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5 Tax Planning Fundamentals for Investors

March 30, 2015

They say that only two things in life are inevitable—death and taxes. But at least death comes only once. Investors need to grapple with tax issues year after year, and sometimes year-round, which makes it important to understand a few fundamentals that can make tax season a little less…taxing.

Knowing your tax rate and how different types of income are taxed; understanding the role of tax-deferred accounts in your tax plan; being able to calculate the cost of investments correctly—these all can add up to a tax efficient investing strategy that helps you keep more of what you earn.

1.Know your tax rate

What percentage of income do you pay in tax? Sounds simple enough, but not only do tax rates vary with income, they vary based on the type of income you've earned. The higher the tax rate, the greater your incentive to find legitimate deductions or credits to offset that type of income.

The highest tax rates are levied on “ordinary” income—that's income that comes primarily from wages, tips and self-employment. Tax rates on this income range from 10% to 39.6%, based on your marginal tax bracket.

Most people will actually pay multiple marginal rates—paying 10% on the first $18,450 they earn; 15% on the next $56,450; and so on for joint filers. In a way, your total federal income tax rate is an average of various rates—which is why the amount you pay rarely corresponds to the exact marginal rate. That said, your marginal rate is extremely important because it tells you what you will pay on the next dollar you make and can inform all kinds of investment decisions such as whether tax-free municipal bonds make sense in taxable accounts or what kind of impact you'll get from making charitable contributions, and so on.

2015 Federal Income Tax Brackets

Besides wages and self-employment income, the ordinary income category also includes taxable bond interest, non-qualified stock dividends, short-term capital gains (gains on the sale of assets held one year or less), income from certain passive activities such as rental real estate or limited partnership interests, and taxable distributions from traditional IRAs and retirement plans.

Another major category of income consists of long-term capital gains—profits on the sale of stocks, bonds and real estate held for more than one year—the rates range from 15% to 23.8%. (Officially, long-term capital gains rates are 15% and 20%, depending on your income. But the Affordable Care Act added a 3.8% levy on “net investment income” reported by high-income filers.) Certain qualified stock dividends are also taxed at the long-term capital gains tax rate.

Profits from selling art, coins or collectibles (such as baseball cards, antiques and classic cars) are taxed at 28%, no matter your income.

2. Invest tax-efficiently

When you’re investing, asset allocation should be your first priority, followed by thoughtful security selection. But then you’ll want to consider what types of accounts you’re using and whether they make sense from a tax perspective, a strategy known as tax-efficient investing.

Investments with the most favorable tax treatments are ideal for taxable accounts; investments that are going to be taxed at a higher rate, or that generate more taxable income, are usually better suited for tax-advantaged accounts. Examples of tax-advantaged accounts include traditional IRAs, 401(k)s, and deferred annuities, which provide tax deferral, and Roth accounts, which can produce tax-free distributions.

Different Accounts, Different Tax Implications

3. Use tax-advantaged retirement and education savings accounts

One of the best ways to hone your tax planning strategy and reduce your ordinary income is to contribute to tax-favored retirement accounts, such as IRAs, 401(k) plans and SEP-IRAs. These types of tax advantaged investments reduce your taxable income by the full amount of your contribution. That not only saves you tax at your highest marginal rate, it can sometimes qualify you for certain types of deductions and credits that would otherwise be lost when your income exceeds certain thresholds.

Consider a couple with $190,000 in taxable income and two children in college. If they don’t contribute to 401(k) plans, they pay federal tax at a top rate of 28%. However, because of their income they also lose out on the so-called American Opportunity Tax Credit, which can reduce their income tax by $2,500 per student, per year.

However, if both parents contribute $15,000 to their 401(k) plans, they reduce their taxable income by $30,000. That saves them $8,400 in federal income tax. Now, they’re also able to claim education tax credits for both of their children. That gets them an additional $5,000 in tax savings. Net savings: $13,400. (And if they live in a state that imposes income taxes, the savings are even more dramatic because they’d owe less state taxes).

Those parents could also benefit from contributing to tax-advantaged savings accounts for education. Contributions to Coverdell Education Savings Accounts and 529 plans aren’t deductible on federal returns (though some states offer tax breaks for 529 contributions), but all the investment income earned within the account accumulates on a tax-deferred basis. If the money is ultimately used for qualified education expenses, withdrawals are tax-free. That can save thousands of dollars in capital gains taxes for diligent savers.

Save For Education, Reduce Taxes

4. Be aware of your “cost basis” and holding period

Capital gains taxes are paid only on the profit when you sell a security or other capital asset at a gain. However, you can minimize your gains by paying close attention to your so-called cost basis and holding period.

In a simple world, cost basis is what you paid for the shares, plus any transaction costs. In the tax world, it can get a bit more complex.

Let’s say you invest $500 a month in a mutual fund. When you first started investing, each share cost just $10, but the share price of the fund varies over time and has ranged from $10 to $120. Let’s say they’re now priced at $100 per share.

When you want to sell a few shares, the IRS will assume that you’re selling the first shares you bought—the ones purchased for $10, which would mean you’d pay taxes on a $90 per share gain. This method is called “first in, first out” or FIFO. Mutual fund investors can also use the “average cost” method, which generally results in a lower taxable gain during rising markets (average cost is not allowed for individual security sales, only mutual funds).

Alternatively, you could use the “specific identification” method to identify the shares you sell (whether they are mutual fund shares, or individual securities). Briefly, you can specify which block of shares you’re selling prior to the sale—Schwab clients can log into their accounts and select the cost basis method of their choice. For example, you can sell the shares that cost $120 and, instead of claiming a $90 gain, you’d claim a $20 per share loss. Eventually, of course, you’re likely to run out of higher-cost shares to sell. But until that point, you can save a lot of tax. (See our full story on calculating your cost basis here.)

Don’t forget about holding period. If you’ve held your investment for one year or less, your gain is taxed at the ordinary rate. No problem, if you’re selling at a loss. But if you’ve got nothing but gains, you generally want to sell the highest-cost shares that you’ve owned for more than one year to take advantage of the lower long-term capital gains tax rate.

5. Get help when you need it

If your portfolio is widely diversified, including everything from stocks and bonds to real estate, limited partnerships and international securities, your tax situation is likely to be complex, involving multiple types of investment income and, possibly, even the dreaded AMT (alternative minimum tax). Having a professional review your sources of income and deductible expenses as part of your tax planning habits will not only save you time, it can often save you money.

Better yet, a good tax advisor can tell you how to structure your portfolio so that it generates the greatest amount of income after taxes. That might include tax-efficient implementation of your portfolio between taxable and tax-advantaged accounts, tax-loss harvesting in taxable accounts, and so on. Remember, it’s not what you make but what you keep that counts. With good advice and a little effort, you may be able to boost your after-tax return and keep more of what you earn.

Important Disclosures

Mutual funds, exchange-traded funds and 529 plans are sold by prospectus only. Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a mutual fund prospectus by calling Schwab at 800-435-4000 or a variable annuity prospectus by calling 888-311-4887. Please read the prospectus carefully before investing.

Withdrawals prior to age 59 ½ from a qualified plan, IRA, or variable annuity may be subject to a 10% federal tax penalty. Withdrawals of earning within the first five years of the initial contribution creating a Roth IRA may also be subject to a 10% federal tax penalty.

Exchange Traded Funds are subject to market risk. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

As with any investment, it's possible to lose money by investing in a 529 plan. Additionally, by investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan.

Risks of REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and credit worthiness of the issuer.

Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Municipal and tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Inflation-protected bond fund portfolios typically invest at least 80% of their assets in inflation-linked securities which can be issued by various types of organizations and whose principal value and resulting dividend yield are adjusted periodically in accordance with the rise and fall in the inflation rate. Principal bond fund risks include but are not limited to market risk, interest rate risk, credit risk, and inflation-protected securities risk. Treasury Inflation-Protected Securities are guaranteed by the US Government, but inflation-protected bond funds do not provide such a guarantee. Please refer to the prospectus for the specific securities in which this fund may invest and their associated risks.

High-yield bonds and lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager.