Tax basics

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Tax is one of the biggest expenses to you as an investor. In order to maximize after-tax return of your investments, you need to employ a variety of techniques. The following is a list of items that you might want to consider. However, it is not meant to be exhaustive.

General

  • Withholding. If you are a salaried employee, it is important to get withholding about right; if you do not have withholding, it is important to pay the right amount of estimated tax. You do not want to significantly underpay your tax, which may result in an underpayment penalty. Underpayment penalties occur if you pay less than 90% of what you owe, and less than 100% or 110%, depending on income, of last year's tax bill. Neither do you want to receive a large refund, which is an interest-free loan to the government, and may delay your getting the money back for a long time if something goes wrong. To adjust withholding, submit a new W-4 to your employer; if your salary is not withheld, you can choose how much to pay in estimated tax.
  • Check your state withholding as well. If you do not file a state withholding form, most states will use the federal withholding, which is often wrong because of different state and federal deductions, or because the value of an allowance is different.
  • Deductions and credits. Claim all deductions and credits that you can legally claim. See below for Saver's Credit and foreign tax credit. There are many others that do not have to do with investments.
  • Tax-efficient fund placement. You should put tax-inefficient investments in your tax-advantaged accounts.
  • Minimizing tax does not necessarily maximize after-tax return. You could place a tax-exempt bond fund in a taxable account and a stock fund in a tax-advantaged account, but that may not necessarily be better than placing a taxable bond fund in a tax-advantaged account and a stock fund in a taxable account.
  • Keep up with tax laws. See Tax news sources for more details.
  • Assess your individual situation. Techniques on this page are applicable to many investors, but they may not work in your individual situation. For example, if your employer sponsored plan is filled with insanely expensive funds, and you plan to stay with your current employer for many years, it may be better to skip your employer sponsored plan.

Tax-advantaged accounts

Tax-advantaged accounts offer benefits which either defer taxes you are required to pay to a future date, or, receive tax-free growth of your current investments.[1]

  • You should make the maximum use of tax-advantaged accounts such as Roth IRA, Traditional IRA, 401(k)/ 403(b)/ 457(b), Health savings account, and 529. If you are self employed, you might consider a SEP IRA or solo 401(k). (You may or may not want to make non-deductible contributions to a Traditional IRA. See Non-deductible Traditional IRA.)
  • Roth IRA vs. Traditional IRA. Place a fund with high growth potential in a Roth IRA with other funds in a Traditional IRA and other pre-tax accounts like 401(k).
  • Roth conversion during a low-income period. If you are retired with a sizeable taxable account, you may be selling shares that you recently bought in your taxable account just before you retired. If that's the case, you have little taxable income because sales of recently purchased shares are mostly return of capital, which is not taxed, so you may want to do a gradual Roth conversion to the extent that the conversion amount does not put you in a high tax bracket. The Roth conversion should mitigate the blow from Required Minimum Distribution. What's considered a high tax bracket depends highly on an individual's situation. If you are between jobs or back in school, you may also want to consider a Roth conversion provided that you have enough money to pay for your living expenses and the tax for the Roth conversion. See Post-Retirement Roth Conversion.
  • Saver's Credit is available to a low-income investor funding an retirement plan such as an IRA or 401(k).

Tax deferment

Several of the previously mentioned tax-advantaged accounts are tax-deferred. Tax deferment is the process of paying the taxes you owe on an investment in a future year, instead of the current year.

It may not be clear why deferring taxes is a good idea, especially if you expect to be in the same tax bracket in the future. For an example, refer to Table 1, in which the taxes you owe on an investment return are paid in year 5, compared to annually.

This example compares a hypothetical investment of $10,000 in a taxable vehicle (such as a bond or CD) returning 6% annually for 5 years. The investor is assumed to be in the 25% tax bracket both during the investment and the withdrawal stage. A tax-deferred account (such as a Traditional IRA) waits until the investor withdraws the funds, and then taxes are paid on the entire, cumulative, amount of gains. In a taxable account, the 25% tax is paid each year on the gains for that given year.

Start with $10,000. After year 1, you will have $150 less total return after taxes (compared to the non-taxed amount of $10,600). Going into year 5, you will be starting with a higher amount ($12,625) if the taxes were deferred than not ($11,925). In year 5 (the year where the taxes have been deferred to) you will end up with a higher starting amount, which shows that deferring taxes is the best approach. In both cases, you pay the tax (25%) on the total return (25% * $3,282 = $821, 25% * $3,382 = $846) but in the tax-deferred example, you were able to accumulate more of a return before taxes had to be paid.

Table 1. Tax Deferment
Year Return   Taxable   Tax-Deferred
Tax Rate Return Taxes Total Tax Rate Return Taxes Total
0 - - - - $10,000 - - - $10,000
1 6% 25% $600 $150 $10,450 - $600 - $10,600
2 6% 25% $627 $157 $10,920 - $636 - $11,236
3 6% 25% $655 $164 $11,412 - $674 - $11,910
4 6% 25% $685 $171 $11,925 - $715 - $12,625
5 6% 25% $716 $179 $12,462 25% (of total return) $757 $846 $12,537
Total 25% $3,283 $821 $12,462 25% $3,382 $846 $12,537

It can be seen that deferring the taxes yields a final, after-tax amount of $12,537 for this hypothetical investor, while paying taxes each years yields a final, after-tax amount of $12,462. Having a tax-deferred account has returned $75 more than a taxable account.

Taxable accounts

Taxable accounts are investments in which taxes are paid in the current year.

  • Specific identification of shares allows you to sell least appreciated shares first, reducing tax liability during the initial phase of retirement in particular.
  • Tax loss harvesting improves the after-tax return of your taxable investments.
  • Foreign tax credit is available for those investing in an international fund that pays tax in foreign countries.
  • In a taxable account, you should rebalance with new money. Taking dividends and capital gains in cash may make it easier to do so.
  • Donating appreciated securities may allow you to deduct the full value of securities with a long-term capital gain, without paying the capital-gains tax that would be due if you converted them to cash.
  • Avoid buying dividends. Avoid buying a fund immediately before it makes a significant distribution; you will pay tax on that distribution. Now, holding cash comes with an opportunity cost as well as non-qualified dividends. For this reason, you may want to avoid buying a fund about one month before a distribution date if it distributes dividends annually; don't worry about the cost for a stock index fund which makes quarterly distributions, as each distribution is usually very small (in the order of 0.5% of the fund asset for a fund with 2% dividend yield).
  • Placing cash needs in a tax-advantaged account. By placing cash needs, such as emergency fund, in tax-efficient stock index funds in a taxable account, you can avoid non-qualified dividends.

References

  1. Tax-advantaged Accounts at Morningstar

External links

General interest:

For academic and practitioner papers: