7 Tax Fundamentals Every Investor Should Know

The tax code might be complicated, but the basic ideas behind tax-smart investing are pretty simple. Here are seven fundamentals to guide you through the many points in your life when taxes may play a role in your financial decision-making.

  1. Know how your income is being taxed.
  2. Use tax-advantaged accounts to help you reach your education and retirement goals.
  3. Invest tax-efficiently between regular and tax-advantaged accounts.
  4. Determine your costs before you sell.
  5. Consider lifetime gifting and charitable gifts.
  6. Have a plan.
  7. Get help if you need it.

1. Know how your income is being taxed.

Virtually all the goods and services we purchase are bought with after-tax dollars. Savvy investors know how important it is to minimize their tax burden. But do you know how each source of income is taxed?

Make sure you understand the different classifications of income, credits, and deductions that may apply to you. For tax purposes, income is categorized by type. The major categories are:

  • Ordinary: Income from wages, self-employment income, interest, dividends, etc.
  • Capital: Income from the sale of property.
  • Passive: Income from investments in real estate, limited partnerships or business activities where participation is immaterial.

There are further classifications within some of these categories. For example, some interest income is considered tax-exempt (for example, interest from state and local municipal bonds) and some dividends are deemed "qualified" and receive special long-term capital gain tax treatment. Also, while capital gains can be either short-term or long-term, there are further categories for such things as collectibles or recaptured depreciation (see IRS Publication 550).

Finally, special rules apply to the interaction between these categories. For example, passive losses can usually only offset other passive income, not ordinary income. Also, while capital losses can offset capital gains without limit, only $3,000 of capital losses per year can be used to offset ordinary income ($1,500 for married filing separately). For both passive and capital losses, carryover rules allow unused losses to be saved for use in future years.

For more information on income, see:
How Do You Define Income?
Investment Expenses: What's Tax Deductible?
Claiming Foreign Taxes: Credit or Deduction?
Year-End Tax Tips for 2013
Taxes: What's New for 2014?

2. Use tax-advantaged accounts to help you reach your education and retirement goals.

If you're going to save anyway, you might as well take advantage of every tax break the law allows. 401(k) plans and traditional IRAs can provide an up-front tax break and the ongoing benefit of tax-deferred compounding as you save for retirement. A variety of small business retirement accounts provide the same tax advantages for smaller companies and the self-employed. And if you're saving for college, putting your money in a 529 plan or Education Savings Account can help your money grow tax-free and can help you avoid paying taxes on future withdrawals, as long as they're used for qualified educational expenses. Here's a brief overview of each account:

  • 401(k)s. A 401(k) savings plan is sponsored by your employer, and lets you save for retirement while reducing your taxable income. If your employer offers a matching contribution, take advantage of it.
  • Traditional IRAs. Traditional IRA contributions are generally tax-deductible, unless you're an active participant in a qualified employer plan like a 401(k). If  you're an active participant, your traditional IRA contribution is fully or partially deductible if your modified adjusted gross income falls below a certain threshold (which varies by year).
  • SIMPLE IRAs, SEP IRAs, and Individual 401(k)s. If you own or work for a small business, the right retirement account for you will vary depending on a number of factors: ease of administration, your age, and your self-employment income, among others.
  • 529 plans. A 529 plan is a tax-deferred, state-sponsored program that lets you invest for a child's college education. You pay no federal taxes on withdrawals as long as they're used to pay for qualified educational expenses. 529 plans don't limit how much you can contribute per year, but they do have a lifetime contribution limit per beneficiary that varies by state. Contributions to a 529 plan are treated as a gift for gift-tax purposes, so be aware of those limitations if you're considering a large contribution.
  • Education Savings Accounts (ESAs). ESAs provide tax advantages similar to 529 plans: Your money grows tax-free and you pay no taxes on withdrawals if they're used to pay for qualified educational expenses. ESAs have a much lower contribution limit—a maximum of $2,000 annually, if you qualify—but they can be used for certain K-12 expenses in addition to college expenses.

Retirement Accounts

 

Account

Contribution limit (2014)

Age 50 or older additional catch-up amount (2014)

401(k), 403(b), or 457 qualified employer plan

$17,500

$5,500 

Traditional IRA and Roth IRA

$5,500

$1,000

SIMPLE IRA

$12,000

$2,500

QRP/Keogh and SEP-IRA 

20% of net self-employment income (or 25% of compensation), up to $52,000

None

Individual 401(k)

20% of net self-employment income (or 25% of compensation) plus $17,500, up to $52,000

$5,500

Education accounts

 

Account

Amount that can be contributed without the donor owing gift taxes

Contribution limit (2014)

529 college savings plan

Up to $70,000 ($140,000 per couple) per beneficiary in a single year if contributor elects to recognize that gift over five years for tax purposes and makes no additional gifts to that beneficiary over the next five years

Lifetime limit per beneficiary that ranges by state, generally upward of $200,000 per beneficiary

Education Savings Account

$2,000 yearly contribution limit is subject to gift-tax rules

$2,000 per year, subject to adjusted gross income limitations (phase-out: $190,000–$220,000, married filing jointly; $95,000–$110,000, single) 

For more information about retirement and education accounts, see:

Is a Roth IRA Right for You?
Saving for Retirement: IRA vs. 401(k)
Saving for College: Strategies for Success
3 Small Business Retirement Plans Worth Considering
Stretching Your IRA: Transferring Wealth to the Next Generation

3. Invest tax-efficiently between regular and tax-advantaged accounts.

When you're investing, asset allocation should be your first priority, followed by thoughtful security selection. Finally, consider what types of accounts you're using and whether they make sense from a tax perspective. Keep in mind, tax-efficient implementation should be the final overlay after you've made an investment decision.

Where tax-smart investors typically place their investments

 

Taxable accounts

Tax-advantaged accounts such as Roth IRAs and tax-deferred accounts including traditional IRAs, 401(k)s and deferred annuities   

Ideal for...

Ideal for...

Individual stocks you plan to hold more than one year

Individual stocks you plan to hold one year or less

Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds

Actively managed funds that may generate significant short-term capital gains

Stocks or mutual funds that pay qualified dividends

Taxable bond funds, zero-coupon bonds, Inflation-protected bonds or high-yield bond funds

Municipal bonds, I Bonds (savings bonds)

Real estate investment trusts (REITs)

4. Determine your costs before you sell.

Short-term gains (on investments held one year or less) are subject to ordinary income tax, whereas investments held over one year are generally taxed at a lower long-term capital gain rate. Once you sell your investment, the gain is calculated by subtracting the sale price from your cost basis (the price you paid). Because investors can buy into the same investment at various prices over time, calculating the cost basis can become complicated. Below are the accounting methods recognized by the IRS.

For individual stocks and bonds, your broker is required to report cost basis on equities acquired after January 1, 2011. Notify your broker which of the following methods you'd like to use:

  • FIFO, or "first in, first out," is the IRS's default accounting method. For a partial sale of a particular stock or bond, the IRS presumes you sold your oldest shares first—unless you gave different instructions to your broker.
  • Specific identification offers more flexibility than FIFO, giving you the opportunity to optimize results. However, you must identify the specific shares you're selling at the time of sale and have your broker confirm that identification in writing within a reasonable period of time.

For mutual fund shares acquired after January 1, 2012 ("covered" shares), your broker's default method (typically, average cost single category) is in effect unless you elect a different permitted method. You have four options:

  • FIFO presumes you redeemed your oldest shares first unless you instructed your broker or fund company otherwise.
  • Specific identification provides the most flexibility and, generally, the most advantageous result.
  • Average cost single category is most brokers' default accounting method for "covered" shares. Prior to your first partial sale, you total the cost basis of your entire position and divide it by the number of shares you own to determine your average cost per share. As with FIFO, the oldest shares are deemed the first to go under the Average Cost method. Most brokers and mutual fund companies will keep an ongoing calculation of average cost basis for you, including automatically reinvested shares.
  • Average cost double category is rarely used due to its complexity.This method allows you to calculate average cost in two capital gains buckets: short-term average cost and long-term average cost. The double category method provides a bit more flexibility than the single category method because you can specify which bucket your shares were redeemed from.

For more information on capital gains (and losses), see:

Calculating Your Cost Basis
Get a Tax Break by Harvesting Losses
Harvesting Losses: Making Lemonade Out Of Lemons
A Primer on Wash Sales
Hedging: Tax Traps for the Unwary

5. Consider lifetime gifting and charitable giving.

Lifetime transfers to loved ones (also known as gifting) and charities are a great way to manage your estate. Any future appreciation on a gift is outside your estate, and you get to participate in the enjoyment of the gift while you're alive.  In the case of charitable gifts, you are also eligible for an income tax deduction.

Currently, you can give up to $14,000 each to any number of persons in a single year without incurring a taxable gift ($28,000 for spouses "splitting" gifts). In addition, you can make unlimited payments directly to medical providers or educational institutions on behalf of others without incurring a taxable gift.

Typically, it's a great strategy to take advantage of the annual $14,000 exclusion, make payments directly to medical and educational providers on behalf of loved ones, and preserve your lifetime gift-tax exemption. However, for those with large estates, it often makes sense to also make taxable lifetime gifts utilizing the lifetime exemption—or beyond if your net worth is very high. One caveat: if the estate tax is significantly changed or even repealed again in the future, you may regret having paid gift tax now in an effort to minimize your estate tax. Do your best and plan with the information available now. Any guess about the future is still just a guess, and the law as it stands is still the law.

Estate taxGift tax
Top rateExemptionTop rateExemption
40% $5,340,000 per person 40% $5,340,000 per person

For more information on charitable giving and estates, see:


Charitable Donations: The Basics of Giving
Why You Need an Estate Plan
 

6. Have a plan.

Take a year-round approach to tax planning. Use last year's return as a starting point and make the appropriate changes according to your projections for this year. This sort of power planning might help you save money in some important ways:

  • Armed with a projection for this year, you can double-check your withholding or quarterly estimated tax payments to make sure you're not paying too much or too little.
  • Based on your projections, you might feel more comfortable making your IRA and/or Education Savings Account contributions earlier rather than later.
  • Knowing your projected marginal income tax bracket will help you make better investment decisions, such as whether municipal or taxable bonds make sense in taxable accounts, which assets go best in taxable vs. tax-advantaged accounts, or how much bang for the buck you might receive from harvesting capital losses.
  • Does it make sense to defer income and accelerate deductions this year? Are you subject to the federal alternative minimum tax (AMT)? Can you reduce your tax burden by making charitable contributions? Running a projection of this year's estimated income tax liability could help you answer such questions and potentially give you a big advantage in planning to maximize after-tax cash flows for the year ahead.

As always, it's a good idea to save all your receipts and keeping organized records. A calendar with important deadlines, including retirement plan contributions, required minimum distributions (RMDs) and estimated tax payments can also help you manage your finances.

Once you are organized and have a plan in place, you'll be better equipped to deal with and even take advantage of any changes that might come your way.

7. Get help if you need it.

Not everyone needs the help of a tax preparer, but if you have questions or need assistance, hiring a professional can be money well spent—especially as the tax rules become more complex. Working with a professional is easier, may save you from overpaying in taxes, and is less costly than an unpleasant tax surprise or a visit from the IRS audit department.  

When to get help
Many taxpayers opt for professional help once they begin to itemize their deductions by filing Schedule A. This might occur in the first year of owning a home and paying mortgage interest, or when deductible taxes exceed the standard deduction. In states with high income taxes such as California and New York, simply paying deductible state income tax can kick a taxpayer over the standard deduction.

Once a return begins to include items such as self-employment income, rental real estate income, home sales or the dreaded alternative minimum tax, you should consult a tax professional.

How to hire a tax professional
By far the best method for hiring a tax preparer is to get a referral from someone you trust. Most states also have professional societies for CPAs and/or Enrolled Agents (EAs), with online resources to search for professionals in your area.

Once you've found a candidate, give them a call and ask some questions. Ask about their certifications, their continuing education requirements, their customer base (how many, what kind), their experience, their tax preparation process, and whether they outsource data entry on the returns they prepare.

Next, ask about fees. Generally, tax firms will follow one of two fee systems. The first is a per-schedule charge, where fees are based on the number and kind of forms needed to file the return. The second method is a per-hour charge for time spent meeting with you and preparing the return. Given enough information about your tax situation and the potential complexity of your return, a reputable tax preparer should be able to quote an approximate fee for preparing your return.

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Important Disclosures

Mutual funds, exchange-traded funds and 529 plans are sold by prospectus only. Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a mutual fund prospectus by calling Schwab at 800-435-4000 or a variable annuity prospectus by calling 888-311-4887. Please read the prospectus carefully before investing.