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3 Things You Must Learn From Your Tax Return

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By the time the clock strikes 12 tonight, another tax season will be over. Some will be able to put the agony past them entirely, while others will resign themselves to filing for an extension and taking up the battle again within the next few months.

But whether you expect a refund or wrote the IRS a check, and regardless of whether you filed months ago or just got around to doing it today, your tax return can give you a valuable glimpse into your finances and what you can do to improve them. Let's take a look at three lessons that your tax return is begging to teach you.

1. Not all income is created equal.
When a dollar goes into your bank account, you don't really care where it comes from. You can spend it just as easily whether you got it from your paycheck, your investments, or found it on the street.

But to the IRS, it makes a huge difference where you got your income. On the earnings side, if you're an employee, then you just pay your ordinary tax rate on your wages, and you're done. But if you're self-employed, then you get to tack on extra self-employment taxes that can run as high as 15.3%.

With investment income, the rules are even more varied. Interest income gets an ordinary-rate hit, unless you invest in municipal bonds, which are tax-free. Some dividends get favorable tax treatment, while others don't, and some capital gains get taxed at a lower rate, while others get charged at ordinary income rates.

Keeping it all straight can be tough, especially when rules change all the time. But unless you know the tax impact of your investments, you won't accurately assess your true returns -- and that could lead you to make mistakes with your investing.

2. Where'd all your investment income go?
If you rely on your investments to make ends meet, then you'll probably notice a disturbing trend: Your interest income has probably just about evaporated. With interest rates near all-time lows, it's gotten increasingly hard in recent years to squeeze income from bonds, bank CDs, and other traditional fixed-income sources. As Wells Fargo's (NYSE: WFC  ) and Citigroup's (NYSE: C  ) latest quarterly results show, low short-term rates have helped boost banks' profits -- and should continue to do so as long as the yield curve remains relatively steep.

Many investors have moved into dividend stocks to try to make up for the income shortfall, and so you may have seen your dividend income go up. Blue-chip stocks have boosted their dividend payouts substantially -- so much, in fact, that many of them have dividend yields that exceed the yields on their bonds. In fact, among the stocks in the Dow Jones Industrials, Merck (NYSE: MRK  ) , AT&T (NYSE: T  ) , and Verizon (NYSE: VZ  ) all have dividend yields that are more than 2 percentage points higher than their 10-year bond yields. That likely reflects the froth in the bond market more than it does the risk involved in owning shares versus bonds.

In this environment, going with dividend stocks over bonds may seem like a no-brainer. But just remember that stocks carry risks that bonds don't -- and an abrupt fall in the stock market could leave you saddled with losses you can ill afford to suffer.

3. The more you keep off your tax return, the better.
I'm not advocating cheating on your taxes. But if you have retirement accounts, then you have a potentially major source of income that you can legitimately shelter from tax.

I'm a huge fan of IRAs, 401(k) plans, and other methods of getting tax deferrals. They definitely help you save on taxes, but even more important is the simplicity they bring to tax preparation. Not only do you not have to worry about income your retirement account assets generate, but you can also buy and sell at will without worrying about the tax consequences of capital gains and losses. That's a benefit that too few people take advantage of -- yet it can make a world of difference to your long-term financial success.

Pay attention
Barring a last-minute IRA contribution, it's too late to change anything that will show up on your 2011 tax return. But going forward, be aware of the impact that your investment strategies have on your taxes -- and try to make the most of your tax-saving opportunities.

Beyond taxes, another aspect of successful retirement planning is making the right investments. The Motley Fool's special report on long-term investing will show you three promising stock picks that can help you reach your financial goals. It won't cost you a thing, but don't wait; get your free report today while it's still available.

Fool contributor Dan Caplinger got his taxes in the mail yesterday. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Wells Fargo and Citigroup and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never taxing.


Read/Post Comments (4) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 17, 2012, at 2:33 PM, 123spot wrote:

    Are dividends on utilities (VZ specifically) taxed at a higher rate in a taxable acct. than on, say, KO? TIA. Spot

  • Report this Comment On April 17, 2012, at 3:58 PM, TMFGalagan wrote:

    @123spot -

    Both utilities and consumer goods stocks can qualify for the lower tax rate on qualified dividends as long as you meet the holding period requirements.

    best,

    dan (TMF Galagan)

  • Report this Comment On April 17, 2012, at 11:10 PM, Chontichajim wrote:

    I moved my LP holdings out of my IRA and into my "post-tax". Not sure if their earnings are taxable from an IRA but since they have to be reported in either case it seemed safer to move them out of the IRA.

    Now just tell us by December if the rates will go up in 2013 so I will know how much to move out of the IRA in 2012 at the current rates.

  • Report this Comment On April 18, 2012, at 11:42 AM, HughWillFool wrote:

    You seem to disparage those of us who routinely use the "automatic" six-month extension to our advantage. Yet the extension has a huge potential tax-planning benefit for self-employed persons.

    Although traditional and Roth IRA's must be funded by the April cut-off, those with SEP-IRA's can still fund their "prior year" contributions right up to the day they file, (so long as they do file within the six month extension period).

    And the amount they can contribute is tied to their self-employment income - not subject to the $5K ($6K for older workers) limit that restricts traditional / Roth annual contributions.

    Being able to use the money for nine+ months into the next year, while waiting to decide how much you want to treat as prior year income, versus putting it into a tax-deferred SEP-IRA, is a HUGE advantage.

    Even if I were fully ready to file on April 15 (17th, this year), I would be motivated to file the extension and see how the bulk of the new year goes, before finalizing my SEP contribution and tax return for the prior year.

    I cannot say what is best for you, and am not qualified to give you tax advice - that is a matter for you and your accountant or other tax professional. However, I would suggest that if you do have self-employment income, you discuss this with them.

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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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