Unless you're an absolute last-minute procrastinator -- or you've filed for an extension -- then it's time to put tax season behind you. But even as you bid farewell to the 2010 tax year by sending off your 1040 to the IRS, now is a great time to start thinking about what you can do to make next year a much better one by cutting your tax bill.
For many people, taxes are something you think about twice a year: once in late December as you scurry to get last-minute deductions in under the wire, and once more in the first two weeks of April as you're getting your annual filings in order. If you make tax planning just as important as the rest of your financial plan, then you'll put yourself in a much better position to save money on your taxes in the future.
Let's look at some simple techniques you can do now to get your tax bill under control for 2011 and beyond.
For many, tax shelters have an ominous ring, suggesting questionable strategies designed more to evade taxes than for any legitimate purpose. But there's one way to cut your taxable income that's completely on the up-and-up: contribute to your 401(k) plan at work.
The nice thing about a 401(k) plan is that if your employer offers one, you can participate without any questions about income limitations or other restrictions. And by contributing part of your paycheck to a 401(k), that income essentially disappears from your tax return -- it's excluded on the W-2 that gets sent to the IRS.
So if you haven't already done so, consider starting or upping your contribution to your 401(k) at work. It's one of the best tax shelters around.
Be tax smarter
Even with tax-favored accounts like 401(k)s, you'll inevitably have to pay some tax on your investments. But you have a lot of control over how much you have to pay.
One way to cut your taxes is to put high-tax investments in tax-favored accounts while using your regular accounts to hold lower-tax investments. For instance:
Top-yielding dividend investments American Capital Agency
(Nasdaq: AGNC), Annaly Capital (NYSE: NLY), and Chimera Investment (NYSE: CIM)have attracted many investors because of their big payouts in the current favorable interest rate environment. But their dividends don't qualify for the low 15% maximum tax rate, making them much better suited to being in IRAs.
- On the other hand, many of the most popular, high-paying traditional dividend stocks do qualify for that lower rate, including Altria
(NYSE: MO), Philip Morris International (NYSE: PM), and Frontier Communications (NYSE: FTR). So with their high yields, you may actually save taxes in the long run by paying the lower 15% rate in a regular account rather than eventually paying a potentially higher rate when you take IRA withdrawals in retirement.
- Some investments are tax nightmares if you hold them in the wrong place. The natural gas ETF United States Natural Gas
(NYSE: UNG), for instance, issues its income on a K-1 partnership return, which adds orders of magnitude to the complexity of your tax return if you have it in a taxable account. If you decide for some reason that you have to own this or similar ETFs despite their structural flaws, then stick it in an IRA.
Don't wait to look for losses
Tax-loss harvesting is something that most investors wait until late in the year to do. But if you have a losing stock that you don't think is going to recover, there's no reason not to get that money working harder for you elsewhere.
Often, stocks go nowhere because the overall market is in the doldrums. The last thing you want, though, is to own a stock that doesn't rise when the rest of the market goes up. Yet that's exactly what happened to many investors last fall, when the broader market shot up throughout the remainder of the year.
Sometimes, it's just time to move on. By cutting bait early, you can sometimes get yourself into a better stock in time to enjoy much better returns than you'd earn hoping for a turnaround from a losing stock.
It's your money
Taxes shouldn't be the only consideration in your investing, but you shouldn't ignore them either. By keeping taxes on your mind throughout the year, you'll identify more opportunities to cut your tax bill and keep more of your hard-earned money for yourself.
Learn all the basics of financial planning with our 13 Steps to Investing Foolishly. It'll get you on track to a great financial plan in no time.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.