Tax Tips for the Individual Investor

Although a lot depends on your personal situation, there are a few simple principles – tax tips, in effect – that apply to most investors and can help you save money. In this article, we'll look at some of those, explaining the tax benefits of making smart decisions in record-keeping, investing and reporting.

TUTORIAL: Personal Income Tax Guide

Are you an investor who ends up paying too much capital gains tax on the sale of your mutual fund shares because you've overlooked dividends that were automatically reinvested in the fund over the years? Reinvested dividends, by increasing your investment in a fund, effectively reduce your taxable gain (or increase your capital loss).

For example, say you originally invested $5,000 in a mutual fund and had $1,000 in dividends reinvested in additional shares over the years. If you then sold your stake in the fund for $7,500, your taxable gain would be the result of subtracting from the $7,500 both the original $5,000 investment and the $1,000 reinvested dividends. Thus, your taxable gain would be $1,500. Many people would forget to deduct their reinvested dividends and end up paying tax on $2,500.

While the reduction in taxable income in this example may not seem like a big difference, failing to take advantage of this rule could cost you significantly in the long run. By missing out on tax savings today, you lose the compounded growth potential those extra dollars would have earned well into the future, and if you forget to consider reinvested dividends year after year, your tax-adjusted returns will suffer considerably in the long term.

Keep accurate records of your reinvested dividends and review the tax rules applicable to your situation every time tax season comes around. Doing this will serve as a reminder of the details you need to use to your advantage again and will hopefully make you aware of new tax avoidance opportunities at your disposal.

When the stock markets perform badly, investors look elsewhere for places to put their money. Many find a safe haven in bonds, which often perform counter to equities – and provide interest income to boot. And here's the best part: You may not have to pay tax on all the interest you received.

How so? If you bought the bond in-between interest payments (most bonds pay semiannually), you usually won't pay tax on interest accrued prior to your purchase. You must still report the entire amount of interest you received, but you'll be able to subtract the accrued amount on a separate line.

Many investors also find short-term government debt a convenient safe harbor for their money. For the retail investor, municipal bonds (munis for short) in particular can offer significant tax advantages. These bonds are often issued by state governments or local municipalities in order to finance a particular project, such as the construction of a school or a hospital, or to meet specific operating expenses.

Most munis are issued with tax-exempt status, meaning the interest they generate does not need to be claimed when you file your tax return. Those that are highly rated, and thus low-risk, can be very attractive investments. (For further reading, see "Weighing the Tax Benefits of Municipal Securities.")

Did you buy a home computer last year? If you did, you can possibly write off a portion of the cost if you used the computer to place trades or to help manage your portfolio. The portion of the computer's cost that is deductible depends on how much you use the computer to monitor your investments. For example, if you paid $1,500 for a computer and you use it to keep tabs on your investments 20% of the time, $300 of the computer's cost is eligible to be written off as an expense.

For investors who invest in small business ventures or are self-employed, there are many operating expenses that can be written off. For example, if you take any business trips during the year that require you to obtain accommodations, the cost of your lodging and meals can be written off as a business expense, within specified limits dependent upon where you travel. If you travel frequently, forgetting to include these types of seemingly personal expenses can cost you sizeable dollars in lost tax savings.

For homeowners who have moved and sold their home during the year, an important consideration when reporting the capital gain on the sale is the actual cost basis of the purchase of the home. If your home has undergone renovations or similar improvements having a useful life of more than one year, you will likely be able to include the cost of such improvements into the adjusted cost base of your home, thus reducing your capital gain incurred on the sale and the resultant taxes.

Every time you trade a stock, you are vulnerable to capital gains tax. Making your purchases through a tax-deferred account can save you a pile of money. Tax-deferred accounts come in many shapes and sizes. The most well known are individual retirement account (IRA) and simplified employment pension (SEP) plans.

The basic idea is that you are not taxed on the funds until you withdraw them, at which point you are taxed at the rate of your income tax bracket. Presumably it'll be lower than at present, because you'll be retired with little or no earned income. (See also "Top Tax Tips for Retirees.")

Also, while the benefits of tax-deferred accounts are substantial on their own, they provide an additional benefit of flexibility because investors need not be concerned with the usual tax implications when making trade decisions. Provided you keep your funds inside the tax-deferred account, you have the freedom to close out of positions early if they have experienced strong price appreciation, without regard to the higher tax rate applied to short-term capital gains.

In many cases, it is a good idea to match the sale of a profitable investment with the sale of a losing one within the same year. Capital losses can be used against capital gains and short-term losses can be deducted from short-term gains. Also, if you have a particularly bad year, you can carry $3,000 of your loss over to future years. This may seem like a counterintuitive method, but it works very well in reality.

The key is that capital gains (or losses) are only applied to your tax return when they are realized. So-called paper gains and losses do not count – since there is no guarantee that your investments will not change in value before you actually do close out your position. However, by actively choosing to unburden yourself (perhaps temporarily) of losing investments, you can successfully match your capital gains with offsetting losses, significantly reducing your tax burden. (Learn more in "Tax-Loss Harvesting: Reduce Investment Losses.")

Buying stocks isn't free. You always pay commissions, and may also pay transfer fees if you change brokerages. These expenses should be added to the amount you paid for a stock when determining your cost basis. When you sell the shares, subtract the commission from the sale price of the stocks.

Think of these costs as a write-off because they are direct expenses incurred to help you make your money grow. After all, brokerage fees and transaction costs represent money that comes directly out of your pocket, as an expense incurred while undertaking an investment.

And although modern discount brokerages often charge relatively low fees, there is no reason to avoid claiming every expense possible when filing your taxes. Many small brokerage fees incurred over the course of an entire year can add up to hundreds of dollars, and for active traders who place hundreds or even thousands of trades every year, their impact can be substantial.

Here is another good argument for the buy-and-hold strategy: Short-term capital gains (less than one year) are always taxed at a higher rate than long-term ones. The difference between the tax rates of long-term and short-term capital gains can be 13% or more in some states and countries, and when you consider the long-term effects of compounding on reduced income taxes incurred today, it can prove very beneficial to hold onto your stocks for at least one year.

Most investors plan to take part in the equity markets for decades, perhaps moving from stock to stock as the years pass, but still keeping their money actively working for them in the market for the duration of their capital accumulation period. If you fit this description, take a moment to consider the tax advantages of using a longer-term buy-and-hold strategy if you are not doing so already – the savings can be worth more than you think.

It seems there are almost as many intricacies embedded into tax laws as there are investors who pay taxes. Part of a successful financial plan is astute tax management, which involves ensuring that you are actively taking advantage of tax avoidance opportunities that apply to your situation and also making sure you do not overlook any expenses or other income-reduction techniques that can lower your taxable earnings.

While many investors are eager to read about the next investment opportunity that holds potential for market-beating returns, few put in the same amount of effort to minimize their taxes. Do yourself a favor when tax season rolls around this year, and take the time to ensure you're doing all you can to keep your money in your pocket. (We also recommend talking to a tax planner.) The savings you uncover may make for a healthy boost to your annual return.