Top Tips for Tax Savings

We're kicking off a Tax-Wise Investing Week on Morningstar.com in the week ahead, and we'll be providing many tips on how to reduce the drag of taxes on your investments. In anticipation of our tax-themed week, I recently asked Morningstar.com readers to chime in with their best tax-savings tip, investment-related or otherwise.

Readers shared a host of worthwhile ideas, including gradual conversions from traditional IRAs to Roths, careful management of income and deductions to avoid falling into a higher tax bracket, and cherry-picking tax-efficient investments for taxable accounts.

To read the complete thread or weigh in with your own best tax-savings idea, click here. 

'Know Your Options and How to Choose Among Them'
Given that Morningstar.com is an investing website, it was no surprise that reducing investment-related taxes was a focus for many who posted.

Several of the tips centered around reducing the drag of taxes on taxable accounts.

Jwalk911 offered a good rule of thumb: "Be slower to take profits (for long-term capital gains) and quicker to take losses in a taxable account."

Bobk47 shared a common-sense tip that's sure to resonate with Bogleheads: "Use low-cost index funds in taxable accounts. Here in Tennessee, we have no income tax but we do have a 6% tax on investment income, including capital gains distributions from mutual funds. Index funds or exchange-traded funds rarely have to distribute capital gains, and you not only defer the federal tax, you completely avoid the Tennessee tax because you can't claim capital gains or losses."

Peter5 noted that limiting capital gains in taxable accounts can be particularly valuable during retirement, when income from IRAs and company retirement plans is often fully taxable at an investor's ordinary income tax rate. He advised, "Buy individual stocks and low-turnover mutual funds in your nonretirement account so you pay at the lower long-term capital gains rate versus ordinary income rates when you withdraw from the IRA."

Jwalk911 likes the control over capital gains you get by holding individual stocks in taxable accounts, writing, "Don't keep mutual funds but rather stocks in your taxable account for maximum control of gains and losses."

Master limited partnerships, which are generally a good fit within a taxable accounts and are an all-around hot topic these days, received a few mentions, from Jwalk911 and others. Bnorthrop provided some tips for handling the tax wrinkles associated with MLPs, writing, "My number-one tip is to invest directly in MLPs in your taxable account because of the distinct tax advantages they offer. Ancillary tip number two is to then start using TurboTax, not only because it makes it easier to maximize all tax-savings opportunities, but specific to MLPs, to input the K-1 data either manually or automatically. More and more MLPs now use tax services that allow K-1 downloads directly into TurboTax. It couldn't be easier."

Poster osarron isn't as convinced of MLPs' virtues, opining, "MLPs are a tax nightmare full of delayed filing and surprise capital gains when you sell." Dragonpat enthused about another tax-reduction strategy: aggressively selling losers from a taxable portfolio. She urged, "Don't be shy about harvesting capital losses in your taxable portfolio. You can rebuy [the same securities] in 31 days at probably a lower basis. Use the losses to offset capital gains. If you have a lot of losses (like in 2008), after deducting $3,000 worth of losses from your income, you can carry the losses over from year to year." Dragonpat went on to share details of a spreadsheet she uses to calculate the tax liability (or lack thereof) associated with each of the securities in her portfolio.

Bking concurred that keeping good cost basis records is essential, writing, "Be shrewd about tracking your cost basis; know your options and how to choose among them." (This article delves into that topic.)

Bondshy, like Dragonpat, is enthusiastic about tax-loss harvesting. "When I rebalance, I sell something that has the biggest capital loss to offset gains for that year. I can buy a similar fund immediately if I want to stay invested."

Tax Diversification and Asset Location
With the benefit of hindsight, FidlStix realized that he has given short shrift to taxable accounts at the expense of tax-sheltered vehicles. "Years ago, after reading up on investing, I was ready to roll up my sleeves and start a portfolio. I thought I'd be really smart and put all my investment money in tax-advantaged accounts (regular IRA and Roth, in addition to 401(k)). Looking back, I was kind of dumb. No taxable account to take advantage of tax-loss harvesting, 15% tax on dividends and cap gains, place for MLPs and tax-free munis, and so on"

Other posters shared tips for wringing the most benefit when holding taxable accounts alongside tax-sheltered vehicles. ColonelDan shared this simple rule for "asset location," writing: "KISS--I keep tax-exempt bonds in my taxable account and all the high-dividend-paying stock funds and taxable bonds in my IRA."

Roth IRAs--both contributions and conversions--were another hot topic, with many posters arguing that it's a good deal to pay taxes today rather than waiting around to see what they'll be tomorrow.

Chief K laid out the case: "If you expect the government to need a lot more money to pay down the national debt, lean toward contributing to a Roth or converting a portion of your standard tax-deferred accounts to a Roth."

But posters also agreed that it doesn't make sense to hurtle into Roth conversions willy nilly; being deliberate can help reduce the tax burden. AlvinSch advised, "Use tax software to determine your actual marginal tax bracket before doing a Roth conversion."

Stockvapors shared this Roth-conversion advice for retirees who will be required to take large required minimum distributions from their IRAs and company retirement plans at age 70 1/2: "If you are facing a large bump in income when you turn 70 1/2, start converting from your IRA into a Roth now. Convert just enough each year that it doesn't bump you into a higher tax bracket. So over time, you can pare down that large bump."

Roth IRAs weren't the only tax-advantaged savings vehicles posters were enthusiastic about, however. Health-savings accounts also received several shout-outs. Frries urged, "Open a health savings account by contributing up to $7,150 per year (married 55 or older)." [Editor's note: That's the 2011 limit; the 2012 limit is $7,250.] "The contribution is fully deductible above the line regardless of income. Earnings are tax-free if used to pay for medical expenses. There is nothing else like it in the tax code: tax-deductible going in, tax-free coming out." 

'Just Enough to Remain in the 15% Tax Bracket'
Posters didn't stick exclusively with ideas for limiting investment-related taxes; they also shared tips for managing their taxable incomes to ensure that they don't bump up into a higher tax bracket.

Bwachol1 shared, "I work just enough to remain in the 15% tax bracket after maxing out my 401(k)."

Cybchris has used technology to assess his tax picture on an ongoing basis, monitoring his business income and expenses and assessing what levers he can pull to reduce the tax hit. "We are self-employed and are bumping up against the Roth IRA contribution limit and the 28% tax bracket. Last year we created a simplified version of our major tax forms (1040, Schedule C, Business Use of the Home, Schedule D) in an interactive spreadsheet. As the year progresses, we can plug in our estimated business income and expenses, and immediately see how much our modified adjusted gross income will be and how much taxes we will owe. We can play with how much we save tax deferred to bring our MAGI down to fit under the limit and/or stay out of the 28% marginal tax bracket. We can also now estimate more accurately how much we can invest to max out the employer side of our Solo 401(k) (or SEP-IRAs), rather than wait for our CPA to give us the final number the following April."

"Bunching" deductions was another commonly used tactic for posters aiming to keep taxes down.DouglasJohnson wrote, "In my state, property taxes are billed in October and due at the end of January. This lets you chose which year to pay them and deduct them. So pay one year's in January and the next year's in December of the same year. Cluster other deductible items, such as charity gifts, the same way. Do this in alternate years and take the standard deduction the other years. This will maximize the effectiveness of the deductions."

FidlStix noted that donating to charity can provide both a tax break and a psychological boost. "The main way we save on taxes is through large (more than 10% of combined salaries) charitable contributions. We gain the additional satisfaction of being able to help people less fortunate than us while my wife and I are still working."

BMWLover values the one-two punch that charitable deductions of highly appreciated securities can provide. "The one thing I like to do is donate appreciated securities to my favorite charities. I'm a long-term investor so I have some stocks with good, long-term gains. Because it doesn't cost me anything to transfer them, it is easy, and I get the benefit of avoiding capital gains while getting the full charitable donation deduction."

Yogibearbull is also bullish on donating to charity, writing, "I used the donor-advised charitable fund to do this. It provided the tax benefit right away but now allows me to give grants over time to various IRS-approved charities. Mine is with  Charles Schwab (SCHW) , but Fidelity, Vanguard, and others have such accounts." He went on, "There was a period when I came a bit short on itemized deductions in Schedule A. So I used contributions of appreciated (long-term) stock to the donor-advised fund to make up for the shortage in Schedule A (itemized deductions). Being retired and mortgage-free now, and I no longer itemize, but I have a decent amount in my donor-advised fund to support regular grants."

'All Those Nickels and Dimes Add Up'
In addition to providing specific tips for easing the tax burden, posters also provided some great general advice.

EasyAsItGoes advocated for scrupulous record-keeping, writing, "Make and keep a record of everything. Buy lunch for co-workers or clients? Keep a record. Drive to a meeting? Keep a record. Paper trail your life and you will not miss anything. All those nickels and dimes add up to something sooner or later."

Several posters plugged tax software as being extremely helpful when monitoring and calculating your tax liability. But EasyAsItGoes thinks there's no substitute for a human being who can ask the right questions and help you find deductions. "Hire a really good certified public accountant. You do what you do really well. Let the folks who live the tax law rummage through your life at the end of the year and look for deductions. But don't wait to see your tax guru just once a year. I try to see him once at midyear, once in the last quarter and then we talk just before the end of the year. It is money well spent."

Finally, stillers made the astute point that knowledge is power when it comes to reducing your tax-related burden. "I have worked 30-plus years in the accounting profession and have seen hundreds of professionals in wide-ranging fields who have virtually no clue about personal income tax planning. Common root causes for this condition appear to be fear, laziness, and the willingness to accept as fair their respective tax liabilities as calculated by third parties.

"So my best tax-savings tip? Simple. Don't be afraid of the tax code. Make serious, ongoing attempts to become more knowledgeable in it, or at least in the parts of it that most directly affect your personal financial situation. This knowledge acts as a financial gift to you that keeps on giving, the net effect of which is compounded daily."

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