How to Save Thousands On Your IRS Bill / 1 · 2017-06-19 · Guide: How to Save Thousands on Your IRS Bill Most investors place their focus on picking winning investments. Yet taxes

How to Save Thousands On Your IRS Bill / 1

The Motley Fool Investors’ Tax

Guide: How to Save Thousands

on Your IRS Bill

Most investors place their focus on picking winning investments. Yet taxes are an essential component of investing and your financial life, and you need to plan for the tax impact that your investment decisions will have.

This report aims to give you the insight you need to save thousands of dollars on your tax bill over your investing career. We’ll start with a broad overview of why taxes matter to investors and what kinds of taxes you can expect to come across in your investments. Then we’ll wander into the weeds to discuss some specific situations you need to be able to handle. Finally, we’ll finish with some other tax issues that many investors ignore -- and that smart investors use to save thousands more from the taxman. Let’s start with a basic understanding of why investors need to pay attention to taxes in the first place.

Image: Matthew G. Bisanz, via Wikimedia Commons.

Why Taxes Matter in InvestingThe key goal in investing is to make your money grow, and in a perfect world, that would be the only thing you’d have to concentrate on to be successful with your finances. Unfortunately, when you make money, Uncle Sam wants his cut, and investment income is key source of revenue for federal and state governments across the nation. As you’ll see in the

forthcoming example, the right decision can mean the difference between having $52,000 more in your pocket -- or seeing it go to the IRS.

If you want to keep as many of your hard-earned investing gains as possible, you have to pay attention to taxes. Let’s look at one example of just how big a difference the right tax planning can make in your financial life.

How a smart tax decision for Apple investors saved $52,000 in taxesIn late 2002, the stock market bottomed out after the tech bust and recession had wrought havoc on the U.S. economy. Apple had released the first version of the iPod the previous year, but few investors foresaw what that simple device would mean for the company’s future, and you could have bought the stock for a split-adjusted price of around $1 per share. For those who were smart enough to buy $1,000 in Apple stock 13 years ago, that investment would be worth around $120,000 if you sold it today.

That key decision to buy Apple stock would have created life-changing wealth. Yet how you bought that stock and the tax implications of that choice are more important than many realize. Consider three alternatives.

Some investors bought their Apple shares in a taxable account. For them, selling now for $120,000 would generate $119,000 in long-term capital gains, with a maximum tax rate of 20%. After taxes, that would leave those investors with $96,200.

Other investors used a traditional IRA to buy their shares. They wouldn’t owe any taxes when they sold the shares in their IRA, but if they withdraw that $120,000, they’ll owe full ordinary income tax rates. Currently, including the net investment income surtax, they could face taxes as high as $52,080, leaving just $67,920 in after-tax proceeds.

Finally, some investors used a Roth IRA to buy Apple shares. As long as they qualified, the tax-free nature of the Roth means they’ll get to keep the full $120,000 even after they withdraw it from their retirement accounts.

Being smart about IRS rules could have put almost double the money in your pocket after taxes,


compared with making the wrong move. With that much at stake, you can’t afford to ignore the impact that tax rules have on your investments.

Tax matters to keep in mindCapital gains are a key aspect of taxation that comes up repeatedly in investing, but it’s far from the only one. You also have to pay attention to other topics, such as these:

• How different types of income, including interest, dividends, and royalty payments, get taxed.

• How the timing of transactions can affect your tax burden.

• The tradeoffs between deductible and nondeductible retirement account contributions.

• The tax advantages and disadvantages of insurance products such as life insurance policies and annuities.

• Special treatment of certain types of investments at tax time.

• Deductions and credits that are available to investors.

Only by keeping these and similar tax ideas in mind will you be able to make the smartest possible investing decisions.

Tax issues should never be the only consideration in an investment decision, but knowing the tax consequences will help you make a well-informed decision that takes every important aspect of your investment into account.

Fortunately, there’s one key advantage that investors can use to keep the taxman at bay. As you’ll see, it works best when you put together a long-term investment portfolio that you’re comfortable committing to for the long haul.

The Biggest Tax Advantage Long-Term Investors HaveUsing a long-term investing strategy has a lot of advantages. By choosing high-quality companies and sticking with them through good times and bad, you

avoid the trading pitfalls that many who buy and sell more frequently often fall into, causing them to miss out on life-changing wealth opportunities.

Long-term investors also have a big advantage when it comes to taxes. For them, investing within a retirement account is a lot less important than it is for short-term traders, because long-term investors retain control over the biggest tax liability that they’re likely to face: capital gains tax on their profits.

The decision only you can makeMost of the time, you have only limited control over when you have to pay taxes in an ordinary taxable brokerage account. If a bond you own pays you interest, you have to include that interest in your taxable income in the year in which you receive it. Similarly, when a stock pays you a dividend, you have to report that dividend income on your tax return for the year in question.

Image: stockmonkeys.com.

The biggest advantage the tax laws give individual investors is that they allow you to decide when you want to pay taxes on your investment gains. If you hold a stock in a regular taxable account, the IRS won’t collect a dime in capital gains taxes until you decide to sell it. As a result, the longer you hold a stock, the fewer times the government takes its cut, and that increases the amount of money you end up keeping.

Sell just once and save $1,100 in taxesConsider two groups of investors. One group invests $1,000 in a stock and holds on to it for 20 years, never selling. The other waits a year and a day (more on why in the next section), sells the stock, and immediately

2 / The Motley Fool’s Tax Guide

buys another stock. Assume that the stocks all rise 10% in value each year.

At the end of 20 years, the first group’s shares are worth about $7,400. If they sell at that point, they’ll pay long-term capital gains tax on the $6,400 increase in value, which at the current 20% rate creates a tax liability of $1,280. That leaves them with $6,120 in after-tax money.

The second group has paid taxes 20 times along the way, each time they sold, with only small tax bills each year. Yet when you add up the total lost to taxes, what remains invested in their stock adds up to just $5,030 -- almost $1,100 less than the buy-and-hold investors ended up with after tax.

The difference comes from the fact that when the second group paid taxes on their gains each year, they lost the ability to earn returns on that money going forward. The money they spent on taxes couldn’t get invested and therefore didn’t produce additional wealth. By contrast, the first group got the benefits of tax deferral by simply hanging on to their stock, and that decision let their money work as long as possible for them before the IRS took its share.

Make the most of long-term investingKeeping in mind the advantage long-term investments have in regular taxable accounts, it makes sense to divide your investments into different categories and choose the right type of account for each one. If you buy a stock knowing you’re likely to trade in and out of it regularly, then using a tax-deferred retirement account such as an IRA will help you avoid the constant tax liability from the churn of buying and selling. By contrast, if you pick a stock you like for the long haul, you can often put it in a taxable account and end up better off than you would in a traditional retirement account because of the favorable long-term capital gains rates that aren’t available in IRAs.

Long-term investing has advantages from a strategic standpoint, even aside from taxes. With the tax benefits, embracing long-term strategies makes even more sense. Yet how the IRS defines “long-term” is a lot different from how most investors think of it. As you’ll see in the next section, holding on to an investment for a year isn’t quite enough to qualify for all the benefits of long-term tax treatment, but an extra day takes you over the threshold and brings immediate tax savings on your best investments.

What a Difference a Year and a Day MakesTo be successful as an investor, you have to make money on the investments in your portfolio. When you sell profitable positions, you’ll have a capital gain, and the IRS will want its cut. Yet the tax code makes a huge distinction between two different types of capital gains, and it’s based on the length of time you own your investment.

The long and the short of itThe key distinction in the tax code is between short-term and long-term capital gains. In general, the tax laws promote long-term investments, and so they tend to favor investors who hold their positions for a long time. By contrast, those who trade more frequently are seen more as speculators than investors, and so the tax laws are designed not to give frequent traders as many of the benefits.

For purposes of separating short-term from long-term, the key period of time is a year and a day. If you hold on to an investment for one year or less and then sell it, any profit will be treated as a short-term capital gain. If you sell it on the day following the first anniversary of your initial investment, though, you can transform that profit into a long-term capital gain.

How waiting for long-term gains can save you hundredsThe tax advantages of long-term capital gains are substantial under current law. For short-term capital gains, your investment profits are subject to the same tax rates that apply to other types of ordinary income,

Image: StockMonkeys.com.


including wages and salaries, interest, and taxable pension income. Those brackets range from 10% to 39.6%, and an additional 3.8% net investment income surtax can apply to certain high-income taxpayers. All told, a $1,000 short-term gain can cost you as much as $434 in federal income tax.

By contrast, long-term capital gains rates are much lower. For those in the lowest two tax brackets, in fact, long-term capital gains are tax-free. Those who pay between 25% and 35% in ordinary income tax rates have a maximum long-term capital gains rate of 15%. The top bracket of 39.6% has a maximum rate of 20% for long-term capital gains. Here’s a simple chart to bring it all together.

Those preferential rates give investors a huge incentive to hold on to an investment longer. Say you invested $1,000 in a stock at $10 per share and it has doubled over the past 11 months to $20. If you sell it now, you’ll owe short-term capital gains tax on the $10-per-share profit, which could cost you anywhere from $100 to $434 in taxes, depending on your tax bracket. Yet if you wait long enough to get the long-term capital gains treatment, you’ll pay $0 to $200 in taxes. Put another way, even if the stock were to drop over the next month and a day, you might still end up ahead on an after-tax basis by waiting for lower long-term capital gains rates to kick in.

Tax decisions should never be the sole factor in deciding whether to hang on to an investment. Yet given the huge difference a year and a day makes, holding out for lower long-term capital gains tax rates can be worth taking on a little extra risk in some cases.

Long-term capital gains aren’t the only way you can control your tax bill. Putting the right kinds of investments in your portfolio can also make a big difference. Next, you’ll learn more about the value of dividend stocks in fighting off the taxman.

How Dividend Stocks Can Cut Your TaxesDividend stocks are a great investment for long-term investors. Top dividend stocks provide not only a steadily growing stream of income for their shareholders but also consistent appreciation in their share prices over the years. Yet many people don’t realize that dividend stocks can be a good way to reduce the amount of taxes you have to pay.

The favorable tax rate for dividend stocksUnder current law, investors who own stocks that pay qualified dividends are eligible for lower tax rates on the income they receive. Specifically, the rates depend on which regular tax bracket you’re in. If you pay the highest 39.6% tax rate on your regular income, then a maximum rate of 20% applies to your qualified dividend income. For those in the 25% to 35% tax brackets, the rate falls to 15%, and those who pay 10% or 15% tax rates on their regular income get to keep their qualified dividend income tax-free.

The justification for this favorable dividend treatment stems from the different ways companies get taxed. When a company pays interest on a bond, it gets a corporate tax deduction for the full amount of the interest paid, so policymakers are comfortable forcing the recipient to pay taxes on that payment. However, companies don’t get a corporate tax deduction on dividend payments to ordinary investors. The resulting concerns about double taxation led lawmakers to offer preferential rates as a compromise, lessening the blow while not eliminating the double tax entirely.

Tax Bracket for Regular Income and Short-Term Capital Gains

Corresponding Maximum Rate for Long-Term Capital Gains

10% 0%

15% 0%

25% 15%

28% 15%

33% 15%

35% 15%

39.6% 20%


Not all dividends qualifyKeep in mind, though, that not all dividends qualify for these lower tax rates. To qualify, a company must be based on the U.S. or must list their shares on U.S. exchanges. In addition, entities such as real estate investment trusts and master limited partnerships, both of which generally avoid corporate-level tax by passing through their taxable income to their investors, typically don’t get qualified-dividend status on their distributions.

Even if a company pays a dividend that’s eligible to be considered as qualified, investors have to pass a test of their own by owning the stock for an appropriate holding period. The IRS requires that you own a stock for at least 60 days during the 121-day period surrounding the date on which the stock trades ex-dividend. The idea is to discourage investors from trading in and out of dividend stocks right when they’re about to pay a dividend, forcing them to pay the higher ordinary income tax rate if they don’t hold on to their shares for at least the 60-day minimum. For long-term investors, though, buying the stock immediately before it pays the dividend or selling immediately after shouldn’t keep you from enjoying the qualified dividend tax rate, as long as you don’t trade again within 60 days before or after the dividend.

Consider the riskThe tax advantage dividend stocks have over traditional fixed-income investments such as bonds and bank CDs gives investors added incentive to make dividend stocks part of their investment portfolios. Investors need to consider the added risk of stocks compared with fixed-income alternatives, but the tax benefit adds some extra after-tax return to push the risk-reward equation further toward dividend stocks.

Beyond capital gains and dividend income, the best way to minimize your tax bill is to use tax-favored accounts. In the next few sections of this report, you’ll learn more about these tax-savers and how they can save a typical investor huge amounts of tax over their lifetimes.

3 Ways Tax-Favored Accounts Can Help You Stiff Uncle SamOne of the best weapons investors have against the IRS are tax-favored accounts. These accounts are available for several different purposes, but they all offer one or more key benefits that can lead to your paying less in taxes and keeping more of your hard-earned money for yourself.

Image: Wikimedia Commons.

The many ways to stiff-arm the taxmanThere are more types of tax-favored accounts than many investors probably realize. They’re most numerous in the retirement realm, where traditional and Roth IRAs, employer-sponsored 401(k) and 403(b) plans, and a range of specialized vehicles such as SEP-IRAs and SIMPLE IRAs are all designed to help people save for retirement more effectively.

However, you can find tax-favored accounts in other areas as well. For education, 529 plans and Coverdell Education Savings Accounts have many favorable characteristics. For healthcare costs, Health Savings Accounts provide some of the same flexibility for investments set aside for eventual use to pay for medical services.


All of these accounts have one or more of the following tax benefits:

1. Ongoing tax deferralAll tax-favored accounts let you defer taxes on the income and capital gains your investments generate for as long as the money stays in the account. That advantage saves you plenty of paperwork, as you don’t have to report annual income figures on your tax return.

When you pay taxes, the money that goes to the IRS isn’t able to earn any additional return for you. Tax deferral therefore also has a tangible and substantial financial benefit, in that by delaying tax payments, that money stays in your account longer, where it can grow and add to your eventual profits. Even though you’ll pay some additional tax on those extra profits, you’ll still typically end up ahead by paying them later rather than sooner.

2. Upfront deductions and creditsSome tax-favored accounts give you an incentive to participate by offering deductions or credits for the amount you contribute. Traditional IRAs and 401(k) plans, for instance, let you reduce your taxable income by the amount you save toward retirement. In addition, eligible taxpayers can receive the Saver’s Credit for

retirement-account contributions, adding up to $2,000 in tax savings for joint filers. Health savings account contributions are also tax-deductible for most taxpayers.

3. Tax-free withdrawalsFor tax-favored accounts that don’t give you an upfront benefit, many offer potentially more lucrative advantages on the tail end. Roth IRAs and Roth 401(k)s let you withdraw money tax-free in retirement, letting you keep all of the appreciation and income you earned during your career.

Often, you have to spend money in a certain way to get favorable treatment. For instance, with 529 plans and Coverdell accounts, tax-free treatment is available only if you use the money for qualified educational expenses. Similarly, distributions from health savings accounts are tax-free only if you use them for appropriate medical expenses. If you use them for other purposes, various provisions apply that take away some of their tax advantages.

In all, using tax-favored accounts is a no-brainer for nearly every investor. With the potential for upfront tax breaks, long-term tax deferral, and tax-free distributions, consider your options and pick the tax-favored account that’s best for your needs.

Type of Account

What’s it For?

Upfront Deduction?

Tax Deferral?

Tax-Free Withdrawals?

Contribution Limit?

Traditional IRA Retirement Yes, subject to income limits

Yes No $5,500 under 50, $6,500 50 or older

Roth IRA Retirement No deduction, some credit eligability

Yes Yes Same as traditional IRA, subject to income limits

401(k) Retirement Yes for traditional; No for Roth

Yes No for traditional; Yes for Roth

$18,000 under age of 50, $24,000 50 or older

529 Plan Education No Yes Yes, if used for education

Varies by plan, but tends to be very high

Coverdell ESA Education No Yes Yes, if used for education

$2,000 per year

Health Savings Account

Healthcare Yes Yes Yes, if used for healthcare expenses

$3,350 for singles and $6,650 for families; extra $1,000 for those 55 and older


How do you know which type is best for your needs? In some situations, you can only have one account, but with retirement savings, the big question that often comes up is which type of IRA makes the most sense. Read on to learn more about this key issue.

Which Type of IRA Is a Smarter Tax Move?Using an IRA can be the best move you’ll ever make in your quest to save for retirement. IRAs give you complete flexibility to invest in nearly any type of investment you want, going well beyond the mutual funds and exchange-traded funds that most 401(k) plans emphasize. With IRAs, you can choose individual stocks, bonds, and even more specialized investment assets such as real estate and precious metals.

The big question with IRAs from a tax standpoint is whether to choose a traditional IRA or a Roth IRA. Both have advantages and disadvantages, and the right decision can differ depending on your financial situation.

Image: Lendingmemo.com via Flickr.

IRAs: Roth vs. traditionalThe gist of the difference between traditional and Roth IRAs is the timing of the tax break you get. With a traditional IRA, you get the main tax benefit up front, since you’re generally able to deduct your contribution from your taxes in the year you put in the money. That advantage puts extra cash in your pocket almost

immediately after you contribute to your retirement account.

By contrast, a Roth IRA doesn’t give you an up-front deduction. Instead, you generally don’t have to pay taxes on withdrawals after you retire.

Which one is right for you?In deciding whether to use a regular or Roth IRA, the first consideration is that there are income limits above which you don’t actually have a choice. Roth IRAs aren’t available for single filers making more than $131,000 in 2015 or $132,000 in 2016. Higher limits of $193,000 for 2015 and $194,000 for 2016 apply for joint filers. Those whose incomes are slightly below these limits can make only partial contributions to a Roth IRA.

Can you open a Roth IRA?

Assuming both types of IRAs are available to you, the key factor in determining which is best for you is to compare your current tax bracket with the bracket you’re likely to be in when you retire. If you’re paying fairly high taxes now, as is common for those in the prime of their careers, a traditional IRA gives you a correspondingly larger tax break -- that is, your deduction translates to greater savings in taxes owed. If you expect to be in a lower tax bracket later, then getting that big deduction now will translate into less tax liability in the future, giving you a larger overall after-tax nest egg for your retirement.

On the other hand, if you’re in a low tax bracket now -- as is common for those just starting out in their careers, or for those who have unusually low incomes during a particular year of their working lives -- then contributing to a Roth IRA is often the better choice. Because you’re in a low tax bracket, the tax savings from a traditional IRA deduction are low. As a result, it’s worth it to give up that up-front deduction in exchange for the ability to get tax-free income in retirement.

Filing Status You Can’t Contribute If Your Income Is Above:

Single $131,000 in 2015; $132,000 in 2016

Married filing jointly

$193,000 in 2015; $194,000 in 2016


It’s impossible to predict with certainty what future tax brackets will look like, so you’ll never be absolutely sure whether you’ve made the right decision until you retire and have perfect hindsight. As a result, some savers hedge their bets by having both traditional and Roth IRAs. Nevertheless, by looking at the specific situation you face and the tax consequences of both courses of action, it’ll be easier for you to choose the IRA most likely to leave you with more money in your golden years.

Tax-favored accounts aren’t the only way to reduce your tax payments to the IRS. In particular, the end of the year brings opportunities to take action to make the check you write in April a little bit smaller -- or the refund you get larger.

Year-End Strategies to Cut Your Tax BillThe end of the year is a common time for investors to look for ways to cut their taxes. In addition to making the most of the deductions we’ve discussed, a couple of strategies for reducing taxable income are especially important at the end of the year.

Harvesting capital lossesOne extremely popular way for investors to cut their tax bill is to sell losing investments. The amount by which your sales proceeds fall short of what you initially paid for the investment is a capital loss. Capital losses are fully deductible against any capital gains without limitation, so if you have a large amount of capital gains, you can generate as much in capital losses as necessary to completely offset the taxable gains. In addition, if you have capital losses left over after you’ve offset any capital gains, you can deduct up to $3,000 in excess capital losses against other types of income on your tax return, such as wages or investment income.

One common question involves stocks on which you want to take a tax loss but that you’d like to continue to own. Tax laws known as wash-sale rules don’t let you claim a capital loss if you immediately buy back an investment you just sold at a loss. You have to wait

Image artist: Laurits Andersen Ring.

longer than 30 days to buy it back to avoid a wash sale and therefore claim the capital loss on your tax return.

To take a capital loss on your tax return, you have to sell the stock before the end of the calendar year. Harvesting capital losses is an available option throughout the year, but most taxpayers wait until November or December to think seriously about ridding themselves of the losers in their portfolios and getting the silver lining of a tax deduction.

Avoiding the mutual fund tax trapIn addition to maximizing your deductible losses, the other thing to keep in mind near year’s end is to avoid traps that can add to your taxable income without aiding your investment performance. The most common such item involves mutual funds.

Many funds make large year-end distributions of their income and capital gains for the year. For longtime shareholders in these funds, the distributions represent a portion of the increase in the value of their shares, and so it makes sense for them to pay taxes on the distributions.


Yet even if you just bought your shares immediately before the distribution, you still have to pay the resulting tax liability. Even though you weren’t invested when the fund earned the income that led to its increase in value -- and its big tax bill -- you have to count the distribution as income anyway. This remains true even if you never see the cash and instead reinvest directly into mutual fund shares.

Some lawmakers have tried to get rid of this onerous provision. For now, though, the best way to avoid the trap is to wait until after the fund makes its year-end distribution before buying new shares. Alternatively, buying fund shares in a tax-deferred account prevents you from having to worry about the timing of distributions.

Tax planning is vital throughout the year, but homing in on these strategies near year’s end can be a great last-minute way to save. Next, you’ll learn about some other things you can do both toward the end of the year, and at other times, to make the most of tax-saving opportunities.

Make the Most of Your DeductionsSuccessful investors earn a lot of income that raises their tax bill. But you can be smart about managing your tax liability by taking maximum advantage of investing-related deductions. Here are some of the most popular deductions investors should focus on.

IRA contributionsOne of the most popular ways to reduce taxable income through investing is by contributing to a traditional IRA. Taxpayers younger than age 50 can contribute up to $5,500 to a traditional IRA in 2015 and 2016, and those 50 or older get an additional $1,000 catch-up contribution to boost the overall limit to $6,500.

Age Maximum IRA Contribution

Under 50 $5,500

50 or older $6,500

If you or your spouse has an employer-sponsored retirement plan at work, then your IRA contribution might not be deductible. Single filers with income above $71,000 in 2015 in 2016 aren’t eligible for a deduction if they have access to a 401(k) or other plan, and joint filers with income of more than $118,000 in 2015 or 2016 also can’t deduct an IRA contribution. If you’re not covered but your spouse is, then the income limit is $193,000 for 2015 and $194,000 for 2016.

Investment interest expenseIf you borrow money to buy investments that produce taxable income, you can deduct the interest you pay on your loan as investment interest expense. To do so, you claim the interest as an itemized deduction, so if you already take the standard deduction, investment interest expense might not increase your tax savings.

One potential stumbling block is that interest on money you borrow to buy certain investments doesn’t qualify for the deduction. Borrow to buy tax-exempt bonds, for instance, and you can’t deduct the interest at all. In addition, borrowing to buy dividend stocks can sometimes leave you disqualified for a deduction if those stocks pay tax-favored dividends. There’s a special election you can make to get the tax benefit of dividend-stock income, but it’s a lot more complicated than situations involving regular taxable interest or other types of income.

Image: Flickr user Chris Tolworthy.

Miscellaneous itemized deductions on investment costsApart from interest expense, most costs of investing can be claimed only as miscellaneous itemized


deductions. In addition to being an option only for those who itemize their deductions, miscellaneous deductions are available only to the extent that they exceed 2% of your adjusted gross income.

If you qualify, you can potentially deduct costs for items such as investment advice, financial publication subscriptions, custodial fees on IRAs, money-management software, and rent on safe deposit boxes that you use to hold stock certificates or other investment-related documents. Even transportation costs to a broker’s office and attorney or accounting fees for collecting income may be eligible.

Other items, however, can’t be deducted. Commissions are built into your cost basis, so you can’t deduct them when they’re paid. Travel costs to a shareholder meeting aren’t allowed. You can’t deduct expenses for generating tax-exempt income, such as with municipal bonds.

Investment-related deductions typically won’t offset your entire tax burden from your investment income. Nevertheless, every little bit counts, and in some cases, investment expenses can give you a valuable tax benefit that helps pay for at least some of their cost.

Deductions are useful, but there are some other tax provisions that can save you even more. Next, you’ll learn about some of the tax credits investors can use to help them cut their tax bills.

Get the (Tax) Credit You DeserveTax deductions are great, but tax credits are even better. Deductions reduce your taxable income, which cuts your tax by only a fraction of the total deduction. Credits, on the other hand, reduce your actual tax bill dollar for dollar. Let’s look at two key tax credits investors can use to pay less to the IRS.

Get extra credit for savingSome workers get matching contributions from their employers for participating in a retirement plan. Yet many people don’t know that the IRS does a matching program of its own with its Retirement Savings Contributions Credit, better known as the Saver’s Credit.

The Saver’s Credit provides as much as $2,000 for those who contribute to a retirement account such as an IRA or a 401(k). The credit is designed for those with low or moderate incomes, with limits on taking the credit and with three income tiers that define how much you can take. The initial thresholds are $61,000 for joint filers in 2015 ($61,500 in 2016) and $30,500 for single filers in 2015 ($30,750 in 2016). You have to earn less than these amounts to be eligible.

The credit covers the first $2,000 you contribute toward a retirement account. The credit is 50% for joint filers making $36,500 or less in 2015 ($37,000 for 2016). Joint filers making up to $39,500 ($40,000 in 2016) can claim a 20% credit, while those beyond that level can claim a 10% credit up to the overall threshold.

Similarly, single filers earning $18,250 or less for 2015 ($18,500 in 2016) get the maximum 50% credit. Above that, singles earning up to $19,750 ($20,000 in 2016) get a 20% credit, while others get 10%.

To Get This % Credit

If Your Filing Status Is

Your Income Should Be

50% Single Under $18,250 in 2015Under $18,500 in 2016

Married Filing Jointly

Under $36,500 in 2015Under $37,000 in 2016

20% Single $18,250 to $19,750 in 2015$18,500 to $20,000 in 2016


$36,500 to $39,500 in 2015$37,000 to $40,000 in 2016

10% Single $19,750 to $30,500 in 2015$20,000 to $30,750 in 2016


$39,500 to $61,000 in 2015$40,000 to $61,500 in 2016

Each spouse in a married couple can claim the credit, and if both contribute $2,000 and have income that qualifies for the 50% credit, the credit amount will be the maximum $2,000. Even though many will get smaller boosts from the credit, it’s still a great added incentive to save.


International investing and the foreign tax creditIf you have international investments, you’ll often have to pay taxes to foreign governments. Fortunately, the foreign tax credit can give you savings on your U.S. tax return that can offset what you pay abroad.

The purpose of the foreign tax credit is to avoid forcing you to pay taxes twice on the same income. In general, the amount of the credit is equal to the lesser of what the foreign government charged you in taxes or what the U.S. government would impose on that overseas income using U.S. tax rates. So if you incurred taxes in a low-tax jurisdiction, the credit will often reimburse you the full cost of those international taxes. In a high-tax jurisdiction, though, the U.S. will credit only what it charges in taxes, leaving you to bear the higher rate on the whole.

The IRS has greatly simplified the foreign tax credit rules. Now, if you invest internationally through mutual funds, you can often just take the amount the fund reports to you at year’s end and claim it as your credit without going the complex calculations that used to apply to nearly every investor.

Using these two credits can help investors save on their taxes. By easing the hit from your tax bill, you’ll have more money left over to invest.

Next, let’s turn to an investment that promises a benefit most alternatives can’t: purely tax-free income.

Are Tax-Exempt Bonds All They’re Cracked Up to Be?We all like the idea of earning income that won’t raise our tax bill. One way to do that is to invest in tax-exempt municipal bonds. Like any other investment, however, they have pros and cons that make them more appropriate for some investors than for others.

Why municipal bonds have tax benefitsThe federal government recognizes the value of encouraging state and local governments to invest in projects that require capital, and raising that capital typically requires those state and local governments to borrow. By making the interest on bonds issued by state and local governments exempt from federal income tax, the federal government makes it cheaper for municipalities to get the cash they need.

How that works into investors’ decision-making process is pretty simple. Say you’re in the 25% tax bracket and you have a choice between two bonds: a regular taxable bond paying 5% and a tax-exempt municipal bond paying 4%. If you look only at the interest rate, the taxable bond looks more attractive. Yet on an after-tax basis, the municipal bond offers a better return, as a 25% tax on the taxable bond’s 5% interest payment will leave you with an effective after-tax yield of just 3.75%. Kick yourself up to a tax bracket of nearly 40%, and the taxable bond’s after-tax yield falls to nearly 3%, making the advantage of the municipal bond even clearer.

By contrast, if you’re in the 10% tax bracket, then the after-tax yield of the taxable bond is 4.5%, making it a better choice than the 4% municipal bond. The tax bracket you’re in makes a big difference in the comparable value of a municipal bond.

An extra benefit from municipal bondsMost states make the interest from these bonds free of state income tax as well. If you avoid bonds from a city that imposes a local income tax, as New York City does, bonds issued by the city government can earn triple-tax-free status, being free of federal, state, and city taxes.

However, that benefit doesn’t do you any good if you’re not subject to the tax in the first place. If you live in a different state, then you generally won’t benefit from double- or triple-tax-free treatment, and you’ll typically have to pay your own state’s income taxes on the interest, as you would with a regular bond. Therefore, you also have to take into account where you live and where the bond is issued in deciding whether a tax-exempt bond investment makes sense.


Remember: It’s a bondFinally, just because bonds are tax-exempt, that doesn’t mean they’re inherently safer than other types of bonds. While Treasury bonds are backed by the full faith and credit of the U.S. government, municipal bonds rely on the health of the state or local government that issues it, and some municipal bonds are tied to specific sources of tax revenue. If those taxes dry up or if a municipality ends up going bankrupt, then bondholders can suffer losses. These events are rare, but they have happened, so being aware of the risks is crucial in making smart decisions.

In the right situation, though, tax-exempt municipal bonds can be a great way to add income to your portfolio while cutting the taxman out of the loop. Just be sure to do your homework to make sure it’s really your best option to maximize return while minimizing risk.

Some aspects of taxation can get quite complicated, especially if you make some unusual investments. Among the hardest to understand are the passive activity rules that govern certain closely held business interests.

How the Passive-Activity Oxymoron Can Trip You UpIf you invest solely in securities of publicly traded companies, your portfolio’s tax implications will be relatively simple. For those who invest in more complex arenas, such as rental real estate or small businesses that are set up as privately held partnerships or limited-liability companies, IRS rules on what are known as passive activities can have serious ramifications for your tax picture.

Image: Denise Cheng, Flickr.

Why passive activities get special treatmentThe idea behind the passive-activity rules is to limit the ability for investors to take net losses against other types of taxable income if they don’t materially participate in the activity. Those involved in the activity on a regular, continuous, and substantial basis generally can take net losses.

The key reason the IRS pays so much attention to passive activities is that they’ve traditionally been used to create tax losses that taxpayers aim to use to offset income from other sources. In particular, the numerous deductions that small businesses and real-estate ventures can take make them prone to investor abuse.

For rental real estate, a slightly different standard applies that requires active participation. You must own at least 10% of the rental property in question, and you either must make management decisions yourself or arrange to have others provide services, such as repairs and maintenance, in a significant manner. Management decisions can include choosing tenants, negotiating rental terms, and authorizing spending on property maintenance and upkeep.

The trap of passive lossesIf you can’t demonstrate that the investment you’ve made qualifies for an exclusion to the passive-activity rules, you can’t take full advantage of any losses you suffer. Passive losses are deductible only against passive income, so if you don’t have enough qualifying passive income, you can’t use passive losses against other types of taxable income.

Fortunately, you don’t automatically lose unused passive losses forever. Instead, you can carry them forward to future years, and if you ever sell the property, you can typically deduct in full any remaining unused passive losses you had to carry forward in the past. Still, the delay in using those losses can diminish the value of the investment substantially by reducing its internal rate of return.

The complexity of dealing with the tax consequences of investing in real estate, private businesses, and other unusual types of investments often leads people to steer clear of them in favor of more common investments with simpler tax treatments. For those willing to take on the challenge, though, investing in these assets can be extremely lucrative, even if it


requires an understanding of some areas of the tax law that most investors never need to consider.

Another complicated area of tax planning comes in when you look at investing abroad. Next, we’ll talk about some of the special rules that can trip up those who buy foreign stocks and other investment assets.

How Investing Abroad Can Be TaxingMany people never seek out investments beyond U.S. borders, while others have identified lucrative investment opportunities overseas. Although better returns can often result from smart international investing, there are some tax issues involved that can make what looks like a great investment much less attractive than at first glance.

Image: Philip Brewer, Flickr.

Dealing with foreign taxFor U.S. investors who invest solely in domestic investments, taxes are pretty simple. If you invest in a taxable account, your investment income and any gains on investments you sell will be included in your taxable income. If you invest in an IRA or other tax-deferred account, you won’t pay any tax.

For foreign investments, though, it isn’t that easy. A foreign country has the right to impose tax of its own on your foreign-source investment income, and that technically could require you to complete a tax return for every country in which you invest. That’s not a very efficient system, and foreign governments rightly acknowledge that it’s also hard to enforce.

As a result, foreign governments often have the payers -- either from the companies that pay interest or dividends to their investors or from the financial institutions that handle the investment assets -- withhold tax at a fixed rate and pay it on investors’ behalf. Rates vary greatly, depending on the country involved and whether it has a tax treaty with the U.S. providing for favorable treatment. For instance, French oil company Total notes that the default French withholding tax rate is 30%, but certain shareholders can qualify for a reduced 15% rate by completing certain forms and arranging to have them filed with the French government.

When you take foreign tax withholding into account, what appears to be a high yield can become less favorable on an after-tax basis. As you saw in the credit section, the foreign tax credit is sometimes available to offset a portion of what you pay to a foreign government, but it won’t always fully make up for the tax you pay.

Taking a retirement hitAn even bigger problem can arise when you have foreign investments in an IRA or another tax-favored retirement account. Some countries will recognize the tax-deferred nature of the IRA and not impose the same withholding tax that it does on taxable brokerage accounts. Others, though, will charge the tax even though the U.S. treats the account as tax-deferred.

Moreover, even when a country does have treaty provisions that respect the IRA’s tax nature, you have to be careful to ensure that your broker handles your account correctly. Sometimes, brokers will simply apply the withholding tax, leaving it to you to get a refund. That’s often more onerous a process than it’s worth.

Investing overseas is a good way to diversify your portfolio, but it can create some additional tax burdens. Understanding them can help give you a more realistic sense of what to expect from your international investments.

Recently, the IRS introduced a new tax beyond the regular income tax. Now, investors have their own special tax that some will have to pay. Read on to learn more.


Will the Net Investment Income Tax Hit You?Regular income taxes often hit investors hard, but the tax laws also single out investors for a special tax of their own. A tax that went into effect in 201,3 known as the net investment income tax, imposes additional liability beyond the traditional income tax for high-income taxpayers who earn more than certain threshold amounts.

The basics of the net investment income taxThe net investment income tax imposes a 3.8% tax on investment income. For single filers, the tax kicks in if your modified adjusted gross income is more than $200,000. For joint filers, the threshold amount is $250,000. For the most part, modified adjusted gross income is the same as the total income on the line marked “adjusted gross income” on your tax return, which basically includes all your earnings from work, investments, and other sources of income. However, those who work overseas and are eligible to exclude their foreign work income from their regular income taxes aren’t allowed to do so for purposes of determining whether their total income exceeds the threshold.

Net investment income includes a large number of items. Common types of income such as interest, dividends, and capital gains are included within the definition. But other types of income also qualify, such as rental income, royalties, non-qualified annuities, and income from certain business interests. Gains from the sale of stocks, bonds, mutual funds, and investment real estate are included, and so is the part of the gain on the sale of a personal residence that doesn’t qualify for a capital-gains exclusion.

Net investment income doesn’t include wages, unemployment compensation, or self-employment income. Social Security benefits aren’t considered investment income, and tax-exempt interest on municipal bonds is also not included.

How to reduce your net investment income taxAs the name of the tax implies, you have to pay the tax only on net investment income. The tax allows you to deduct various expenses related to how you produce the income. For instance, money you spend on investment advice and brokerage fees can be

deductible, as can interest on margin loans or other borrowed funds you use to invest. A portion of tax-preparation fees, expenses incurred in producing rental or royalty income, and fiduciary expenses for trusts or estates can be deducted as well. Most importantly, a portion of state and local income taxes attributable to the investment income is available as a deduction.

In addition, making use of tax-deferred accounts such as IRAs can help you reduce your net investment income tax. Just as income on these accounts doesn’t get taxed on your regular return, you also don’t have to include it in your net investment income for purposes of calculating the tax.

One other thing to keep in mindFinally, even though it’s currently aimed at high-income taxpayers, the net investment income tax is likely to become more important to middle-class taxpayers over time. The threshold amounts aren’t indexed for inflation, and so as income levels creep higher, a larger number of taxpayers will end up having to pay the tax.

The net investment income tax doesn’t have an extremely high rate, but it’s another thorn in the side of the taxpayers to whom it applies. Investors need to structure their financial affairs to take the tax into account if they want to minimize their total tax bill.

Income taxes are something you’ll deal with all your life. By contrast, there’s one tax that doesn’t take effect until you die -- but by then, it’s too late to take steps that could save your heirs millions. Next, we’ll take a closer look at the estate tax and how it can hit investors hard.


The Big Tax You’ll Never Live to PayThey say the only sure things in life are death and taxes. Although you’ll pay income taxes throughout your life, there’s one tax you won’t live to pay, even though it could be the biggest one you’ll ever owe.

Most investors see the estate tax as a tax on the rich that they won’t have to worry about. Yet if you’re a successful investor, even saving modest amounts over time can leave you with a large enough portfolio to have to consider the potential impact of estate taxes on what you leave to your heirs. Here are some basics you should know about estate taxes and how to do what you can to lessen the blow.

The basics of the estate taxThe estate tax applies to the value of your assets at death. The current rate on taxable estates is 40%.

The key word there, though, is “taxable.” Everyone gets a lifetime exemption against gift and estate tax, which in 2015 is $5.43 million ($5.45 million in 2016). For most people who never make taxable gifts during their lifetimes, this means you can own up to $5.43 million in assets and pay no estate tax. Moreover, larger estates are subject to tax only on what exceeds the exemption amount. So if your estate is $5.5 million, you’d owe 40% tax only on the $70,000 above the limit, or $28,000.

Moreover, certain types of bequests can reduce your taxable estate. Most people are allowed to leave an unlimited amount to their spouse without paying any estate tax at all. Similarly, gifts to charity aren’t subject to the estate tax.

Estate-tax strategies to considerThe estate tax is complex enough to merit a completely separate report, but here are a few tactics to keep in mind. First, if you believe you’re at risk of having a taxable estate, the sooner you start making gifts during your lifetime, the better off you’ll be. You’re allowed to make annual gifts up to the applicable annual gift-exclusion amount -- $14,000 for 2015 and 2016 -- to as many people as you want without having to pay any gift tax or use up your lifetime exemption.

There are also some types of gifts that don’t have limits. If you want to pay someone’s educational expenses and make payment directly to the person’s college, no annual limit applies to the amount you can give. The same holds true for paying medical expenses, again as long as you make the payment directly to the hospital or medical professional rendering the services.

Finally, one specialized strategy involves life insurance. If you own a policy on your own life, the proceeds can be included in your estate. However, if you create a life insurance trust to own the policy for you, those proceeds won’t be included in your estate, even if the proceeds eventually go to exactly the same person.

The estate tax is a complex area of the tax laws that can require sophisticated planning. By keeping these general ideas in mind, you can go a long way toward avoiding the full impact of the estate tax.

Even the most meticulous taxpayers have to worry about getting audited by the IRS. To be prepared, you’ll want to make sure you have all the documentation you need for the deductions, credits, and other tax benefits you’ve claimed. Next, you’ll find some tips on how to survive an audit.


What Tax Records Should You Keep?No one likes to think about getting audited. But if it happens, it’s not the end of the world -- as long as you’ve kept the right records. For investors, your brokerage firm keeps and reports much of the information you’ll need to substantiate the positions you take on your tax returns. Yet it’s still important to know what you’re most likely to need and whether you can count on your broker to come through in the clutch.

Investors and auditsWhen an audit focuses on your investment income, some common themes come up:

• The amount of interest or dividend income on your return doesn’t match up with what the payers of that income reported on the 1099s they sent to you and to the IRS.

• There are disparities on reported sales proceeds and the cost basis for securities you sold during the year between what your broker said and what you put on your tax return.

• There are mistakes in treating taxable income as tax-free, and vice versa.

• There was improper accounting for mutual funds or stocks in which you had dividends and other distributions automatically reinvested in additional shares, especially upon sale of the shares of the stock or fund.

A lot of audit issues arise because of conflicting information that the IRS receives. It’s also hard for the

IRS to identify problems with information you supply when it doesn’t have an independent source to verify it. It’s therefore critical for you to (1) make sure the information that your brokerage firm reports to the IRS is correct, and (2) have access to copies of that information for as long as the IRS has the right to audit you.

Understanding audit statutes of limitationsAs long as you aren’t found to have acted fraudulently or in bad faith, the usual time limit for an IRS audit is three years from the later of the date you file your return and the return’s filing deadline. In some cases where the taxpayer leaves out income of more than 25% of what’s reported, that limit can extend up to six years. In cases of fraud, there is no statute of limitations.

As a result, once you file a return that includes in vestment income, you should hang on to the 1099s, brokerage statements, and other records relating to that income for at least three years. After that, the IRS typically won’t be allowed to come back and audit your return unless an exception applies.

The complication in keeping tax records for an investor is that it’s rare to have a cut-and-dried situation in which you make an investment, earn income on it, and then sell it all at one time. More often, you’ll have multiple transactions that span for years, and that will require you to hold on to records for a lot longer than three years.

For instance, to prove the proper amount of your capital gain when you sell a stock, you need to have evidence of how much your cost basis is. Doing so will require records that show how much you paid for the stock. For long-term investors who tend to hold their shares for years or even decades, that means digging through a long paper trail to show you made the right calculations.

More recently, brokers have started taking responsibility for many of these items themselves, keeping records of cost bases and including them on 1099s. But for older records, including stocks purchased prior to 2011 and mutual funds purchased before 2012, brokers aren’t required to dig up old information, and so it’s still up to you to know the right amount and be able to back it up.


The safest thing to do with investment records is to hang on to them until you’ve sold entirely out of the position and have waited an additional three years. That means a lot of extra paper in your filing cabinet, but it beats the alternative of not having those records when the IRS comes looking for them.

Go Forth and Pay No More Tax (Than You Have to)If you’ve made it this far, congratulations! You know a lot more about investing and taxes than most investors do. The strategies in this report won’t entirely wipe out your tax bill in most cases, but they’ll nevertheless help you pay less. That leaves more money in your pocket and helps you make the most of your smart investment choices.

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How to Save Thousands On Your IRS Bill / 1 · 2017-06-19 · Guide: How to Save Thousands on Your IRS Bill Most investors place their focus on picking winning investments. Yet taxes