Continuation: 32 (20 to 25) Fool-Proof Federal Income-Tax-Saving Strategies
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20. Consider tax-exempt securities. Income from municipal bonds is free from federal taxes. Better still, invest in municipal bonds issued in your own state and you can save state and perhaps local taxes as well as federal taxes. Focus on after-tax yield when comparing the returns on different income investments. For example, if you are in the 31% bracket, a municipal bond paying 5% is equivalent to a taxable investment earning 7.25% (see “How to Boost your Savings”). Seniors may pocket even more tax savings from municipals. Although tax-free interest counts when figuring how much of your Social Security benefits are taxable, the lower yields on tax-exempts will hold down on the extra tax.
21. Round up all mutual fund transactions. To avoid getting socked by the IRS with a negligence penalty, carefully review all the Forms 1099-B you received from your mutual funds during the year. You may have more gains or losses than you think. You also incur gains or losses each time you pick up the phone and switch from, say, a stock fund to a bond fund in the same fund family.
22. Don’t overstate mutual fund capital gains. If you calculate the tax basis (the cost on which your capital gain or loss is based) of your mutual fund shares and come up with a round number like $10,000, you’ve probably erred in Uncle Sam’s favor. You likely forgot that your dividends and capital gains distributions were automatically reinvested in new shares. Because you have reported those amount as income in prior years, you will wind up paying taxes on them twice if you don’t add the reinvestments to your basis. Here’s how to figure your taxable gain: First, start with your original purchase price. Then, add together any amounts the fund reported to you during the year as undistributed capital gains and ordinary income dividends. Next, subtract any nontaxable dividends that represented a return of your investment. The result is your basis. Subtract that figure from the sale price. Viola! Your taxable gain.
23. Unload your most expensive shares first. When selling stocks, bonds, or mutual funds you’ve bought over time, cut your taxable gains by identifying the shares you want to sell –that is, the ones that cost you the most. This strategy works best when fund prices have fluctuated dramatically. Review your brokerage or mutual fund statements to find the dates when you paid the most for each share or bond. Then write a letter or redemption to your broker or mutual fund, specifying which shares you’re selling according to the date you paid. Keep a copy for your records and ask your broker or fund for confirmation in writing. If you don’t specify which block you are selling, the IRS will use what’s known as the first in, first out method. That simply means the first shares you bought will be presumed to be the first shares you sold, which could force you to pay more in taxes than necessary.
24. Look for mutual funds that are tax-efficient. These are the ones that produce the highest returns for investors, net of taxes on income, and capital gains distributions. The average diversified stock fund had a tax-efficiency ranging from 84% to 88% over three, five, and ten years, according to the Morningstar mutual fund service. Translation: Shareholders returned to Uncle Sam 12% to 16% of the annual gains they received from their funds. (you can find the fund’s tax-efficiency rating in Morningstar Mutual Funds at your library). There are now about 15 so-called tax-managed mutual funds that are specifically designed to increase your after-tax returns by, for example, limiting trading in their portfolios.
25. Consider a home-equity loan or credit line instead of a car loan or 401(k) loan. Interest on up to $100,000 of a home-equity loan is generally tax-deductible; interest on those other kinds of debt is not.
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