What You Can Learn From Your 2015 Tax Return
The line items tell you a lot about your investment choices--and what you could do better.
Note: This article is part of Morningstar's February 2016 Tax Relief Week special report.
The market has been lousy for the better part of a year. And unfortunately, the current tax season promises to compound the pain for many investors.
After all, prior to last year, stocks had been on a tear. Valuation-conscious investors may have been unloading highly appreciated securities; strategic buy-and-holders may have been scaling back on winners and rebalancing into bonds and/or foreign stocks. These actions can improve a portfolio's future risk/reward profile, but they also have the potential to boost your tax bill if you carry them out in your taxable account.
Even investors who did nothing may own mutual funds that made capital gains distributions. Owing to a confluence of events--a strong market since 2009 and an exodus of investors from actively managed funds and into index products--investors have gotten hit with high capital gains distributions from many funds for several years running, and 2015 was no exception.
But as painful as it is to write that check if you owe additional money on your 2015 taxes--above and beyond what you paid throughout the year--there's a tiny silver lining: Your return and its supporting documents can supply valuable intelligence about your investments. You can see what your financial assets and your investment habits are actually costing you (or maybe saving you) from a tax standpoint.
As you review your tax return, 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 interest income, or "interest," and line 8b shows tax-exempt interest 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 for your taxable savings, once the tax effects are factored in.
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. If you didn't receive a 1099 from financial institutions where you know you hold cash, don't be alarmed; it's (highly) possible that your interest was less than $10, so the institution doesn't need to send you a 1099. You're technically still required to report that interest, however; you should be able to find the amount by going online.
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. Even if you don't own a dedicated real estate fund, you may end up with substantial REIT investments if you have a large position in a value-oriented equity fund or equity-income fund. In a similar vein, some of your dividend-focused mutual funds may hold investment types like convertibles and preferred stocks to boost their income; income from those securities doesn't typically qualify for the favorable qualified-dividend treatment. Part II of Schedule B depicts dividends received from all sources last year.
Line 13 of Your 1040: Capital Gain (or Loss)
As noted at the outset of this article, many investors may have realized sizable capital gains in 2015--whether they triggered the gain with their own selling or one or more of their funds realized gains and made a distribution. 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? Investors in actively managed funds have seen the biggest capital gains distributions in recent years, underscoring the virtues of opting for exchange-traded, broad-market traditional index, or tax-managed funds for equity exposure instead. All of these investment types tend to do a good job of limiting taxable capital gains. 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 20% capital gains bracket for single filers earning more than $413,200 per year in 2015 (the 20% rate kicks in for married couples filing jointly who earned more than $464,850 in 2015).
Line 25 of Your 1040: Health-Savings Account Deduction
Have you evaluated whether a health-savings account, used in conjunction with a high-deductible healthcare 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 healthcare costs. Yes, the HSA/HDHP combination can be a bit more of a hassle than being covered by a traditional healthcare plan, but healthy higher-income workers, in particular, stand to benefit from having an HSA.
Line 32 of Your 1040: IRA Deduction
Many investors reflexively assume a Roth IRA is the way to go. 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 $71,000 in 2015 who are covered by a company retirement plan can make at least a partially deductible contribution to a traditional IRA for the 2015 tax year. 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 $118,000. You can deduct your IRA contribution for the 2015 tax year as long as you make it before April 18. (Use that deadline as a motivator to put at least some money to work since the market has fallen a bit.)
Even if you can't deduct your IRA contribution or make a Roth contribution because you earn too much, the backdoor Roth IRA is still an option. True, the president's budget proposal for fiscal-year 2017, released in early 2016, included a provision that would effectively put an end to the maneuver. But for now, at least, high-income earners can get money into the Roth column by funding a traditional nondeductible IRA (there are no income limits on contributions) and converting to Roth a while later. Just be sure you don't have a lot of traditional IRA assets that have never been taxed (for reasons outlined here), and remember to file form 8606, which documents your nondeductible IRA contribution.
Line 50 of Your 1040: Retirement-Savings Contribution Credit
Single filers with incomes of up to $30,500 in 2015 and married couples filing jointly with incomes under $61,000 in 2015 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
Whereas taxpayers under age 65 can deduct only those medical and dental expenses that exceed 10% of their adjusted gross incomes, taxpayers or their spouses who are older than age 65 currently have a lower threshold: qualified medical and dental expenses that exceed 7.5% of their AGIs are deductible. Note that that threshold for deductible medical and dental expenses will jump to 10% for taxpayers over 65 at the end of 2016. If you've found that you've come close to the deductible threshold but have fallen short, you may be able to bunch together expenses (such as elective procedures) in a single year to take advantage of deductibility.
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.
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 $18,000 (for those under age 50) or $24,000 (over age 50) for 2015, see if you can swing a higher contribution rate in 2016. (Contribution limits remain the same in 2016 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 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.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.