What Investors Can Learn From Their 2014 Tax Returns

Note: This article is part of Morningstar's February 2015 Tax Relief Week special report. The article originally appeared Feb. 8, 2015.

The rapid uptake of tax-preparation software means that fewer and fewer taxpayers are filling out their tax returns the old-school way: with pen, paper, and a calculator. That's probably for the better: Not only are the major tax software packages easy to use, but they can help reduce errors and save you money by prompting you to see if you're eligible for valuable credits and deductions.

But preparing a tax return by hand does have one thing going for it. As you fill out each line and the supplemental forms and schedules, you can't help but take a closer look at each of the nitty-gritty numbers that go into your return: your income from various sources, any retirement-plan contributions or distributions, and income and capital gains distributions from the various investments in your portfolio. Those numbers can yield valuable intelligence about what you're doing now and what you could be doing better--not just in order to improve your tax bill, but to improve your total financial picture.

Whether you prepare your taxes using a software package, delegate to a CPA, or tackle your taxes the old-school way, don't just file your return and stuff your copy in the drawer without further review. Instead, look it over, compare it to returns from prior years, and take notes. As you do, here are the key line items and forms to focus on.

Line 8 of Your 1040: Interest Income Line 8a depicts your taxable interest income for the year; line 8b is your tax-exempt interest. Compare these figures to your interest income on previous years' returns; chances are they've been dropping. That's OK, at least in relation to the income you receive from bond funds; bond prices have generally been on an upward trajectory, offsetting the reduction in yields.

However, you may be able to boost your interest (without taking on additional risk) by making a few small changes. By focusing on the cheapest bond funds you can find, you may be able to plump up your yield, if only slightly. Morningstar Medalist bond funds tend to have very low costs.

And if you received multiple 1099s from various cash and cashlike accounts that generated piddling amounts of income (or worse yet, you received no 1099 at all because your income was less than $10), consider consolidating those accounts with an online bank account to receive a higher payout. Many online banks are currently paying out 1% (or close to it).

Also, pay attention to your taxable versus tax-exempt interest. If you're in a high tax bracket, housing high(er)-yielding bonds in tax-sheltered accounts will help reduce the drag of taxes in future years. If you must hold bonds in your taxable account for liquidity purposes, investigate whether municipal bonds might not be a better fit given your tax bracket; the tax-equivalent yield function of Morningstar's Bond Calculator can help with this determination.

Line 9 of Your 1040: Dividend Income Are you receiving a bigger share of your total income stream from dividends than you did in the past? If so, just be sure to that you're comfortable with the higher principal volatility that will accompany any stock--even high-quality dividend payers--relative to high-quality bonds. Also, be aware that the valuations in many dividend-rich sectors--utilities, real estate, and health care--are on the high side right now, according to Morningstar's analysts.

Here's another area where asset location can come into play; if you are paying taxes on a large sum of nonqualified dividends, such as REITs, consider relocating them to a tax-sheltered account such as an IRA.

Line 13 of Your 1040: Capital Gain (or Loss) The year 2014 was one in a string of several good years for the market, so it was a reasonable time to take some profits from equities via rebalancing. However, if you're reporting large capital gains on this line because one of your mutual funds made a distribution, make sure you're paying enough attention to tax efficiency within your taxable account. This article discusses the risks of holding active funds in a taxable account; tax-managed funds, exchange-traded funds, and index funds will tend to be more tax-efficient equity holdings.

If you land in the 10% or 15% tax bracket, however, capital gains can be your friend. As financial-planning expert Michael Kitces outlines here, such investors may want to sell highly appreciated securities to reset their cost basis. There's no tax cost to do so, and if they eventually sell, the spread between their new basis and the sale price will be lower.

Line 15 of Your 1040: IRA Distributions Retirees aren't the only ones who have to report IRA distributions; investors who are converting Traditional IRA assets to Roth also have to do so. The tax due on the distribution or conversion is based on the ratio of assets that have been taxed to those that have never been taxed within your Traditional, SEP, and SIMPLE IRAs. If you have aftertax dollars inside of your IRA and want to properly account for them when you make a distribution (that is, avoid paying taxes on them again), you'll also need to file Form 8606. Form 8606 is where you account for nondeductible IRA contributions, essentially "showing your work" to determine which portion of your IRA distribution is taxable.

Line 25 of Your 1040: Health-Savings Account Deduction If you made a contribution to a health-savings account in 2014, you can enter it here. More and more workers are getting pushed into high-deductible health-care plans (HDHPs), which are usually accompanied by a health-savings account to defray out-of-pocket costs as they incur them. But the healthy and wealthy have reason to give the HDHP/HSA combination a look even if they have other health-plan choices. That's because HSAs offer a tax break on the way in--you deduct your contributions on your tax return. Then, the money accumulates tax-free, and withdrawals for qualified health-care expenses are also tax-free. The one hitch is that some HSAs are larded with fees; check out the details of your employer's plan before signing on.

Line 32 of Your 1040: IRA Deduction April 15 is your deadline for IRA contributions if you want them to count for 2014. Many pundits say that everyone should contribute to a Roth IRA, but that will only be the right answer for investors who will be in a higher tax bracket in retirement than they are today. If you are closing in on retirement, haven't saved much, and can deduct your contribution, funding a Traditional IRA and deducting it is apt to 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 $70,000 in 2014 who were covered by a company retirement plan can make at least a partially deductible contribution to a Traditional IRA. Married couples filing jointly who were eligible to contribute to a company retirement plan can make at least a partially deductible IRA contribution if they earned less than $116,000.

Line 51 of Your 1040: Retirement Savings Contribution Credit Single filers with incomes of up to $30,000 in 2014 and married couples filing jointly with incomes under $60,000 in 2014 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.

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-bond funds that explicitly avoid AMT-subject bonds, such as

Exercising incentive stock options (line 14), while a less common issue now than it was in the '90s and early '00s, 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.

Box 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 2014, see if you can swing a higher contribution rate in 2015; contribution limits have gone up to $18,000 for those under 50 and $24,000 for those 50-plus.

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.