Sad to say it, but it is tax season again. No, it is not time to file tax returns, but by the time that rolls around it will be too late to do anything to change one’s taxes. This is the time to start taking steps to reduce your tax bill. Before getting started, let me say emphatically that I am not an accountant and you should speak to one before doing anything. This is just how I understand the tax rules and I could very well be wrong or there could be something special about your situation.
One often hears about the rich using “loop holes” to avoid taxes, as if there are some fancy mistakes in the laws that only some high-price accountant can find and exploit. The fact is, most of these loop holes are written into the law on purpose, either because not doing so would not accurately affect income (sure, you made $1000 selling lemonade but the ingredients cost you $900, so you really only made $100) or as a way to drive behavior (buy an electric car and we’ll reduce your taxes). To effectively reduce taxes requires one to take advantage of laws written for both of these aims.
In stock investing, the main way to ensure your investment income listed accurately reflects your true income is to recognize losses. The ways to do this are:
1. Make sure you account for any stocks, bonds, or other investments that have become worthless. If you were a holder of bonds for a company that went bankrupt in 2010 it is likely that they have become worthless or you were paid pennies on the dollar for them. Make sure this finds its way onto your tax returns. Likewise, if you own shares of stock in a bankrupt company it is likely they are worthless. If they are no longer trading, you may be able to simply write them off (check with an accountant on this). If they are only selling for a few pennies a share, even though it may cost $50 to do so, it would be worth selling the shares to close out the transaction and recognize the loss.
2. Sell your losers. A fundamental of any tax strategy is to recognize losses early and let winners ride. This is why it is usually advantageous to pay property taxes in December, even though they are not due until later, to bring that expense into the earlier tax year. Likewise with stocks it makes sense to sell stocks that have performed poorly and not lived up to expectations. In general you can offset gains directly with losses and even offset some current income ($3000 per year last time I checked). You can even carry the loss into future years to offset future gains (again, check with a CPA).
Note that I would not advocate selling a stock purely to record a loss, or holding a stock that has gone up to delay recognizing the gain. The movement of stocks is such that changes in price can quickly offset any gain on taxes. I am just saying that it is good to go through your portfolio this time of year, find the dogs that will never recover, and clean house.
A note of caution here about a wash sale. A wash sale occurs when you sell shares of a stock at a loss and then buy back shares of the same company within 30 days. The same is true if you buy shares of stock in a company that you already own and then sell other shares at a loss within 30 days of the purchase. If this is done you will not be able to deduct the loss from your taxes. The rule is in place to prevent people from taking a loss in paper only since they did not really sell the stock. Note that this does not prevent you from buying a stock and selling the shares that you bought within 30 days, or selling a stock at a gain and then buying it back within 30 days. It is only when you sell to recognize the loss for tax purposes but then end up holding essentially the same position you had that the rule applies.
The second way to plan for taxes is to take advantage of some of the laws designed to drive behavior. In investing, these involve effectively using the tax advantaged accounts such as 401ks and IRAs. These accounts were developed because the government wants people to save for their retirements. Here are some things to consider:
1. Invest early and consistently in tax-free and tax-deferred accounts. Eventually you will need money for retirement even though it will probably not seem like it now if you are in your twenties or thirties. It is very difficult to find money for savings once you have several different obligations and you are using most of your income for other things. It is therefore best to start putting money into retirement accounts early and to make the deposits as automatic as possible. Get into the habit fo sending a check to your IRA each month as one of your regular bills or have money taken from your paycheck for a 401k at work. If you receive a raise at work, consider increasing contributions with some of the additional money.
2. Never, never, ever touch money in retirement accounts before retirement. It is always tempting when one sees the large sums of money in retirement accounts to use the money to pay off bills, do home improvements, take a trip, or do other large purchases. Because most people do not save regularly, the amounts that build up in these accounts can seem astounding, making the temptation to use the money immense for some. Also, because some companies put money in 401K accounts, many see this as ‘free money” anyway and think nothing of the 60% or so in taxes they pay when removing it early.
Unfortunately, the government doesn’t make it easy by making ways for people to get into their retirement savings before retirement with ideas like using retirement savings for college or buying a house. I’m not certain if this is to create more taxable income for the government or through a bad understanding of economics and personal finance, but the exemptions exist. Another gimmick is to borrow money from a 401k and then “paying yourself interest.”
All of these strategies will result in a lot less money being available at retirement. Just remember that every dollar you remove from a retirement account will result in a loss of about $100 when you are ready to retire. If you remove $10,000 to buy a home, you’ll have $1 million less at retirement. Unless you will be out on the street unless you do, it is never wise to touch retirement dollars.
3. Put high yielding investments in tax-free or tax-deferred accounts. Many people have both regular investment accounts and an IRA or another tax-deferred account. As stated elsewhere in this blog, as one gains money and gets closer to retirement funds should be shifted from growth stocks that make money primarily through capital gains and into older stocks, bonds, limited partnerships, and REITs that pay out more income, thereby reducing the risk (because some income is still gained even if the stock market does not rise). Because these investments pay out money all of the time, generating taxable income for the investor, it makes sense to hold these types of investments in the non-taxable account and hold the growth stocks in the taxable account. That way the taxes will not be due immediately when dividends and interest is paid, allowing the money to compound.
Because the growth stocks will not incur a gain until sold, and because capital gains tax rates tend to be lower than for income, the money invested in the taxable account will also tend to grow and compound. Note that mutual funds with managers who tend to sell often, and thereby create capital gains, should also be held in tax-deferred and tax-free accounts since one does not have control of when and if capital gains are realized then. The taxable account should therefore contain mainly low-turnover funds and individual growth stocks that the investor plans to hold for a long time.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.