The fourth number to know is the amount of your ordinary dividends and taxable interest.
This is shown on lines 2b and 3b on Form 1040.
Line 2a shows tax-exempt interest while Line 2b shows taxable interest. Tax-exempt interest would include income from tax-exempt sources, such as municipal bond income. Taxable interest is generated from investments that produce taxable income, such as CDs or high-yield savings account.
Line 3 shows your dividend income. Line 3a is qualified dividends that are taxed at your long-term capital gains tax rate. Line 3b shows total ordinary dividends, which includes qualified dividends.
The difference between ordinary and qualified dividends is how they’re taxed. Ordinary dividends are generally taxed at your ordinary income tax rate.
Here’s how to use these two numbers within your tax strategy: asset location.
There are three buckets that we always talk about with clients.
You have your tax deferred bucket, like your IRA and your 401k.
You have your Roth bucket, which you've already paid taxes on and all the growth and income is tax-free.
You have your taxable bucket where you pay taxes every year on the income that's generated and you pay capital gains on any growth when you sell an investment.
Asset location is knowing where to own the different types of investments in each of those three buckets. For example, if you have a municipal bond that you're not paying taxes on, you wouldn't want to hold that in an IRA. You'd prefer to hold that in a taxable account to get the tax benefits of tax-free income from municipal bonds.
On the other hand, if you have a bond that pays taxable interest, you wouldn't want to hold that in a taxable account because you'd be paying income taxes on that every year. Instead, you'd rather hold that in the IRA where all of that income is tax deferred.
Example: Mark is retired. He holds bond funds in a taxable account which generates $20,000 in taxable interest each year. He holds equities in his IRA. He’s in the 22% federal tax bracket. The taxable interest from his bond funds generates $4,400 of federal tax annually. By reversing the placement of his bonds and equities, he could reduce the amount of income taxed at his ordinary tax rate each year without changing his overall portfolio.
This is where asset location decisions come into play. Knowing your taxable interest and ordinary dividend numbers will tell you if adjustments can be made in asset location to lower your annual tax bill from investment income.
Capital Gain or Loss
The fifth number to know is capital gain or loss. This is on Line 7a on Form 1040.
A capital gain or loss is realized through selling an investment in your taxable account. If you own a mutual fund, it can distribute capital gains to its shareholders without you having to sell shares directly.
Capital gains and losses are accounted for on Schedule D of your tax return. The net gain or loss shows up on line 7a of Form 1040.
A gain from an investment held for longer than one year is taxed at your capital gains tax rate. A gain from an investment held for one year or less is taxed as ordinary income. Before selling an investment, it’s important to know how much you’re about to realize as a capital gain or loss and what tax rate you’ll pay.
You can determine your capital gains tax rate by taking your taxable income and comparing it against long-term capital gains tax brackets. The lowest long-term capital gains tax bracket is 0%. Someone in the 0% capital gains tax bracket could recognize a capital gain but not owe any taxes. Those in a higher capital gains bracket may end up owing taxes on their realized gains.
Line 7a also shows if you realized a net loss. If you sell an investment at a loss, you can use the loss to offset capital gains realized throughout the year. If your losses exceed your gains, you can use it as a deduction against ordinary income up to $3,000 each year and carry it forward until it’s used up.
The takeaway here is to know how much you’ve realized in capital gains or losses, the tax impact, and if gains are being generated by trading activity or through mutual fund distributions outside of your control. If you notice your mutual funds are generating large gains distributions, it might be a signal to review whether more tax-efficient vehicles, such as certain exchange traded funds, could be more appropriate.
In Summary
Review your tax return after getting it back from your tax preparer. It only takes 15 minutes and could uncover opportunities to save on taxes in the coming year. It’s also good to double-check your tax return for accuracy. Tax preparers are usually swamped with work near the tax deadline and mistakes happen.
The five numbers for retirees to know on Form 1040 of their tax return in the order we covered them:
Taxable income – line 15
Standard vs. itemized deductions – Line 12e
Adjusted Gross Income – Line 11a
Ordinary dividends and taxable interest – Lines 2 & 3
Capital gain and loss – Line 7a
In reviewing tax returns for our retired clients, I often find 1-2 areas that can be made more tax-efficient. Your income and expenses may not change too drastically from year to year, but small adjustments in tax planning can make a meaningful difference and add up over time.
We’re here to help keep more of your money in your hands instead of paying too much to the IRS. Get in touch with us to schedule a complimentary review.
Travis
Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor. This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.
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