax bracket.
So you may pay a lot more than 35% on your retirement distributions.
Those who invest for the long haul do so for capital appreciation, and they scoff at income investors with 1% or so returns who are struggling to meet their expenses. And it may pay for you to investoutside any tax-qualified plans. You may give up a current tax deduction. But your long-term gain won't be taxed at more than 15%.
Say you've got a $100,000 gain on your investment when you retire. That minimum $20,000 in tax savings would pay for a whole lot of tax deferral and a current $3,000 deduction. It's at least another point of view.
Invest in U.S. Savings Bonds
Lots of tax savings here:
- You can defer the income on a federal basis until you redeem the bonds.
- On a state level, it's even better. The income is tax-free.
Don't forget the break that savings bonds offer middle-income families on education expenses. You may be able to exclude the interest income on your federal income taxes if you redeem your bonds in a year when you also pay for qualified higher education expenses. Unlike borrowing to invest in a business, where you have to show how the money is used, there's no one to trace what you do with the savings-bond cash. You don't even have to use those exact dollars to get the deduction.
The tax-free exclusion phases out as your income increases. Last year, on a joint return (or a return of a qualifying widow or widower), the phase-out started at $100,650 in modified adjusted gross income and was complete at $130,650. For others, it phased out between $67,100 and $82,100.
For 2009, on a joint return (or a return of a qualifying widow or widower), the phase-out starts at $104,900 in modified adjusted gross income and is complete at $134,900. For others, it phases out between $69,950 and $84,950.
Swap those bonds!
How about selling your bonds and recognizing the loss? That gives you the tax deduction. Now buy similar, but not identical, bonds. Maintain the same maturity, interest rate and level of risk. The price at which you sell the old should be the same as the price of the new.
Nothing has changed with respect to the current value of your portfolio. Your out-of-pocket expense is the transaction cost -- the broker's fees. But you've snatched a tax deduction. And if you hold your bond to maturity, you'll get the full value back from the issuer at maturity. It's a clear win-win.
Deduct those investment expenses
- Investment subscriptions, such as Forbes, Fortune and Barron's.
- Financial newspapers, such as The Wall Street Journal or The Financial Times.
- Long-distance phone calls to your broker.
- Taxi rides to your broker.
- Parking fees when you go to meet with your broker.
- Management fees or even IRA fees if paid from outside the account.
- Investment education such as courses in investing. This can include get-rich seminars.
- Fees for investment advice.
- Safe deposit box expenses.
- Custodial fees.
- Bookkeeping/record-keeping costs to keep track of your investments.
- The cost of investment research.
- The cost of investment books.
- Anything else you can relate to your investments. This can include taking your broker -- or your accountant -- to lunch to discuss your portfolio.
Two final points:
Brokerage commissions aren't deducted as such. They're added to the cost of a buy and deducted from the proceeds of a sell. So, they get "deducted" when you actually sell the security.
Margin interest, to the extent of investment income, is allowed as an "interest" deduction.
