How to Use Your Tax Return to Identify Potential Investment and After-Tax Opportunities

Did you know your tax return, Form 1040, tells a story about how to potentially improve your investment strategy and increase after-tax wealth? In this article we will walk you through how to interpret your tax return to identify opportunities that you may not have considered.

Source: https://www.irs.gov/pub/irs-pdf/f1040.pdf

Before we begin, it’s important to discuss the impact of taxes on investing decisions. The goal is to increase after-tax income and wealth rather than simply decrease the amount of taxes you pay. 

Here’s an example: You have the choice between a corporate bond yielding 6% or a municipal bond yielding 4.5% of similar quality and maturity. The interest on the corporate bond is taxable while the interest on the municipal bond is tax-free.

If your marginal tax rate is 37%, your after-tax yield from the corporate bond is 3.78% while the after-tax yield from the municipal bond is still 4.5%. Even though the corporate bond has a higher yield, the tax savings from the municipal bond produces a higher after-tax yield.

The point is this - seek to maximize your after-tax wealth and income rather than simply minimizing taxes. You should evaluate each option with that in mind.

With that said, let’s dive into reading a sample tax return.

Interest Income & Asset Location

Lines 2a and 2b below indicate how much interest income you received in a non-qualified account like your brokerage, money-market, or high-yield savings account.

Lines 2a and 2b tell you how much tax-exempt and taxable interest you received during the year. On its own, it’s not really enough information to affect any decisions but you should dig down into the sources of the interest to see if you’re really getting the highest after-tax yield.

Earning interest income in a taxable account is not as tax efficient as earning interest income in a qualified account like a Roth IRA or 401(k). This is because you pay taxes each year when it’s earned and theoretically reduces compounding. When earned in a pre-tax qualified account you get better compounding because you’re not paying taxes on the income until you make a withdrawal, which could be years or decades away. It’s even better in a Roth account because you are not paying taxes at all on the income.

This is where asset location comes into play. If a portion of your overall portfolio is generating income, it may be better tax-wise to have these assets in a qualified retirement account like a Roth IRA, 401(k), 403(b), or 457 type plan. 

Dividends - Ordinary & Qualified

Dividends come from investments in stock of a company or a REIT. 

Ordinary dividends are taxed at the higher ordinary income tax rate while qualified dividends are taxed at the lower capital gains tax rate.

A qualified dividend is a dividend paid from a company where you’ve held the stock more than 60 days before the dividend was declared. REIT dividends are generally not qualified dividends eligible for lower rates.

This means if you have ordinary dividends, besides from a REIT, it’s coming from dividend-paying securities you recently purchased or that you’re habitually holding shares for short periods of time.

Like interest income, it’s more tax-efficient to hold income-generating assets in a qualified account to increase compounding.

The takeaway here is to be aware of how your dividends will be taxed, whether as ordinary income which is taxed at a higher rate or at the lower capital gains tax rates.

IRA Distributions

Ideally, you’ve been taking advantage of the backdoor Roth and don’t have any pre-tax IRA money to generate taxable distributions. If you have amounts on lines 4a that are being taxed on 4b, you should consider Roth conversions.

If there’s no amount on line 4a, you’re not taking full advantage of tax-favored savings by contributing to your backdoor Roth.

Capital Gains

Does line 7 have a loss of $3,000? If so, you likely have a capital loss carryforward. When your capital losses exceed your capital gains, you can only deduct $3,000 of loss each year with the unused loss being carried forward until it’s used up or you pass away.

Additionally, if you have a capital loss carryforward, you are able to recognize capital gains and have the losses offset the gain. This is useful for tax-loss harvesting or when you’re expecting a large gain from the sale of an investment.

On the other side, if you have large capital gains you may be missing out on tax-loss harvesting opportunities to offset the gains. The idea behind tax-loss harvesting is to identify positions that are at a loss, selling them to recognize the loss, then purchasing a similar (but not too similar) security. These are really just paper losses since you’ve purchased a similar security to maintain the same portfolio characteristics. These bank of losses can be used to offset current and future capital gains.

Taxable Income & Marginal Tax Rate

Line 15 is your taxable income on which your income tax is computed. If we know your taxable income we can refer to the tax tables to know your marginal tax rate.The marginal tax rate is used to compute the tax effect of a change in taxable income. For example, if your federal marginal tax rate is 37% and you increase your taxable income by $100, you’ll pay an additional $37 in income tax. Conversely, if you decrease your taxable income by $100 you’ll pay $37 less in tax. 

For state tax purposes, you would add the state marginal rate to your federal rate to determine your combined marginal rate.

Summary

Your tax return says a lot about your financial life. When factored in with the rest of your financial picture you are able to optimize your investment decisions and maximize your after-tax income and wealth.

Disclaimer: This article is provided for educational purposes only and does not constitute specific tax or investment advice. Examples provided are for illustrative purposes only. Individuals should seek the opinion of a qualified tax or investment professional prior to taking any action.