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, let’s use the tax code to make your investments work harder for you.
To achieve that goal, 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 security sales for the lowest tax
Today, there is a monstrous difference between the tax on long-term
capital gains and the tax on other income. The rate on long-term capital
gains may be as low as 5%. With the sale of stock, it can’t be any
higher than 15%.
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, you need hold a security for more than 12
months.
Say you bought 1,000 shares of Microtax on Jan. 1, 2004 at $50. If you
sold prior to Jan. 2, 2005, you’d be taxed at the higher rate on any
gain.
Let’s say 2004 was a great year and say that, by early December, the
price is $150. You’re looking at a pre-tax 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? I would. You end up with $11,500 more than if you
sold before year's end.
Time your stock buys to avoid wash sales
Wash sales only apply to losses. If you sell a security for a loss and
buy or have bought a substantially identical security within 30 days
either before or after the loss sale, you can not deduct that loss until
you sell the new security. Technically, the loss amount is added to the
basis of the new shares.
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
If you own a mutual fund, you’re taxed on your share of any of the
funds’ inside gains from dividends received or stocks sold. (An inside
sale occurs when a fund sells a security out of its portfolio.) But the
fund only looks at its books once a year to determine who actually owns
the shares of the fund. Those people get the dreaded 1099s.
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
OK, I know that’s the complete opposite of what everybody else
recommends. But, sometimes the “best” advice isn’t really the “right”
advice for you.
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
only see tax rates moving higher.
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 invest outside 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
Our government really wants your money. Even if they have to borrow it.
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. On a joint
return for 2004, the phase-out starts at $89,750 in modified adjusted
gross income and is complete at $119,750. For others, it phases out
between $59,850 and $74,850.
In 2005, the phase-out starts at $91,850 in modified adjusted gross
income and is complete at $121,850. For others, it phases out between
$61,200 and $76,200.
Swap those bonds!
If you still have those long-term bonds you bought at $1,000 face value
with interest at 4%, I’ve got some bad news for you. Interest rates are
going up. That means the market value of your bonds is going down. What
to do?
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 brokers’ 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
If you itemize your deductions, your investment expenses are deductible
as miscellaneous itemized deductions. That means you can deduct the
amount that exceeds 2% of your adjusted gross income. The investment
expenses may include:
Investment subscriptions such as Forbes, Fortune and Barron’s.
Financial newspapers such as the Wall Street Journal or 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/recordkeeping 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 last 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.
This article first appeared
HERE.
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