If you have invested in the stock market during the past few years, it may feel like the day-to-day movements of the stock market are out of your control. The stock market goes up one day or down another day based on various news and data that is released each day. No one can consistently predict the short-term movements of the stock market. There is one very real aspect of investing, however, where the investor wields a substantial degree of control: income taxes. Let’s take a short guided tour through your federal income tax return (IRS Form 1040) to see if you are investing tax efficiently.
Form 1040 Schedule B. Schedule B is used to report interest income and ordinary dividends. Does your Schedule B Line 1 include any interest income from taxable bonds? Does your Schedule B Line 5 include any ordinary dividends from bond or REIT mutual funds, where such dividends are not included in Form 1040 Line 9b as qualified dividends? If you answered yes to either question, consider placing these bond or REIT investments in your Traditional IRA or 401(k). If you currently own stock funds in your Traditional IRA or 401(k), sell the stock funds in these tax-deferred accounts and buy them in a taxable account. This will make space for the bond or REIT funds in your tax-deferred accounts. For most investors, it is preferable to hold bond or REIT funds in a tax-deferred account because these funds are generally less tax efficient than stock funds and benefit more from the tax deferral feature. If you must hold bonds in a taxable account and are in a high income tax bracket, consider tax-exempt bonds.
Form 1040 Schedule D Lines 1 or 8. Schedule D is used to report realized capital gains and losses. Are you reporting any capital gains on Schedule D Line 1 or Line 8? If so, investigate the source of such capital gains. A taxable capital gain is triggered by selling an investment at a price that is greater than the cost basis of the investment. This may sound like a good thing from an investment perspective, but from a tax perspective, it is better to defer realizing gains as long as possible. Sometimes, there are legitimate reasons for incurring capital gains, such as diversifying a concentrated stock position or replacing high-cost mutual funds with low-cost index funds. If you are trading frequently, however, in search of the next hot stock or mutual fund, consider investing in index funds instead. Not only is there a good chance that the index fund strategy will beat your previous strategy, but you will end up with a lower tax bill.
Form 1040 Schedule D Line 13. This line is entitled “capital gain distributions.” Is there a number greater than zero on Schedule D Line 13? If so, is the capital gain distribution coming from an actively managed mutual fund? If you own shares of a mutual fund that generates a capital gain within the fund, it is required to pass along that gain to you so that the IRS can tax you. The distributed gain shows up on Line 13 – not a good thing from a tax perspective. As you may have guessed by now, it is better to defer gains as long as possible within the fund. In general, actively managed mutual funds generate capital gain distributions far more frequently than index funds because actively managed funds trade more frequently. Some exchange traded equity index funds have never distributed taxable capital gains in the history of their existence (this is good!). Consider replacing your actively managed mutual funds with index funds.
Form 1040 Schedule D Lines 6 or 14. Do you show a number other than zero on Schedule D Line 6 or Line 14 (capital loss carryover)? If not, you are probably not using a strategy called tax loss harvesting. Here is how it works. Say you own a large-cap equity fund that tracks the S&P 500 index. You purchased it many years ago for $50,000. Now it is worth $30,000. You sell the S&P 500 fund at a long-term capital loss of $20,000. In order to maintain your exposure to large-cap equity, you use the $30,000 in sale proceeds to purchase immediately a large-cap equity fund that tracks another large-cap index, such as the Russell 1000. If you repurchase the same S&P 500 fund within 30 days of selling it, the IRS will not allow you to claim the capital loss, but you are allowed to purchase a similar but not “substantially identical” fund and still claim the capital loss. What is the net result? You have $20,000 in capital losses that can be used to offset any other capital gains that year. If you do not have any capital gains that year, you can use up to $3,000 of the capital loss to offset any other taxable income, such as wages, interest, and dividends. The remainder of the loss can be carried forward to future years indefinitely. In this example, if you have no other realized gains or losses that year, $17,000 ($20,000 minus $3,000) of the capital losses would be carried forward to the subsequent tax year and be reported on the subsequent tax year’s Form 1040 Schedule D Line 14. There is one caveat. You may incur transaction expenses in buying and selling funds. So, it is not a good idea to conduct tax loss harvesting trades too frequently.
As you can see, there are many strategies for managing your investment related income taxes. Use the tax law to your advantage to enhance your after-tax investment returns.