The Tax Man Cometh! Take Steps to Reduce Your Tax Bill

Did your financial behavior add to your tax bill?  Consider these steps to reduce your future tax bill.

Mutual fund investments are a good place to start.  New clients often ask me,  “I didn’t take the dividends and interest so it isn’t taxable, right?”  WRONG! In a non-retirement account all activity in the account has a tax consequence.  You need to choose wisely what goes into that account.  The fund managers may be generating taxable income.

Mutual funds are required by law to distribute 90% of the interest dividends and capital gains to the shareholder each year.  Even if you reinvest these distributions, they are still taxable.

So what do you do as an investor?  Be strategic in how you invest.

Retirement accounts offer an umbrella that defers taxes on your investments.  This is a good place to have investments that pay interest and dividends.

Be wary of mutual funds that are frequent traders or have a high turnover in the fund.

These activities lead to capital gains that are taxable.  Short-term capital gains are from transactions where the stock was held for less than 1 year.  These gains are taxed at regular tax rates.  If the stock sold was held for longer than 1 year, it is long-term capital gains and currently has a preferred tax rate of 0%, 10% or 20% depending on your tax bracket.

High turnover in an account will also have more expenses due to active trading.

How does an investor avoid these problems?

Place growth funds with a low turnover in a taxable account.  These are often index funds.

Or you may use Exchange Traded Funds (ETF).  These look like mutual funds in that they are a pool of various stocks or bonds.  They are structured a little differently—instead of buying and selling stocks they are “exchanged.”  (This is using 1031 exchange tax law used also in real estate.)

Municipal bonds may also be a consideration for a taxable account.  Federal tax laws do not tax interest from municipal bonds.  Only Idaho municipal bonds are tax-free at the state level in Idaho.

Tax Harvesting is another technique that can be used to minimize taxes from your investing.  This is selectively choosing investments that are currently a loss and selling them to recognize that loss.  This can be done to offset gains.

An easy way to reduce your tax picture is to contribute to retirement plans.  If your employer matches your contributions, at least contribute enough to receive the full match.  If you have earned income but no employer sponsored retirement plan, you may be able to contribute to an IRA

Roth IRA is another good option for minimizing your tax consequences from investing.  As a retirement account, it shelters the income from taxation.  It isn’t tax free when you make the contribution, but IS TAX FREE when you take it out.

Frequently, it is suggested you use a Roth if you think your tax rate will be higher in your retirement years.  I like to use Roth accounts when a large sum of money is needed to replace a roof or buy a new car.  The money comes out tax free, it doesn’t increase the amount of social security that is taxable like other sources of money may.

You do have some control over your tax bill.  You can be tax savvy with your investing.


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