Tax basics

= Introduction =

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, they are not meant to be exhaustive.

General

 * Withholding. If you are a salaried employee, get withholding about right.  You do not want to significantly underpay your tax, which may result in an underpayment penalty.    Underpayment penalties occur if you pay less than 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.  To adjust withholding, submit a new 2008 W4 to your employer.


 * 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. 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  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 go back to school after working for a few years, you may be in a low tax bracket.  In that case, you might consider converting a Traditional IRA or a pre-tax 401(k) plan to a Roth IRA, taking advantaged of the low tax bracket.  Also, 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 IRA.

Taxable account

 * 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.

= Links =

For academic and practitioner papers:


 * Reference Library: Asset Location
 * Reference Library: Taxable Account Investing
 * Reference Library: Retirement Plans and Tax Deferred Investing