Investing with Your Eye on Taxes

Unfortunately with investing, as with just about any other
activity that generates income, gains are taxable. That
downside doesn’t mean that you shouldn’t try to invest successfully.
But you should realize that you do pay taxes on
investment gains. Consider the following:

Savings accounts

The gains on simple savings accounts, CDs, and money market
accounts are taxed as income at the local, state, and
federal level. Banks and financial institutions report these
gains to the IRS and state tax offices, just as all investment
gains are reported.

Mutual funds

With mutual funds, unfortunately, you have to pay tax each
year on the capital gains and dividends that the fund distributes
to each of its shareholders. You also have to pay taxes
on your own gains when you sell shares — another reason
for a long-term buy-and-hold strategy. The exceptions are
funds that invest in U.S. securities. You still have to pay federal
income tax on any gains, but you’re free of state and local
tax in most situations.

Although some people believe that municipal bond funds are
free of federal income tax, that’s only true of municipal bond
investments themselves. You pay taxes on capital gains on any
profits that a municipal fund makes from selling bonds.

Stocks

With stocks, you don’t pay taxes on your gains until you sell
your shares — a
feature which fans of stock investing say is
a clear advantage in the long run. The downside, however, is
that when you do cash in shares down the road, your tax
bracket or the tax rate may have increased.
If you do have a
stock loss (
which means a stock is worth less
than what you bought it for), but the stock is one you want
to own, consider selling the stock and rebuying shares at a
lower price. The IRS allows you to consider this a wash sale,
so you won’t have to pay capital gains tax. Note that you must
wait 31 or more days before you can buy back the stock or
else the IRS doesn’t allow the deduction.

Bonds

Price appreciation (if any) on a bond — whether it is a corporate,
government, or municipal bond — is taxable when
the bond matures. Interest on municipal bonds is exempt
from federal tax, but may be subject to state and local tax
(depending on if you live in the state or locality doing the
issuing). Interest on U.S. government bonds is exempt from
tax at the state level, but taxable at the federal level.

If you buy a
bond from Fannie Mae or Ginnie Mae (
the
quasi-government agencies that guarantee mortgages), then
gains are taxable at the local, state, and federal level.
Tax-deferred investing
Don’t forget to take advantage of any form of tax-deferred
investing available to you. Max out on the retirement plans
offered to you at work (such as your 401(k) plan). Investing
in this way really does boil down to a choice of paying yourself
or paying the IRS.

With retirement plans such as a 401(k), you enjoy the added
bonus of being able to deduct your contributions, up to a
maximum of 15% of what you earn, from your income each
year for tax purposes. Now that’s hard to beat. The maximum
amount that you can deduct depends on the plan. Some
plans allow 8%, some 10%. But no plan is allowed, by law,
more than 15%.

Contributions made to a 401(k) plan are deductible from
gross income for income tax purposes. If you do your taxes
yourself, you deduct your overall annual contribution from
your gross income. If an accountant or attorney does your
taxes, she or he does the deduction for you.

Just as hard to beat is the Roth IRA. If you have adjusted
gross income under $95,000 as an individual, you can tuck
away $2,000 in a Roth IRA each year and begin to take distributions
tax-free when you hit the age of 591⁄2. If you’re married
and you and your spouse have a combined adjusted gross
income of $150,000 or less, you can tuck away $4,000 a year.
Unlike regular IRAs, Roth IRAs allow investments even if
you’re enrolled in an employer-sponsored retirement plan.
The same goes for self-employed folks. With the Roth, you
get tax-free capital gains every year, and you get to take withdrawals
tax-free when you hit retirement age at 591⁄2, provided
you’ve had the account for at least five years.