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Over the past 10 years, it's been hard enough coming up with winning investments. The last thing you need is the uphill battle that every investor faces: making a profit even after paying the tax man.

During the bull market of the 1990s, investments of all sorts seemed to go up effortlessly. Both stocks and bonds enjoyed enormous gains during that decade, and with double-digit annual returns being fairly commonplace, it didn't seem to matter whether the IRS took its share of your overall gains -- you still had plenty to spare.

But in 2000, that started to change. Two huge bear markets during the past decade made any gains at all something to be treasured, rather than taken for granted. And with total returns dropping precipitously, investors suddenly realized they couldn't afford for anyone to try to cut in on their hard-earned gains; least of all, the IRS.

There are any number of big taxes that investors face. For the most part, though, they break down into two categories: taxes on the income you receive, and taxes when you decide to sell your investments.

Dealing with dividends
Investing in dividend-paying stocks can be one of the best ways to balance all of your financial needs. If you need your investments to provide you with a steady income while also maintaining some potential to grow in value, then stocks that pay dividends can be your best chance to achieve both goals.

The problem, though, is that anytime you receive income on an investment in a taxable account -- whether it comes from bonds, stocks, real estate, or virtually any other type of asset -- you're going to have to pay tax on that income. Depending on your tax bracket and what you invest in, that can dramatically reduce the amount of money you can actually spend after taxes. Consider the following:

Stock

Pre-Tax Dividend Yield

Effective Yield After Tax

AT&T (NYSE: T  )

5.9%

5.0%

San Juan Basin Royalty Trust (NYSE: SJT  )

3.5%*

2.3%

Equity Residential (NYSE: EQR  )

4.0%

2.7%

Source: Yahoo! Finance.
Assumes 15% maximum tax rate on qualified dividends and 35% tax rate on nonqualified dividends and other income.
* Yield based on dividends paid over past 12 months.

As you can see, taxes can take away a huge portion of your effective income. Or even worse, if you don't account for those taxes along the way, you can get a nasty surprise come April.

Triggering capital gains
In addition to dividends, you'll have to pay taxes whenever you sell an investment. This especially comes into play during powerful rallies like the one we've seen since last March.

Many investors who were courageous enough to invest at those lows are currently sitting on huge gains. But if you want to lock in those gains, selling can be expensive. Just take a look at these examples:

Stock

$1,000 Invested in March
Is Now Worth

Potential Tax Hit
if Sold Today

Wynn Resorts (Nasdaq: WYNN  )

$4,369

$1,179

Ford Motor (NYSE: F  )

$5,908

$1,718

Bank of America (NYSE: BAC  )

$4,195

$1,118

Apple (Nasdaq: AAPL  )

$2,575

$551

Source: Yahoo! Finance.
Assumes taxpayer in 35% tax bracket for short-term capital gains.

Because it's been less than a year, those gains will be taxed at your ordinary tax bracket -- up to a 35% rate. As you can see, in some cases, the gains are substantial enough that the tax on them is actually larger than your original investment.

Conversely, if you wait until more than a year has passed, then you can cut those taxes by more than half, thanks to the 15% maximum rate on long-term gains. But you also run the risk that your gains will disappear.

How to handle taxes
In general, there are three things you can do to cut your tax bill:

  • Don't trade stocks more often than you have to.
  • Use tax-deferred investment vehicles like IRAs for income-producing investments.
  • Take advantage of 15% maximum rates on qualified dividends and long-term capital gains -- while they last.

As an investor, you'll be in a constant struggle with the IRS. But taking the right steps to minimize your tax will make a huge difference in your returns -- and protect you from the threat that taxes pose to your financial future.

Look back at 2009 and look forward to the coming year as we review recent history and predict what the future will bring.

Fool contributor Dan Caplinger constantly battles to minimize his taxes. He doesn't own shares of the companies mentioned in this article. Apple and Ford Motor are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy could have destroyed the Death Star even without Han Solo's help.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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