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Taxes 101: It’s Not What You Make, It’s What You Keep

31 March 2016 in

As the income tax filing deadline looms this month, many of us already have an idea of how painful April 15 will (or will not) be. If Uncle Sam took a big bite, it may be worth reviewing for next year’s tax season to see whether you’re doing everything you can to retain the most of your investment income. And if you haven’t filed, there is still time to open or contribute to an IRA account that may help shrink your taxable income.

As an investor, you may want to consider the following questions to help you shave your tax bill:

  • Do you have an investment account to help you save for retirement?
  • How long did you hold your investments?
  • If you sold any of your holdings, did you make a profit or loss?
  • Did you earn income from dividend payments?

Here’s a quick rundown of how you can use the four questions to help position your portfolio for tax-efficient investing and do consider exhausting the limits on the strategies outlined below.

Less Income = More Income

Even taxpayers who don’t invest a single cent know that the lower your taxable income, the lower your tax bill. The three avenues to lowering taxable income are investing for retirement, investing for college and saving for health expenses.

Saving for Retirement

Fortunately, those who do invest have several ways to use funds earmarked for investing in a way that lowers taxable income. Because money in a regular account has already been taxed for income – and will be taxed a second time when you sell your investment for a profit, consider your options for retirement savings accounts to deliver some tax shelter.

Traditional IRA Roth IRA 401(k)
Tax Treatment
Traditional IRAs are tax-deferred investments.

  • You pay taxes on the funds you withdraw in retirement.
  • You may be able to deduct your IRA contribution from your taxable income depending on your income level and whether you or your spouse is covered by a retirement plan at work.
    • For example, if you earn $50,000 in a year, and contribute $5,000 to your IRA, you now have a taxable income of $45,000.
    • But if you are covered by a retirement plan at work, you may not be able to take any IRA deductions (see Annual caps below).
With Roth IRAs, you invest your after-tax dollars.

  • Therefore, you avoid federal taxes on the funds you withdraw in retirement.
  • Roth IRAs are not tax deductible.

If you are 59½ or older, and have held the account for at least five years, there are no tax obligations or penalties for withdrawals.

There are other qualified distributions that circumvent penalties. For instance, if you have held the account for at least five years and are disabled, or will use the funds to pay for qualified first-time homebuyer expenses, you are exempt from penalty.

To learn more about qualified distributions, see the Internal Revenue Service Roth IRA publication.

401(k) plans are employer-sponsored tax-deferred investments.

  • You pay taxes on the funds you withdraw in retirement.
  • The money you contribute to your 401(k) is deducted from your pretax income, lowering your taxable income.
Annual caps for your contributions
For the 2015 and 2016 tax years, your combined contributions to your traditional and Roth IRAs cannot exceed $5,500 ($6,500 if you’re age 50 or older).

Anyone can make contributions to traditional IRA but whether you can take the full deduction to lower your taxable income will depend on:

  • Your income level
  • Whether you are covered by a retirement plan at work

2015 tax year

2016 tax year

For the 2015 and 2016 tax years, your combined contributions to your traditional and Roth IRAs cannot exceed $5,500 ($6,500 if you’re age 50 or older).

You are eligible to contribute to a Roth IRA only if your income falls under a certain threshold.

In 2015, the cap remains $18,000, with an additional $6,000/year catch-up contribution for employee taxpayers aged 50 and above.
Other considerations
Use a traditional or Roth IRA to create a properly diversified portfolio for retirement, especially if your 401(k) plan provides few fund choices.

The deadline for making IRA contributions for a tax year is typically April 15 of the following year.

Remember there are no free rides as tax-deferred does not mean tax-free. You will pay taxes on the income when you withdraw the funds either at retirement or at an earlier date, in which case you would likely face penalties for early withdrawals.

Use a traditional or Roth IRA to create a properly diversified portfolio for retirement, especially if your 401(k) plan provides few fund choices.

The deadline for making IRA contributions for a tax year is typically April 15 of the following year.

Roth IRAs are suited to people who do not qualify for a traditional IRA.

Some 401k plans offer a limited number of funds to choose from so you may want to explore traditional or Roth IRAs so you can control attributes like fund management costs and diversification.

Some employers match the contributions made by their employees to their 401(k) plans. This is free money so take advantage!

Sources: Amount of Roth IRA Contributions That You Can Make for 2016; 401(k) plans; and Traditional IRAs, Internal Revenue Service.

Investing for College

Investors also can cut their taxable income by saving for their children’s college educations through a 529 plan. The amount you put aside is deducted from your taxable income and isn’t taxed when you take it out for college.

But remember that last bit – when you take it out for college! You’ll likely want to be very sure that this investment is used to pay for qualified higher education expenses. If the money is pulled for any other reason, you will pay taxes on the investment proceeds as well as an additional 10 percent penalty.3

Saving for Healthcare Expenses

A health savings account (HSA) – up to $3,300 for an individual and $6,750 for a family — is funded by pretax dollars to use on qualified healthcare expenses.

A health savings account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a high-deductible health plan (HDHP). Spending from HSAs are tax-exempt and your contribution reduces your taxable income.4

The Long and Short of Capital Gains

It’s pretty simple: For run-of-the-mill stock investing, the Internal Revenue Service offers a tax advantage for investors who hold their positions longer. Specifically, any profit you make from selling an investment is termed a capital gain – if you have held the asset for less than a year, it’s a short-term gain; if you hold it for a year or longer, it’s a long-term gain.

Short-term capital gains are taxed at ordinary rates as high as 35%, while long-term capital gains are taxed at a maximum of 15% for most stocks and funds.5

While taxes on short- or long-term holdings can also be affected by an individual’s tax bracket, you may want to consider the tax implications of any profitable investments just short of the one-year mark.

Losses from Stock Sales: It’s All About the Timing

Maybe you didn’t earn a profit, though. We’ve all had those investments that didn’t exactly work out as planned – perhaps a poorly timed idea, an initial profit that faded and never came back, or just plain bad luck. However it happened, you needed to push the sell button.

But not all is lost with “capital losses”. For one thing, you’re allowed to soften the blow to your tax bill by subtracting your losses from your other income, including other capital gains or your regular employment income. For example, if you sold stock in ABC for an investment loss of $1,000 and sold stock in XYZ for a gain of $1,500, your capital gain tax bill would be $500.

Here, too, a limit is in place – you can only claim up to $3,000 in losses each year, but you can carry losses into future tax years.6

About That Dividend…

A common strategy for equity investors is to put some of their funds in stocks that also pay out regular dividends. Of course, these payouts are technically income, and so they’re also taxable for as long as you own the stock.

Here too, though, the federal government smiles on holders of dividend-paying stocks, taxing “qualified” dividends at rates lower than ordinary income tax rates. If your ordinary income is taxed in the 28 percent bracket, for example, your qualified dividends would be taxed at 15 percent.7

Dividend-paying stocks offer taxpayers the advantage of having the payouts taxed at lower rates while offering the double-barrel potential of income generation and appreciating value.

The nuances behind the four questions above should be explored further by investors who need more information for specific issues. The IRS website is a good starting resource for further research.

  1. Internal Revenue Service press release, Oct. 21, 2015, https://www.irs.gov/uac/Newsroom/IRS-Announces-2016-Pension-Plan-Limitations%3B-401(k)-Contribution-Limit-Remains-Unchanged-at-$18,000-for-2016, (accessed March 27, 2016).
  2. Internal Revenue Service press release, Oct. 21, 2015, https://www.irs.gov/uac/Newsroom/IRS-Announces-2016-Pension-Plan-Limitations%3B-401(k)-Contribution-Limit-Remains-Unchanged-at-$18,000-for-2016, (accessed March 27, 2016).
  3. Internal Revenue Service website, https://www.irs.gov/uac/529-Plans:-Questions-and-Answers, (accessed March 27, 2016).
  4. Internal Revenue Service website, https://www.irs.gov/publications/p969/ar02.html#en_US_2015_publink1000204045, (accessed March 27, 2016).
  5. Internal Revenue Service website, https://www.irs.gov/taxtopics/tc409.html, (accessed March 27, 2016).
  6. Internal Revenue Service website, https://www.irs.gov/taxtopics/tc409.html, (accessed March 27, 2016).
  7. Internal Revenue Service website, https://www.irs.gov/publications/p550/ch01.html#en_US_2015_publink100010074, (accessed March 27, 2016).

Motif does not provide tax advice. This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, investors should consult with a qualified tax advisor, CPA, Financial Planner, or Investment Manager.

Data contained herein from third party providers is obtained from what are considered reliable sources. However its accuracy, completeness ore reliability cannot be guaranteed.

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