Now that Tax Day is done, what should investors do?

Executive summary:

  • Of the many signs of spring, perhaps the least enjoyable for Americans is Tax Day
  • But just because another Tax Day has come and gone doesn't mean you should stop thinking about taxes and their impact on an investment portfolio
  • The Form 1040 is a treasure trove of information about an investor's tax bill. You can use it to help your clients find ways to reduce their 2024 tax liability

Spring arrives every year. The birds start singing, the flowers start blooming, and the weather begins to change (and sometimes act erratic). If you are into sports, the "boys of summer" are back on the field (or maybe you are watching the final stages of Champions League games). The start of spring is also known for the ultimate American non-holiday: Tax Day!

Tax Day usually falls on April 15th each calendar year (unless a holiday or a pandemic moves that date). For many of us, the next day brings relief. The stress, the panic for some of us, the gathering of papers and filling out little boxes with sometimes not-so-little numbers. Once it's over, it's over…right? This is where I will say: Don't put away that tax form yet! The Form 1040 is a treasure trove of information about each individual investor. If you or your clients are not happy about the amount of taxes paid on your portfolios, if you want more of your money to stay in your pocket and not Uncle Sam's, if you want to feel more control of your financial tax well-being – follow along as we dive deep into the tax Form 1040.

Focus Item # 1 – Interest

When it comes to interest payments, as some might say – the whole world has changed! Since the U.S. Federal Reserve Bank's raised interest rates in 2022-2023, investors are experiencing something new in their fixed income portfolios and time deposits: they see much higher interest payments.

This is where Line 2 comes in. Line 2 shows the total interest received. The beautiful thing about Line 2 is that it breaks interest down into two categories: tax-exempt interest (Box 2a) and taxable interest (Box 2b). This should make it very easy to make an assessment. Are you paying too much in taxes because of interest payments? Look at these two boxes; if there are numbers, arguably, most of the interest received should be in Box 2a – Tax Exempt Interest. Box 2a benefits from a 0% Federal Tax Rate (hence the phrase "Tax Exempt.")

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Form 1040

Source: Department of the Treasury - Internal Revenue Service

If, however, there is a large number in Box 2b – Taxable Interest, you should ask yourself why and investigate. This interest is taxed as ordinary income at the federal level, and it could incur the 3.8% NIIT (Net Investments Income Tax) surcharge – which could push the tax rate up to as high as 40.8%. Take a look at this to save yourself a lot of money! Because of this very high tax impact, the hurdle rate for taxable interest is considerably higher. This might be an easy thing to fix and a great way to lower the tax bill on your portfolio – and on your clients' portfolios.

Focus item #2 – Dividends

Dividends have been a source of attraction for many investors for a long time. Who doesn't like seeing dividends appear in their account? Well, me. It's not that I don't like receiving payments from companies I am invested in. Instead, I know that a dividend is basically a return of capital that could be reinvested into the business or used to buy back shares. Growth of share price (i.e., capital growth) is a much more effective after-tax way of growing wealth.

There are two different types of dividends, and you can see all dividends received in Line 3 of Form 1040. Line 3, Box 3a, shows Qualified Dividends. If you receive dividends, you generally want to see the vast majority of them in this box. Qualified Dividends receive the preferred capital gains tax rate – which tops out a maximum of 23.8%. Each individual investor may be taxed at a lower rate than that, depending on their income level. Regardless, the rate is going to be considerably lower than the full-board income tax rate.

The least favorable scenario is to have a lot of dividends included in Box 3b – Ordinary Dividends. These dividends, like interest, are taxed at Ordinary Income Tax rates. If you are curious, among the types of investments that pay these types of dividends are Trusts (such as REITS), Partnerships (like MLPs), and foreign stocks where there is no qualifying tax treaty with the U.S. Some of these may generate an attractive enough total return to make the extra tax burden worthwhile. But do your research and fully understand what the tax impact may be.

Focus item #3 – Capital gains

Who doesn't like making money?!? On the face of it, capital gains seem like a good thing. You might think to yourself: "But don't I want capital gains in my portfolio as that means I am making money." Let's demystify this one.

There is a difference between 'growing capital' / 'growing wealth' and generating realized capital gains. Line 7 will show the total amount of realized capital gains for the tax year. This is different from appreciation in the portfolio. If you see a sizeable number listed here, it makes sense to investigate further by looking at Schedule D to see if the majority of it is long-term capital gains or short-term capital gains. Long-term capital gains receive the preferred tax rates I mentioned earlier. Short-term capital gains should be kept to an absolute minimum as they are 1) taxed at the higher income tax rate and 2) could be indicative of an investment strategy that is not long-term focused.

Growing wealth and growing your capital is about investing for the long term with a strategic plan. While yes, at times, capital gains will be realized when certain activities happen in your portfolio, they should be 1) small, 2) long-term capital gains, and 3) infrequent. Lots of capital gains are realized on a frequent basis, with many of them being short-term gains. This implies a strategy that may not be suitable for a client's taxable investment account or tax situation. If you see a sizeable figure in Line 7 relative to what might be expected for the income level, and if on the Schedule D, much of it is short-term capital gains – it's time to do some research. There could be an easy fix to slow down and even stop the leakage being experienced because of taxes.

MSCI China price book ratio

Your post-Tax Day check-up: Do it now, as waiting will only cost you more!

Everyone should enjoy the better weather, the singing birds, and the beautiful blossoms spring brings with it. However, it would help if you also did a check-up on your client's tax situation once the April 15th filing process is completed. Taking a deeper dive into what taxes were paid for 2023 and what types of income should help you find ways to reduce them for the 2024 tax year.

Often, it's items we take for granted or think are inconsequential that could make for a larger amount owed to the Internal Revenue Service in taxes than expected. Using the Form 1040 to help your clients uncover line items that may be generating an unnecessary tax cost and address it now may mean that next year (and beyond), they will pay less tax on their investments. It's not what you make, it's what you get to keep that matters!

Access our Form 1040 Guide