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Next Step for Taxes: You're Not Done Yet

Jeff Brown

NEW YORK (MainStreet) —Once April 15 has passed, our first choice is to put this whole, annoying process behind us. But before you do, just take a little time to make next year’s tax prep easier – and maybe trim your 2013 tax bill as well.

Whether you’re awaiting a refund or had to write a check, think about filing a new W-4 form with your employer, to adjust your tax withholding. Use your new 2012 return as a guide.

If you had to write Uncle Sam a check, you had too little withheld from your paychecks, and you were probably socked with interest charges and penalty on the shortage. By increasing the withholding, you can avoid those charges next year.

If the government will be sending you a refund, you had too much withheld. Though many taxpayers treat a refund as a windfall – free money for a splurge – it’s really just a return of your own money. In effect, you give the government an interest-free loan. You’d be better off getting that money piecemeal, through slightly higher paychecks. So use the W-4 to have your withholding reduced.

Unfortunately, a W-4 cannot anticipate things like taxable gains on investments you sell during the year. And even though you can control your own sales, you may receive capital gains distributions you cannot control from mutual funds. By law, funds must pay shareholders the net profits from stocks, bonds or other assets the fund managers sold during the year. These distributions, which usually come in November or December, are taxable even if you have the money reinvested in more fund shares – unless the fund is in a tax-favored account like a 401(k) or IRA.

So, to avoid interest and penalties on investment gains, file estimated taxes during the year with Form -1040 ES. It’s almost impossible to get your tax liability right, down to the penny, before actually doing your return, because the capital gain on which you pay taxes in June may be offset by an unanticipated capital loss you take in December. But the closer you get, the better.

While we’re on the subject, look back over your return to assess those capital gains distributions from mutual funds. If you simply reinvest distributions, think about switching to comparable funds that have the same overall return but provide it through share price gains without the big distributions. That way you’ll make just as much but will postpone capital gains tax on profits until you sell the shares.

Index-style mutual funds and exchange-traded funds tend to have smaller distributions than actively managed funds, because managed funds have more buying and selling as managers pursue hot investments. Index products use a buy-and-hold strategy.

Another way to avoid these annoying annual taxes on distributions is to hold the funds that make them in tax-advantaged accounts like 401(k)s and IRAs. That way you’ll postpone all taxes until you make withdrawals, generally after turning 59.5.

Keep in mind, though, that withdrawals from these accounts are taxed as income, at rates as high as 35%, or even 39.6% for well-to-do investors. Long-term capital gains earned in ordinary, taxable accounts are subject to a maximum rate of 15% (or 20% for the wealthy).

Because weighing all these factors is so tricky, investors should keep tax matters in mind year-round.

So the next step in easing next year’s tax burden is to set up a good record keeping system. It doesn’t have to be a fancy spread sheet -- just a box with file folders is good enough, so vital information doesn’t go astray. Many brokerages and mutual fund companies have good tax information on their sites, including the cost basis for investments a customer has accumulated over time. Take an hour to explore the firm’s website, and you may find that many calculations of profit and loss have already been done for you.

Next step: put as much as you can afford into your 401(k) or similar workplace retirement plan. Contributions are deducted from your taxable income, reducing your tax bill. For 2013, the maximum contribution is $17,500, plus $5,500 for investors 50 and older. (At a minimum, contribute enough to get your employer’s maximum matching contribution.)

Finally, think about what to do with any refund you’re expecting. While spending it on a vacation or night on the town may top your list, a good alternative is to pay down high-interest credit card debt. Paying off a balance that costs 15% a year is like earning 15% a year. You won’t make that in bank savings.

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