How to use your tax return to get better at investing.
One common missed opportunity is failing to contribute to an individual retirement account or other retirement plans, assuming you qualify to make deductible investments, as most Americans do.
If you work with a financial adviser — or a prospective one — that person might offer to check your latest income tax return to help you become better at investing. Or you can do it yourself.
The information on tax returns doesn’t necessarily correlate with what’s in your portfolio, but there can be signs of tax-inefficient investing and missed opportunities.
One common missed opportunity is failing to contribute to an individual retirement account or other retirement plans, assuming you qualify to make deductible investments, as most Americans do.
Only about one in 12 eligible investors contributes money to an IRA, making them an underutilized tool.
Similarly, you might be wasting an opportunity to let your money compound longer if you withdraw IRA money earlier than required, especially if you must pay taxes and a penalty for pulling out cash before age 591⁄2. Investors list their IRA contributions and withdrawals on federal Form 1040.
Tax-inefficient investing often involves placing the wrong types of instruments in less-than-appropriate accounts. For example, you wouldn’t want to hold municipal bonds or bond funds within an IRA because muni interest already is tax-free, negating the sheltering benefits of the IRA.
Although muni interest generally isn’t taxable, you do need to disclose it on federal tax returns. Muni bonds typically don’t yield as much as corporate bonds and bond funds. Thus, they aren’t the best choices for people in low tax brackets.
These are some of the “secrets” to be found in tax returns, wrote Sheryl Rowling, a certified public accountant at Rowland & Associates in San Diego, in a recent edition of Morningstar magazine. Here are some of her other suggestions:
Look for excess cash by reviewing interest listed on Schedule B of form 1040. Too much cash could be a sign you invest too conservatively. If you have a lot of nonsheltered income from certificates of deposit, bonds and even stock dividends, shift some yield-focused investments to retirement accounts. This can be especially wise for high-income taxpayers subject to the Medicare surtax, Rowling noted.
Look for too much concentration in a few stocks. High dividends from one or a handful of stocks could signal that you hold too much of your wealth in a few companies, which can reflect a lack of diversification. It’s also smart to check whether you own stocks that pay “qualified” dividends. These are preferable to nonqualified dividends, as the tax rates are lower.
Examine capital gains and losses on Schedule D. A lot of gain or loss entries could be signs of too much trading, possibly driving up costs and incurring unneeded taxes. Also, examine the dollar amounts of gains. If they’re large, it could mean you’re choosing to sell lower-cost lots or batches of shares. Usually, it’s smarter to sell high-cost lots, as these have smaller gains on which taxes apply.
Perhaps the key tip is to look for a lot of short-term gains. This can be a big sign of inefficient investing, as higher, ordinary-income tax rates apply on short-term gains compared to those held more than one year (and qualifying for lower capital-gains rates).
If possible, follow a “harvesting” strategy by selling some investments at a loss and using these losses to offset taxes on other investments sold at a gain.
The tax-reform package adopted late last year aimed mainly to cut taxes and simplify return preparation. It didn’t overtly target the “marriage penalty,” but there are a few provisions that eased things for couples — and one notable new item that hurts them.
The marriage penalty refers to rules that impose an increased tax burden on couples compared to what two individuals would pay if filing separate returns.
The key factor that worsens the marriage penalty is the new federal limit on state and local tax deductions. The same $10,000 cap on these itemized deductions applies to both single and joint filers, researcher Wolters Kluwer said.
With other deductions, couples receive twice the benefit of single taxpayers.
Conversely, the legislation eliminated several marriage penalties where they had existed, said Mark Luscombe, principal federal tax analyst at Wolter Kluwers.
For example, the new rates don’t include a marriage penalty except for the top 37-percent bracket, which kicks in for singles with income above $500,000 and for married couples above $600,000.
For lower brackets, the married-couple thresholds are exactly double those for singles.
Under the old rules, marriage penalties were associated with several of the higher brackets. For example, the old 25-percent tax rate applied for singles with up to $91,900 in income, compared with up to $153,100 in income for married couples.
The new tax bill eliminated the personal exemption and the phasing out of itemized deductions for high-bracket taxpayers. As both of those provisions had a marriage penalty, eliminating them removed the associated marriage penalty.
As a result of a recent Justice Department investigation, 21 members of an India-based fraud ring were sentenced this month to prison terms, providing a timely reminder of how the Internal Revenue Service legitimately deals with the public.
The conspirators targeted U.S. residents, including legal immigrants, with lies and threats of deportation, claiming to be representatives of the IRS and of U.S. Citizenship and Immigration Services. The callers told victims they owed money to the government and would be arrested or deported if they didn’t pay fast.
However, the IRS and its authorized private collection agencies don’t call to demand immediate payment, and they don’t accept payments on prepaid debit cards, gift cards or wire transfers — methods favored by fraudsters.
In most cases, the IRS first will first mail a bill to people who owe money. Payments should be made payable to the U.S. Treasury, not third parties.
The IRS and its collection agencies don’t threaten immediate arrest. Nor do they ask for credit card or debit card numbers over the phone or demand payments without first allowing taxpayers to question or appeal the amount.