Tax Tips for the Individual Investor

A few simple tax tips of record-keeping, investing, and reporting can apply to most investors and can help you save money.

Reinvest Dividends

Investors can limit capital gains on the sale of mutual fund shares by automatically reinvesting dividends in the fund. Reinvested dividends increase your investment in a fund, effectively reducing your taxable gain (or increasing your capital loss).

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 is $1,500 ($7,500 minus the original $5,000 investment and the $1,000 reinvested dividends). Many people forget to deduct their reinvested dividends and end up paying tax on a higher amount.

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 in the long run. By missing out on tax savings today, you lose the potential compounded growth those extra dollars would have earned in the future, and if you forget to consider reinvested dividends year after year, your tax-adjusted returns will suffer.

Keep accurate records of your reinvested dividends, and review the tax rules applicable to your situation every tax season.

Bonds

When the stock market performs badly, investors look elsewhere for places to put their money. Many find a haven in bonds, which often perform counter to equities—and provide interest income to boot. The best part: You may not have to pay tax on all the interest you receive. If you bought the bond in-between interest payments (most bonds pay semiannually), you usually won’t pay tax on the accrued interest 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.

Municipal bonds (aka munis) can also offer significant tax advantages. These bonds are often issued by state governments or local municipalities 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.

Reducing Taxes

Investors who invest in small business ventures or are self-employed can write off many operating expenses. For example, if you take 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 depending on where you travel. If you travel frequently, forgetting to include these types of seemingly personal expenses can forfeit a lot of tax savings.

For homeowners who moved and sold their home during the year, an important consideration when reporting the capital gain on the sale is the cost basis of the purchase. If your home underwent renovations or similar improvements with a useful life of more than one year, you can likely include the cost of the improvements into the adjusted cost basis of your home, reducing your capital gain incurred on the sale and the resulting taxes.

Tax-Deferred Programs

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. Individual retirement accounts (IRA) and simplified employment pension (SEP) plans are two examples.

You are not taxed on the funds until you withdraw them, when the money will be taxed as income. Presumably, at that time your tax rate will be lower than now because you’ll be retired with little or no earned income.

Tax-deferred accounts provide an additional benefit of flexibility; 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 experience strong price appreciation, without regard to the higher tax rate applied to short-term capital gains.

Match Profits/Losses

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.

So-called paper gains and losses do not count since there is no guarantee that your investments will not change in value before you close out your position.

Add Broker Fees to Stock Costs

Buying stocks isn’t free. You always pay commissions and may also pay transfer fees if you change brokerages. The Internal Revenue Service does not allow you to write off transactions fees, such as brokerage fees and commissions, when you buy or sell stocks. But these expenses should be added to the amount you paid for a stock when determining your cost basis.

Think of these costs as write-offs because they are direct expenses incurred to help 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. Many small brokerage fees incurred over a year can add up.

Hold on to Your Stocks

Short-term capital gains (less than one year) are taxed as ordinary income, a higher rate than the capital gains rate that applies to long-term gains. For example, the capital gains rate is no higher than 15%, while the top marginal tax rate for ordinary income is 37%. When you consider the long-term effects of compounding on the money you save on your taxes today, it can prove beneficial to hold onto stocks for at least one year.

The Bottom Line

Many investors are eager to learn about the next investment opportunity for market-beating returns, but few put in the same effort to minimize taxes. Part of a successful financial plan is astute tax management. This tax season, ensure you’re doing all you can to keep your money. And talk to a tax planner: The savings you uncover may make a healthy boost to your annual return.