海角大神

Johnny writes in:

The one thing that has kept me from diving into investing is fear of taxes. Every time I read about taxes and investments, it seems really, really complicated and I鈥檓 worried I鈥檓 going to be stuck with a big tax bill at the end of a given year even if I think I did everything smartly.

That鈥檚 an understandable worry. Investment taxes can be a bit difficult to swallow at times, but there are a few rules you can follow to make things easier for you.

My first suggestion is to聽use a solid tax preparation software package when you do your income taxes.聽A good software package like TurboTax will walk you through everything you need to do in terms of filing your taxes correctly. You鈥檒l avoid making significant errors, so you can be confident about the taxes you file.

The second step I鈥檇 suggest is to聽keep careful track of every dime you invest.聽Note the date that you invested the money, what you invested it in, and how many shares of that investment you were able to purchase. I use a spreadsheet for this very task.聽

The third step 鈥� and this is probably the most important one 鈥� is to聽keep very careful track of every dime that鈥檚 paid out from your investments.聽If the investment pays out a dividend, record it. If the investment pays out a capital gains distribution, record it. Any time you receive cash as a result of an investment, you need to make absolutely sure that you write it down.

Now, for many investments, people choose to re-invest the proceeds. That鈥檚 a reasonable choice, but it鈥檚 also the choice that can get people into tax trouble.

Let鈥檚 say you have $50,000 invested in a mutual fund. The fund decides to pull out of several investments, believing them to be at their peak. The fund then has to pay out a distribution. Let鈥檚 say they鈥檙e paying out a distribution that鈥檚 worth 20% of the face value of their shares, which means you鈥檙e getting $10,000. If you just re-invest that money immediately, as many people do, you now own some more shares of the fund, but you鈥檙e also on the hook for $10,000 in additional income on your tax form, which can ding you pretty hard if you鈥檙e not prepared for it.

Investments that do this kind of distribution quite often are referred to as 鈥渉igh turnover鈥� funds.聽If you鈥檙e investing outside of a retirement account, I鈥檇 avoid these investments like the plague.聽(If you鈥檙e investing inside of a retirement account, it really doesn鈥檛 matter because the taxes are all deferred.)

What鈥檚 an example of an investment with very low or no turnover? Individual stocks have no turnover, as you just own them and hold them until you sell them. Pieces of land have no turnover for the same reason. Index funds usually have very low turnover, like the聽.

Some investments earn聽dividends, which work much like interest in a savings account. Dividends are either taxed like ordinary income or, if you鈥檝e held the investment for a significant period, like a long-term capital gains (meaning at a lower rate than ordinary income). Again, these are often reinvested, so you鈥檒l need to keep track of these carefully.

My solution is that聽whenever I reinvest a dividend or distribution, I put a bit of money in a savings account to cover the taxes on that dividend or distribution.聽Usually, my investment house sends me a notice whenever a distribution is paid out and reinvested. When that happens, I鈥檒l just move a bit of money from a checking account into a savings account to cover the taxes there. At some point, the taxes might be big enough for me to have to come up with a different solution, but I鈥檓 certainly not there yet!

When you actually聽sell聽an investment and reap more money than you paid into it, that difference is a capital gain. You鈥檙e going to owe taxes on it. If you鈥檝e held that investment for more than a year, it鈥檚 a long-term capital gain, meaning you鈥檒l get a lower tax rate on it than your normal income. If you鈥檝e not held the investment for that long, then it鈥檚 a short-term gain, which means you pay normal income taxes on it.

For that,聽I usually put aside 40% of the proceeds from any investment I sell for taxes.聽If I buy something for $1,000 and sell it for $2,000, I鈥檓 going to put aside $400 for the taxes on that gain. I might not end up owing that much, but having more than enough to cover the taxes is better than not having quite enough to cover them.

Like I said at the beginning,聽using a good tax software package makes this all really easy, provided you kept good records along the way.聽I have bought and sold many investments and had many distributions and dividends come my way and I鈥檝e never had an issue thanks to good record-keeping and a good tax preparation package.

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