What Does Your Tax Return Say about You?

Taxes—ugh. The very thought of them can make a lot of us feel stressed, especially as tax time approaches.

But there’s a silver lining. By looking at some of the details of your tax return, you can learn a lot about yourself as an investor. And you might even find ways to save on taxes in the process.

What’s your (real) risk tolerance?

You might think you have a pretty high tolerance for risk. So you tend to invest in more volatile assets.

But are you still carrying over large losses from 2008 – 2009? If so, you might not be as risk-tolerant as you think.

Every year, the tax code allows for up to $3,000 in losses to be itemized from your tax return. If you have more than $3,000 in losses, you can carry the remainder over to the next tax year.

This can be a great way to minimize your taxes. But if you had such large losses in 2008 – 2009 that you’re still carrying them over, it could be because you tend to buy high and sell low.

Are you a day trader?

We’d all like to outsmart the market. But research has shown time and time again that people who buy and hold have outperformed people who trade frequently.

On top of that, every time you trade and have a gain, there’s a tax associated with it. It might be a long-term capital gain tax or a short-term capital gain tax. Regardless, taxes are a cost. And higher costs will drive down your returns.

Are your investments tax-efficient?

You may notice that you owe the IRS taxes on your investments even though you haven’t sold any assets. This is known as “the mutual fund tax trap.” And it can create tax inefficiencies.

Unfortunately, this can be a tough issue to address. The solution may mean selling the tax-inefficient asset and moving to one that’s more efficient.

Don’t have the stomach to create a taxable event? Consider gifting a mutual fund with a high turnover rate to charity. You’ll receive a charitable deduction. And getting that asset out of your portfolio might help you pay fewer taxes over the long term.

How charitable are you?

Could your charitable contributions use a boost? In addition to the obvious benefits of doing something nice for someone else, charitable contributions also provide tax benefits.

There are several different strategies you can use. If you’re older than 70½, for instance, and are required to take a required minimum distribution (RMD) this year, you can send that RMD directly to a qualified charity. That eliminates your taxable distribution for the year.

What’s your true marginal tax rate?

Many people look at the highest bracket they’re in and assume they pay that full amount. In reality, though, their total tax bill is probably a lot lower.

It’s a good idea to understand your true tax rate (also known as your effective tax rate). Knowing what that is today—and what it could be in retirement—can help you build a more effective portfolio.

For example, are you retired with an effective tax rate of zero percent? If so, it might be a good time to do a Roth conversion. Or maybe sell some appreciated assets to diversify your account.

Are you saving for retirement?

One of the biggest tax deductions you can receive is contributions to an employer-sponsored retirement plan like a 401(k) or 403(b). It lowers your adjusted gross income. And that’s the number the IRS uses to determine if you’re eligible for any other tax deductions down the road—like for child care or a Roth IRA.

If your employer doesn’t offer a retirement plan, that’s OK. You can still open an IRA. If you’re self-employed, consider a SEP-IRA or a SIMPLE IRA.

A health savings account (HSA) can also provide a tax deduction. It can help lower your adjusted gross income and give you a potentially less expensive, high-deductible form of health insurance.

Make a plan

Taxes are facts of life. But don’t let them lower your income any more than necessary.

Setting up a tax-efficient plan can help you minimize your taxes and maximize your potential income. Consider buying tax-inefficient asset classes in tax-deferred accounts. Alternately, buy tax-efficient asset classes in taxable accounts.

And don’t forget about using a Roth IRA or a Roth 401(k) as a way to tax diversify your retirement income. One of the biggest issues today is that most individuals have more than 90 percent of their assets in tax-deferred accounts. This will limit their options when it comes time to retire.

Recognizing income at the right time is also important. If you recognize income at the wrong time, it can have negative effects—like increased Medicare premiums or being ineligible for a subsidy as part of the Affordable Care Act.

Get expert advice

Tax laws are complicated, to say the least. That’s why it’s important to sit down with an expert and discuss tax strategies—so you can minimize the negative effects of taxes and maximize your potential income.


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Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.

The subject matter in this communication is provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.