7 tax basics every investor needs to know
(MoneyWatch) The tax code is frustratingly complicated but the basic ideas behind tax-smart investing are fairly simple and straightforward. With this year's tax-filing deadline just days away, it's a good time to review the fundamentals every investor should know when it comes to financial planning and taxes.
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, according to Rande Spiegelman, v.p. of financial planning at the Charles Schwab (SCHW) Center for Financial Research:
1. It's not what you make, but what you keep that matters. All the goods and services you purchase are bought with after-tax dollars, and savvy investors know how important it is to minimize their tax burdens, Spiegelman writes in a recent report. "For example, in a 35 percent combined marginal tax bracket, an after-tax dollar spent is equivalent to $1.50 pretax earned," he says. "So, think twice (or at least 1.5 times) before you spend that next dollar."
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, notes Spiegelman. Traditional IRAs and 401(k) plans can provide an upfront tax break, and the ongoing benefit of tax-deferred compounding as you save for retirement. If you're saving for college, putting money in a 529 plan or education savings account can help your money grow tax-free.
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," Spiegelman writes. But after that, it's important to 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," notes Spiegelman.
4. Count the cost (basis) before you sell. Don't forget that frequent trading can cost you a bundle at tax time. Short-term gains -- or gains on investments held a year or less -- are subject to ordinary income tax, whereas investments held over one year are generally taxed at a lower long-term capital gains rate.
5. Give before it hurts. Lifetime transfers to loved ones and charities are a great way to manage your estate, and also to see the benefits while you're still alive, says Spiegelman. "Gifting provides a couple of added bonuses, as well," he adds. "Any future appreciation on the gift is in the hands of the beneficiary and outside your estate, plus you get to participate in the enjoyment of the gift while you're alive." You can give up to $13,000 each to any number of persons in a single year without incurring a taxable gift (or $26,000 for spouses "splitting" gifts).
6. Be prepared. Stay organized and plan ahead. Watch out for deadlines when it comes to retirement plan contributions, required minimum distributions, estimated tax payments, year-end gifts, and other matters. "Don't wait until the last minute either before the end of the year or April 15th," Spiegelman says. And, of course, be sure to save all your receipts and keep organized records.
7. Get help if you need it. Not everyone needs a tax preparer but it can be money well spent, especially as the tax rules become more complex. "Using a pro is easier, may save you from paying more tax than you should, and is less costly than a nasty tax surprise or a visit from the IRS audit department," writes Spiegelman.