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What Your Tax Return Is Telling You

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar.

It's Tax Relief Week on, and today we're talking about what you can learn from your tax return.

So whether you've already completed your return for 2010 or if you're still working on it, take a moment to look over that return, and you might learn some interesting things. Here with me to offer details is Morningstar's Christine Benz, director of personal finance. Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So this is an important document. I know that everyone has a sense of relief when they are done with it.

Benz: Absolutely.

Stipp: But it pays to take a few moments and review it again, because it can tell you some important things about how you're maintaining your tax liability.

Let's start with one of the most important things I think for a lot of people on their tax return: salary. What can you learn by checking the salary this year and comparing that to past returns?

Benz: Right. So as part of the tax preparation process, you'd usually have your hands on your W-2 Form. So you want to check your salary trend from year-to-year. Hopefully it's a positive trend, these days, but for many people they're still digging their way out of the recession. So just observe what's going on there.

Another thing I would pay attention to as part of the W-2 is look at your 401(k) contribution. So if you're eligible to make one, and eligible to max one out, make sure that you're doing so. So the contribution limits for 2010 were $16,500 for those under 50 and $22,000 for those over 50.

Stipp: So certainly if you are not hitting those limits, it will be a good idea to see if you can divert some more funds towards that. One thing we talked about before, of course, is you're paying a little bit less in some of the Social Security areas, so maybe you might be able to divert some of those savings from your paycheck into the 401(k) if you're not maxing out?

Benz: I think that's a great strategy, Jason, and I think it's also a valuable strategy to try to pace yourself throughout the year with those 401(k) contributions. So try to figure it out so that it's coming out in equal parts throughout the year. That way you can really take really maximum advantage of the smoothing effects that dollar cost averaging can give you.

Stipp: Another area that you might want to take a look at are the taxable investments that you have. What things can you learn about how you're being taxed on your securities, your stocks and your funds?

Benz: Right. So you would have two lines on the tax form, taxable interest as well as tax-free interest. Take a look at those lines. If you've got a lot of taxable income, it could be a red flag that you've got a problem with asset location.

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So, generally speaking any investment that's kicking off ordinary income--whether it's money markets or CDs, and granted that's a pretty small sum of income these days--but any cash-like vehicle like that, as well as bonds, you may want to think about to the extent that you can, moving those assets into your tax-sheltered accounts and leaving non-income-producing assets in the taxable accounts.

Stipp: Another thing that I know a lot of readers have is dividend income. So what can you learn? There are different types of dividends, and they're taxed differently. What can you learn by checking out your tax return?

Benz: So you'll see your total dividends, and you'll also see qualified dividends, and those are the dividends that qualify for that nice 15% tax rate for most people. In some cases it's actually 0% for folks in lower income brackets.

So if you've got a lot of dividend income that is not qualified, meaning that you're paying tax at your ordinary income tax rate, look at what those vehicles are, what those investments are that are kicking off that sort of income. Think about locating those in your tax-sheltered accounts as well.

Stipp: So you have income-producing investments. Sometimes you also have capital gains when you sell an investment. When you're looking at the capital gains that have a tax liability associated with them, what lessons might you draw from that? What insights can you get?

Benz: Well, we talk a lot about tax loss harvesting, Jason, so you can take tax losses or sell securities that you're holding at a loss and use those losses to offset capital gains. So, if you do have a lot of taxable capital gains, that may be a good thing. It might be that you've had some winners that you've sold, but just make sure that if you have capital gains that you're taking all the steps that you need to, to offset them. So make sure that you're going through that thought process. It's too late to move the needle for your 2010 tax return, but it's something to keep in mind before the end of 2011 while you're managing your investments. Think about harvesting those tax losses.

Stipp: Another important thing that I know is on a lot of investors' minds right now is the deductions that they take on their tax return. What can you learn about the deduction trends that you've seen across your 2010 and maybe some earlier returns?

Benz: Right, so there are a lot of different deductions that you can take, but one I would focus on if you're a homeowner is the mortgage interest deduction for people early in the lives of their mortgages where a big part of their payments is composed of mortgage interest. That can be a really valuable deduction, but as you get further along in your mortgage, that may become less and less valuable, and I think that's an argument for considering prepaying your mortgage, so paying extra above and beyond what your lender is requiring, because that mortgage interest deduction, one of the benefits of having that mortgage, is ebbing away. So look at what that number is. See if maybe you want to accelerate your payments. I think that's a good idea under most circumstances, but especially if you're not getting much of that mortgage interest deduction.

Stipp: So lastly, Christine, this could probably be a video all of its own, but the Alternative Minimum Tax, the AMT, is something that increasingly has become on investors' radar. What can they learn about AMT from their return and their liability there, and how can they start to manage that?

Benz: Right. So as part of calculating your tax return, you have to calculate your tax hit under the normal tax system as well as under the alternative minimum tax system. If you do find that you've fallen into the AMT zone for your 2010 return, to me that's a good reason to think about seeking out some tax help--someone who is experienced in AMT matters. That person may be able to coach you on avoiding the AMT band in the future. So I think that's one thing to think about it.

Another thing is, if you are finding that you're perennially falling into the AMT zone and you do own municipal bonds, there are some bond funds that specifically avoid bonds that are subject to the alternative minimum tax, and these would typically be private-activity bonds. So you want to focus on those funds that either call themselves AMT-free or they might call themselves tax-free. Do your homework and make sure that you're in one of those funds to at least reduce your AMT-related burden.

Stipp: So it sounds like even if you've already completed your 2010 return, might have a little bit of extra work to review that one more time, but it could pay off for you, maybe this time next year?

Benz: Exactly, just spend a few extra minutes at the end.

Stipp: All right, Christine. Thanks for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.