John Waggoner offers valuable advice on cutting your 2010 tax burden for USA Today.
You know the symptoms: The spots before your eyes. The dizziness. The searing pains akin to riding a luge down a lava flow. Fortunately, tax season will soon be over.
But if you want to avoid such pains next year, you have to start now. Luckily, making the moves won’t hurt much at all. Let’s start with capital gains payouts. Every year, a mutual fund must tally up the gains and losses from its trades. If it has more gains than losses during the year, it must pay out those gains to you, and you must pay taxes on them. Every little bit hurts at tax time.
Consider Fidelity Select Gold, for example, which paid out $0.767 per share in long-term capital gains last year. If you owned 1,000 shares, you got a $767 taxable payout. Assuming a 15% capital gains rate, your tax bill just went up by $115.
Short-term capital gains distributions are even worse: You owe regular income taxes on short-term gains. Funds can’t pay out capital losses, but they can carry them forward from one year to the next. For that reason, capital gains payouts at most funds last year weren’t terribly onerous. Nevertheless, if the bull market continues, you can expect that 2010 capital gains payouts will rise.
And over time, taxes can severely erode your returns. For example, the average stock fund gained an average of 1.14% a year the past 10 years. After taxes: 0.34%, says Lipper, which tracks the funds.
One solution: Consider tax-managed funds, which try to offset losses and gains. Although these funds do try to keep capital gains payouts at a minimum, there’s no guarantee they will.
Another solution: Consider an index fund or exchange traded funds. Index funds are typically very tax-efficient, and they normally have far lower annual costs than actively managed funds do. Because they have no manager and keep very little cash on hand for redemptions, an index fund will be a highly cost-effective and tax-smart way to lose money. On the other hand, most active managers can’t dodge bear markets, either.
Next, fill your retirement accounts:
•If you have a 401(k) plan with a company match, contribute enough to get the full match. This has nothing to do with tax savings: You should never pass up free money. Your taxes will be deferred until you retire.
•Fund a Roth individual retirement account. Although you contribute after-tax money to a Roth, you pay no taxes if you hold the Roth for at least five years and you make your withdrawals after you reach age 59½.
A Roth is a great plan if you’re worried about taxes rising in the future. It’s better to pay taxes now, at current rates, than pay later at higher rates. If you’re younger than 50, you can contribute $5,000 to a 2010 Roth; those 50 or older can sock away $6,000.
The problem: If you’re married filing jointly, your modified adjusted gross income must be less than $177,000 in 2010 to fully fund a Roth. If you’re single, the limit is $120,000.
It’s better to keep your income-generating investments, such as money market funds, CDs and bonds, in a retirement account, such as a 401(k) or an IRA. Funds that are prone to regular distributions, such as those that invest in bonds, real estate investment trusts, or stocks with big dividends, are best kept in a retirement fund, too.
Think twice before putting individual stocks or tax-efficient funds into a retirement account other than a Roth. Even if tax rates rise, it’s a good bet that capital gains rates will be lower than ordinary income tax rates.
But that’s not the only reason. If you own a stock, you can take capital losses. You can’t in a retirement account. And capital losses, while painful, can be valuable indeed. Suppose you have two stocks, whose names and identities are entirely fictional: SuperSmartCo has seen its price soar from $20 a share to $50 a share in just nine months; SuperDumbCo, on the other hand, has plunged from $15 to $2 in the same amount of time. You have 100 shares of each.
You made a $3,000 profit on SuperSmartCo. You’re in the 25% tax bracket, and this is a short-term gain, so you’d owe $750 in capital gains taxes.
If you sold your SuperDumbCo shares, however, you’d have a $1,300 loss. You could use your $1,300 loss to reduce your $3,000 gain to $1,700 — and your tax bill would fall to $425.
Income-oriented investors should consider municipal bonds if their tax rates are high enough. A high-rated 10-year tax-exempt bond yields 3.25%, says Bloomberg. A person in the 25% tax bracket would have to earn 4.3% in a taxable investment to earn the equivalent of 3.25% after taxes.
Taxes are necessary, but don’t suffer more than you need to. Act now and save pain later.
http://www.usatoday.com/money/perfi/columnist/waggon/2010-01-29-invest29_ST_N.htm
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