What Your 2013 Tax Return Is Telling You
Go line by line to see whether you're maximizing credits and deductions and practicing tax-efficient portfolio oversight.
Investing Specialists
Note: This article is part of Morningstar's February 2014 Tax Relief Week special report. An earlier version of this article appeared April 16, 2012.
Around tax time, you often read stories about what you can glean by eyeballing your tax returns. Are you withholding too much or too little? Taking advantage of all the credits that are available to you? Making enough charitable contributions?
In addition to those general personal-finance takeaways, your tax return and its supporting documents can supply valuable information about your investments, enabling you to see what your financial assets and your investment habits are actually costing you (or maybe saving you) from a tax standpoint.
Before you stash a copy of your 2013 return in a drawer, take note of the following line items.
Line 8 of Your 1040: Interest Income
You can see the raw dollar amounts of your interest income on line 8 of your 1040 form. Line 8a shows taxable income, and line 8b shows tax-exempt income, generally from municipal bonds. If you have a high level of taxable interest income, make sure that you're paying attention to asset location and have assessed whether taxable bonds and money markets, rather than municipals, are truly the better bet once the tax effects are factored in. The tax-equivalent yield tab on Morningstar.com's Bond Calculator can help.
Part I of Schedule B provides specific details on how much interest income various securities have delivered. If you have paltry levels of income from a smattering of cash accounts, see if you can consolidate them into a single, higher-yielding option.
Line 9 of Your 1040: Dividend Income
Line 9a shows the total amount of ordinary dividends you received last year; those that count as qualified--meaning that they're subject to more favorable tax treatment--are on line 9b. As with taxable interest above, take a hard look at any investments, such as REITs, that are paying nonqualified dividends that you're being taxed on; those investments are better housed in a tax-sheltered account such as an IRA, if possible. Part II of Schedule B depicts dividends received from all sources last year.
Line 13 of Your 1040: Capital Gain (or Loss)
Last year was a terrific year for the stock market, so it's a good bet that you'll see a positive number on this line--maybe even a large one. If one of your fund holdings made a big capital gains distribution last year, have you considered whether that fund might be a better fit in a tax-sheltered account? Additionally, selecting the specific share identification method of cost-basis accounting can help you exert a higher level of control. Managing those capital gains distributions is especially important if you fall into the new 20% capital gains bracket for people earning more than $400,000 per year.
Line 25 of Your 1040: Health Savings Account Deduction
Have you evaluated whether a health savings account, used in conjunction with a high-deductible health-care plan, or HDHP, is a good fit for you? For those who are relatively healthy and have cash on hand to cover out-of-pocket expenses that might arise until they hit the maximum for the year, HSAs can serve as supplemental savings vehicles. You'll enjoy tax benefits on your contributions and the money in your HSA will roll over from one year to the next. In retirement, any unused monies can be withdrawn tax-free to cover qualified health-care costs. Yes, the HSA/HDHP combination can be a bit more of a hassle than being covered by a traditional health-care plan, but healthy higher-income workers, in particular, stand to benefit from having an HSA.
Line 32 of Your 1040: IRA Deduction
There's been so much commotion around Roth IRAs for the past several years--conversions, backdoor Roth IRAs, and so on--that the humble Traditional IRA has gotten lost in the shuffle. But if you are closing in on retirement, haven't saved much, and can deduct your contribution, funding a Traditional IRA may be a better bet than putting money into a Roth. If you're not contributing to a company retirement plan, you can deduct your Traditional IRA contribution regardless of income level. Single filers earning less than $69,000 in 2013 who are covered by a company retirement plan can make at least a partially deductible contribution to a Traditional IRA. Married couples filing jointly who are eligible to contribute to a company retirement plan can make at least a partially deductible IRA contribution if they earn less than $115,000. You can deduct your IRA contribution for the 2013 tax year as long as you make it before April 15.
Line 50 of Your 1040: Retirement Savings Contribution Credit
Single filers with incomes of up to $29,500 in 2013 and married couples filing jointly with incomes under $59,000 in 2013 can take advantage of a credit for their contributions to IRAs and company retirement plans. The lower the income, the larger the credit--up to $1,000 for individuals and $2,000 for married couples. A credit, in contrast with a deduction, is especially valuable in that the credit amount is deducted directly from your bottom-line tax bill. Note that this credit is in addition to--not instead of--allowable deductions for contributions to Traditional IRAs and 401(k)s. Form 8880, which you'll need to fill out and attach to your 1040 form (not 1040EZ) to claim the credit, provides more details on how to calculate it.
Lines 1-4 of Schedule A (Itemized Deductions): Deductions for Medical and Dental Expenses
It's not investment-related, but one big change for the 2013 tax year that affects people under age 65 is that medical expenses are only deductible to the extent that they exceed 10% of adjusted gross income. That's up from the previous threshold of 7.5% of adjusted gross income. (If your or your spouse is over age 65, the 7.5% threshold will remain in effect through 2016.) If you found yourself with significant medical and dental expenses in 2013 but were unable to hit the threshold, make a plan for future years. For example, you can bunch expenses such as elective procedures in a single year so that at least a portion of your expenses will be deductible.
Line 23 of Schedule A (Itemized Deductions): Deductions for Other Expenses
Are you doing a complete accounting of your investment-related costs? Some of these expenses are deductible, such as dollar amounts paid to financial advisors and your Morningstar.com Premium Membership, and some are not, such as mutual fund expense ratios.
Form 6251
This is the form you use to determine whether you owe the Alternative Minimum Tax and if so, how much. On it, you can see the specific line items that affect whether you're subject to the tax.
Those with a big share of their portfolios in municipal bonds should keep an eye on line 12, which depicts income distributions from private-activity bonds; these distributions are not subject to the regular tax, but they are subject to the AMT. Such investors may want to consider muni funds that explicitly avoid AMT-subject bonds, such as Fidelity Tax-Free Bond (FTABX). Bear in mind, however, that private-activity bonds may have higher yields than other munis, so you may be sacrificing a higher yield for lower tax costs.
Exercising incentive stock options (line 14) is one of the key ways to bump yourself into the AMT zone. An accountant who's well versed in the ins and outs of stock options can help you strategize to reduce the tax burden.
Line 12b of Your W-2: Retirement Plan Contributions
Here you'll find your contributions to your employer's retirement plan for the preceding tax year. Take note of the dollar amount--if you didn't contribute the maximum amounts of $17,500 (for those under age 50) or $23,000 (over age 50) for 2013, see if you can swing a higher contribution rate in 2014. (Contribution limits remain the same in 2014 as they were in the prior year.)
Alongside Box 12b you'll see a letter denoting your contribution type. The notation "D," "E," or "G" indicates that you've made pretax (Traditional) contributions to a 401(k), 403(b), or 457 plan, respectively, whereas the letters "AA," "BB," and "EE" denote Roth (aftertax) contributions. Whether you expect your tax rate to be higher or lower in retirement is the main determinant of whether to go with Roth or Traditional contributions; if you're not sure, most plans will allow you to split your contributions between the two account types.
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