Year-end Tax Tips
Here is a list of some year-end tax tips from Morningstar:
Woulda, coulda, shoulda.
Would have sold that loser fund. Could have opted for munis. Should have kept better records.
If you're like most investors, these sorts of admonishments flit through your head just once a year--while you're preparing your taxes--only to be forgotten until the next tax season rolls around.
But the best time to think about improving your tax position for next year is right now, while you still have time to enact changes that can meaningfully affect your bottom line.
In a previous column, I highlighted some tax-savvy ideas for managing your portfolio; those tips make sense no matter what the season. But in this week's column, I'll share some concrete steps you can take in the next couple months to make sure that your tax bill in 2006 is no higher than it need be.
1. Contribute to your tax-advantaged accounts. One of the best ways to cut your tax bill is to reduce your taxable income. No, I'm not suggesting you take a pay cut, but you should be sure to take advantage of any retirement-plan contributions you can make to reduce your taxable income. If you haven't recently reviewed how much you're socking away in your 401(k) plan, it pays to do so, as contribution limits have gone up: You can contribute $14,000 to your 401(k) plan in 2005, and savers over age 50 can pitch in an additional $4,000. If you're on pace to fall below that contribution limit, consider ratcheting up your contribution before year-end.
Some taxpayers may also be able to contribute up to $4,000 to a traditional IRA (individuals over age 50 can contribute $4,500, and married couples filing jointly may contribute up to $8,000--$9,000 if both spouses are over 50), and you'll be able to deduct that contribution from the income you report on your tax return. Bear in mind that to be eligible for a traditional deductible IRA, your income must come in below a certain threshold; single filers earning more than $55,000 and joint filers earning more than $75,000 won't be eligible. To help find the right IRA for you, check out this article; Morningstar's IRA Calculator is also a handy tool.
2. Beware of ticking tax time bombs. Have you had big winners in your portfolio? If so, there's a very good chance that they'll be making capital gains payouts later this year--which means you could wind up owing taxes on those gains. In a recent Wall Street Journal article, authorities from Vanguard, Fidelity, and T. Rowe Price all acknowledged that their firms' funds will likely be making larger capital gains payouts in 2005 than they have in the recent past; that's apt to hold true for most fund shops. Among domestic-stock offerings, funds from the small-blend, small-value, mid-value, real estate, and natural resources categories--all of which have been standout performers recently--are the most likely to make big capital gains distributions this year. International-stock funds--particularly foreign small/mid-value, Latin America, and emerging-markets offerings--could also be making big capital gains payouts.
If you were planning to buy into one of these asset classes, by all means wait until after they've made their distributions for the year. That way, you won't be on the hook for taxes on gains you weren't around to enjoy. Many fund shops begin making capital gains distribution estimates available later in October and into November, and capital gains payouts typically occur in December. If your fund company doesn't list this information anywhere on its Web site, call to find out whether your fund is planning a distribution, how much it will be, and when it will occur.
And while an imminent capital gains distribution isn't usually a good enough reason to sell a fund, it can be an indication that an asset class' best days may be behind it. If you were planning on lightening up on your winners as part of a rebalancing plan, it's smart to unload your shares before you're on the hook for capital gains taxes. Click here for tips on being tax-savvy as you rebalance your portfolio.
3. Tread carefully with tax swaps. Some investors and financial planners use tax swaps to try to reduce the tax collector's cut. One form of tax swap consists of looking at your fund lineup for offerings that are about to make big distributions, then selling those funds before they make their payouts. Once distribution season is over, you swap into another fund with a similar mandate, thereby maintaining your asset allocation. (You can't buy the same fund back without running afoul of IRS rules; also, beware of swapping an index fund for another that tracks the same benchmark.) For example, you could sell Fidelity Low-Priced Stock FLPSX before it makes a distribution, then buy Vanguard Small Cap Index NAESX after distribution season is over.
If you try to do this, however, don't forget about your own tax position in a fund: If you yourself have a taxable gain in the fund (say you bought it at an NAV of $12 and it's now trading on $20), you'll be forced to pay taxes on that gain, and the swap could end up costing you more money than simply paying taxes on the distribution would receive. You also need to keep other potential costs related to the swap in mind--back-end loads or redemption fees levied on the funds you sell may also well make the swap counterproductive.
4. Harvest your losers. Tax swaps can be much more effective if you're holding an investment at a loss. You can sell your loser and use up to $3,000 of net investment losses to offset income in the current year (and you can use the losses to offset capital gains indefinitely), then swap into a substantially identical fund. Many growth funds--even decent ones--are in the red over the past five years, and you too may be in the red over the life of your investment. If you find yourself in that position, you can sell, book a loss to offset gains elsewhere in your portfolio, then buy a similar fund that invests in that same universe.
5. Mind your bonds. The Fed's ongoing spate of interest-rate hikes has been good news for income-focused investors, but fatter payouts also equal higher tax bills. That's because the income that taxable bonds and bond funds produce is taxed at your ordinary income-tax rate (as high as 35%), whereas the maximum rate for long-term capital gains is 15%. As I noted in a recent column, you needn't be in the highest tax bracket for a municipal-bond fund to be a better bet for you than a taxable one is. Turn to Morningstar's Bond Calculator to compare aftertax yields of municipal and taxable funds--you may well find that munis are the way to go.
And while you're checking up on your portfolio's bond stake, also pay attention to which funds are in your taxable and non-taxable accounts. To the extent that you own taxable bonds and bond funds, particularly high-yielding offerings (such as junk-bond and emerging-markets bond funds), you'll want to be sure to hold them in your tax-sheltered accounts; ditto for high-turnover stock funds that generate a lot of short-term capital gains.
6. Put the AMT on your radar. You've probably heard ominous warnings about how the alternative minimum tax (AMT) is set to ensnare more and more middle-class and upper-middle-class taxpayers. Trouble is, many individuals won't know whether they could be on the hook for the AMT until they go to file their tax returns, and by then it's too late to reverse the damage. I'll devote an upcoming column to the AMT, but in the meantime, you should be aware that exercising stock options is an activity that could very likely put you into the "AMT zone." Talk to an accountant before you exercise your options; you also owe it to yourself to read my colleague Sue Stevens' article, "Stock Option Basics".
7. Get generous. If you're among the millions of individuals who have contributed to the Hurricane Katrina relief effort--or to any other charity, for that matter--your generosity could come in handy come tax time. If you itemize your deductions, you can deduct charitable contributions; just be sure to save receipts and canceled checks as proof. And if you're helping those near and dear to you, remember that you can contribute up to $11,000 per year per recipient without triggering gift tax. If you're helping a loved one with medical expenses or college tuition, you can circumvent the gift-tax system entirely by making a check payable directly to the medical or educational institution.