Tax basics

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Tax is one of the biggest expenses to you as an investor. You might need several of the techniques outlined below to get the best after-tax return from your investments. This list is not exhaustive.

Withholding
If you are employed and receive a salary, it is important to set your tax withholding on your salary so that is about right; that is, close to what you would owe. (Otherwise, where you do not have tax withheld from a salary, you want to be sure to pay the right amount of estimated tax.)

If you significantly underpay your tax, you might face in an underpayment penalty. The IRS applies this if you pay less than 90% of what you owe, and less than 100% (or 110%, depending on income), of your tax liability for the previous year.

On the other hand, you do not want to significantly overpay your tax and receive a large refund. This is effectively an interest-free loan to the government, and it might take a while to get your money back, in particular if something goes wrong.

IRS Form W-4 is the way you adjust your employer's tax withholding. You give this to your employer, not to the IRS. (If your employer does not withhold tax from your salary, you can choose how much to pay in estimated tax.)

Withholding safe harbors
Safe harbors are another way to avoid underpayment penalties. From IRS Form 1040-ES, Estimated Tax for Individuals:

"... you can avoid a federal underpayment penalty if either 1. You owe less than $1,000 in tax, after subtracting your withholding and refundable credits, or 2. Your withholding and refundable credits are greater than the smaller of:
 * a) 90% of the tax for this year's return, or
 * b) 100% of the tax on your previous year's return (only if the previous year's return is for 12 months)."

The "100%" applies to most people, but can be higher or lower for others. See IRS Form 1040-ES for details. Rules are more complicated when you make estimated tax payments. For more, see IRS Form 2210, Underpayment of Estimated Tax.

State tax withholding
If your state has an income tax, check your employer's state tax withholding as well as your federal tax withholding.

If you do not give your employer a state withholding form, most states will default to using the numbers you supplied for federal withholding. However, this often leads to the wrong amount of state tax withheld, either over or under, because state and federal deductions may differ, or because of different tax or other allowances.

A state's income tax withholding "safe harbors" may also differ from those for federal income tax.

Deductions and credits
Claim all deductions and credits that you can legally claim. For example, saver's credit and foreign tax credit. (There are many others that are unrelated to investment.)

Tax-efficient fund placement
Put tax-inefficient investments in your tax-advantaged accounts. Some fund types, like total market stock index funds, are extremely tax-efficient, because they produce low dividends (that are mostly qualified) and capital gains. By contrast, bond funds can be extremely tax-inefficient.

For more, see: Principles of tax-efficient fund placement

Other notes
Paying the lowest tax does not necessarily mean the highest after-tax return; a better return can overcome a higher tax rate. You could hold 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 holding 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.

Look closely at your own individual situation. The ideas in this article apply to many investors, but they may not work for you specifically. For example, perhaps your employer's 401(k) offers only very expensive funds. If you plan to stay with this employer for many years, then unless your employer offers a generous match on your contributions, it may be better to opt out of that plan.

Tax-advantaged accounts
Tax-advantaged accounts either defer taxes to the future, or let you grow your investments entirely tax-free.

Tax-deferred accounts
Make as much use as possible of tax-advantaged accounts such as Roth IRA, Traditional IRA, 401(k), 403(b), 457(b), Health savings account, and 529 plans. 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. For more, see: Non-deductible Traditional IRA.

Roth IRA vs. traditional IRA
Hold funds with high growth potential in a Roth IRA, and hold other funds in a Traditional IRA, and in other pre-tax accounts like 401(k)s. This means you make the best use of your Roth IRA space.

Roth conversion during a low-income period
If you are retired with a sizable taxable account, you may be selling shares that you recently bought in your taxable account just before you retired. That generates low taxable income, because the proceeds from selling recently purchased shares are mostly non-taxable return of capital.

Where your income is currently low, gradual Roth conversions might be useful, at least provided you can stay in the lower tax brackets. Roth conversions will help to reduce your tax later from Required Minimum Distributions.

Whether a tax bracket is high or not depends somewhat on your situation, and in particular what you estimate or expect your tax rates might be in future.

If you are between jobs, or at school or college, you might also consider Roth conversions, provided that you have enough money to pay for your living expenses and the tax for the Roth conversion. See Post-Retirement Roth Conversion from Fairmark.com (archive copy).

Saver's credit
The government offers saver's credit to low-income investors saving into retirement plans such as IRAs or 401(k)s. For this to apply, you need to meet some age and income eligibility criteria.

Tax deferral
Several of the tax-advantaged accounts mentioned above are tax-deferred. Tax deferral means that you pay the taxes you owe on an investment in a future year, rather than in the current year.

You might be unclear about why deferring taxes is a good idea, in particular if you expect to be in the same tax bracket in the future. The table below shows a hypothetical example, comparing annual tax to deferring it for five years.

This example compares $10,000 invested with a 6% annual return over five years. It assumes a 25% tax bracket, both during investment on withdrawal. In a tax-deferred account (such as a Traditional IRA) tax is paid when the investor withdraws the funds, but on the entire, cumulative, amount of gains. In a taxable account, the investor pays 25% tax each year on the gains for that year.

Start with $10,000. After year 1, there is $150 less total return after taxes (compared to the non-taxed amount of $10,600). The effect of annual tax compounds, so that by the end of year 5, the value is higher ($12,462) where tax was deferred than where not ($12,537). Tax was 25% in both cases, but deferring it produced a better investor result.

Having a tax-deferred account has returned $75 more than a taxable account ($12,537 - $12,462).

Taxable accounts
Taxable accounts are those where you pay taxes in the current year. There are several ways that you might be able to reduce your tax on these:
 * Specific identification of shares allows you to sell least appreciated shares first. This can reduce your tax liability, especially just after retiring.
 * Tax loss harvesting improves your after-tax return, letting you use a limited amount of capital losses to offset (generally higher) income tax.
 * You can take a foreign tax credit if you invest in an international fund that pays tax in foreign countries.
 * In a taxable account, rebalance with new money. Taking dividends and capital gains in cash can make this easier.
 * If you donate appreciated securities you may be able to deduct their full value, including a long-term capital gain. This give a better result than where you face capital gains tax if you sold them before donating.
 * Try to avoid buying a fund immediately before it makes a significant distribution, because you will pay tax on that distribution. However, holding cash comes with an opportunity cost as well as non-qualified dividends. Where a fund distributes dividends annually, you might want to avoid buying it about one month before a distribution or ex-dividend date. Do not 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).
 * You may be able to improve your tax efficiency by placing cash needs in a tax-advantaged account. This could include your emergency fund or a home downpayment.

Hierarchy of tax authority
The IRS publications are not the defining authoritative source of information. Authority is based in US law, specifically the Internal Revenue Code (IRC) in Title 26 of the United States Code (26 U.S.C.).

Treasury regulations (26 C.F.R.), commonly referred to as Federal tax regulations, pick up where the Internal Revenue Code (IRC) leaves off by providing the official interpretation of the IRC by the U.S. Department of the Treasury.

In addition to participating in the promulgation of Treasury (Tax) Regulations, the IRS publishes a regular series of other forms of official tax guidance, including revenue rulings, revenue procedures, notices, and announcements. See Understanding IRS Guidance - A Brief Primer for more information about official IRS guidance versus non-precedential rulings or advice.

The authoritative instrument for the distribution of all forms of official IRS tax guidance is the Internal Revenue Bulletin (IRB), a weekly collection of these and other items of general interest to the tax professional community.

As implied earlier, forms of taxpayer assistance — IRS Publications, forms and form instructions — are provided for guidance only. Taxpayers should not rely solely on such documents.