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After all, nobody likes taxes, but we all have to deal with them, so we might as well handle them in the best way possible. When the end of the year approaches, many investors thoughts turn to how they can avoid paying tax. (Notice we said avoid, not evade.) Although a lot depends on your personal situation, there are a few simple tax principles that apply to most investors and can help you save money (We also recommend talking to a tax planner.) In this article, well look at the tax benefits of making smart investment decisions, writing off expenses, effectively managing your capital gains and more.
Dividends
Are you an investor who ends up paying too much capital gains tax on the sale of your mutual fund shares because youve overlooked dividends that were automatically reinvested in the fund over the years? Reinvested dividends increase your investment in a fund and thus 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.
Bonds
When the stock markets perform badly, investors make the flight to quality and look elsewhere for places to put their money. Many find a safe haven in bonds. When you are calculating your taxes, remember to report the interest income on your tax return: you may not have to pay tax on all the interest you received. If you bought the bond in between interest payments (most bonds pay semiannual interest), you usually wont pay tax on interest accrued prior to your purchase. You must still report the entire amount of interest you received, but youll 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 when the equity markets are less than robust. Municipal bonds are often issued by local governments or similar entities in order to finance a particular project, such as the construction of a school or a hospital, or to meet specific operating expenses. For the retail investor, municipal bonds, or munis, can offer significant tax advantages. Most munis are issued with tax-exempt status, meaning the returns they generate do not need to be claimed when you file your tax return. Combined with the added safety of the low-risk nature of municipal bonds, they can be very attractive investments when stock market expectations are weak. (For further reading, see Weighing the Tax Benefits of Municipal Securities.)
Write-Offs
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 computers 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 computers 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