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What You Can Learn From Your Tax Return

Fri, 25 Apr 2014

Your 2013 tax return can teach you valuable lessons on asset location, the Medicare surtax, HSAs, deductions, and more.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar, you may have finished up your taxes in the last week, but Morningstar's Christine Benz says it would be a mistake to put that tax return in the drawer without giving it a close second look. She's here to explain why.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: You say there are some lessons that you can glean from looking at your tax return. If somebody else prepared your taxes, especially you might want to take a look because there could be some valuable information there. The first thing is about the investment-related taxes that you've paid. Why would you want to take a really close look at those?

Benz: You can effect change and perhaps lower your tax bill, if you're paying attention to a couple of key concepts. 

One is asset location, so to the extent that you have tax-advantaged investment wrappers, such as 401(k)s, IRAs, and so forth, you can make sure that you're housing investments that are kicking off a lot of income on a year-to-year basis or if they're paying out a lot of taxable capital gains regularly, make sure that you're holding them within the confines of those tax-sheltered vehicles where you're not paying income taxes or capital gains taxes on those distributions on a year-to-year basis.

So really plug into that issue if you have high income producers or high capital gains producers, or funds with high turnover rates, for example. Make sure that you're trying to keep them inside those tax-advantaged vehicles.

Stipp: You say in recent times it's not so much the yield that you're getting on bonds, but as you say, it's those capital gains where you could actually be paying a lot of money?

Benz: Right. So 2013 was a great example, a great equity market where we had a lot of actively managed funds dishing out pretty high capital gains to their shareholders. It's not saying that everyone needs to run to exchange-traded funds, which will tend to limit those capital gains on a year-to-year basis, but if you do want to hold those actively managed, higher-turnover, capital gains-producing investments, just do hold them inside an IRA or a 401(k).

Stipp: Christine, the second thing you say to keep an eye out for is Medicare surtax. First of all, who is subject to this tax?

Benz: This will tend to be an issue for people who have high incomes, so married couples filing jointly who have modified adjusted gross incomes over $250,000 or single filers who have more than $200,000, as well as a lot of net investment income. So you have to have both of those things to be subject to the surtax.

Stipp: If you do have both of those things, or you paid the surtax on a portion of those earnings, how might you think about not paying as much or not having to be subject to it in the future?

Benz: Well, it really gets back to those concepts we just discussed, where you want to pay attention to asset location. So if you have investments that are kicking off a lot of regular income, you want to make sure that you are housing them in some sort of tax-advantaged account if you possibly can. And then you also want to think about making sure that your taxable accounts, and people at this level probably do have taxable accounts as well as tax-sheltered accounts, make sure that those taxable accounts are as tax-efficient as they possibly can be.

So municipal bonds actually look like a winner from the standpoint of this new Medicare surtax, in that they do not add to your modified adjusted gross income nor do their income distributions count as net investment income. People like this will probably want to run the numbers to look at whether taxable-bond holdings in their taxable accounts make sense at all because those income distributions will increase their susceptibility to this tax.

Stipp: So the thing that you want to take a close look at is those tax-sheltered accounts and whether you are getting the most out of them? Are you maximizing them? What are some key things I should be looking at there?

Benz: You want to make sure that on your W-2, if you were in a position to do so, that you are fully funding your 401(k) or 403(b), 457, the contribution limits are all the same for all of those vehicles. Also [you want to be] making your full IRA contribution whether Roth or Traditional, and there are a lot of kind of different factors that factor into which account type is the better one for you, but making sure that if you again are in a position to do so that you're fully funding those IRA vehicles.

Also [don't forget about] the spouse who maybe isn't earning an income because he or she is staying home with kids or whatever the case may be, making sure that you're making a contribution on behalf of that nonearning spouse. And in that case, you can make a full IRA contribution for him or her, as well, as long as you have enough earned income to cover that contribution amount.

Stipp: And what about HSAs, the health savings accounts? What should I be looking at there and maximizing there and optimizing?

Benz: We've talked about these accounts before, Jason. I'm a big fan of them for high-income individuals especially. The key reason is that if you are in a position to pay some of your health-care costs out of pocket, you can pick up a triple tax benefit on the amount that you are able to put in the HSA.

You put your money in; it goes in on a pretax basis. Your money compounds on a tax-sheltered basis, and assuming that you use the money for qualified health-care expenses, it comes out on a tax-free basis. It's the triple tax-advantaged account type, and it's something that you really want to look at if you are a high-income person who tends not to have a lot of health-care expenditures on a year-to-year basis.

You also want to think about your distributions from your HSA on your tax return, as well. Also you want to make sure that you aren't pulling everything out that you are putting in, that ideally if you can, that in fact you're shouldering some of those health-care expenditures out of pocket, that you're paying out of pocket instead of pulling from the HSA. That way you're preserving those great tax benefits that go along with investing in an HSA.

Stipp: And a last thing to look at is the deductibles that you take and when you take them. You can be strategic here, and it can have a big benefit.

Benz: It can, and especially for people who are barely exceeding the standard deduction with their itemized deductions, they may benefit from using the standard deduction in some years and bundling their itemized deductions together for other years. So they may be able to, for example, prepay their real estate tax in the year where they intend to itemize. They may be able to defer certain medical procedures, for example, if they think that they'll be able to hit the Internal Revenue Service's now 10% threshold for deductible medical expenditures.

So think about bundling, bunching those itemized deductions together, saving them for that year when you do itemize, and using the standard deduction in other years.

Stipp: So maybe the last thing I want to do is to pull out my tax return after I just put it away. But if I spend a little bit of time, it might make next year's tax season a little bit easier.

Benz: I think so. Thanks, Jason.

Stipp: Thank you, Christine. From Morningstar, I'm Jason Stipp. Thanks for watching.

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