Tax Tips for Single Filers, Part II

In Tax Tips for Single Filers, Part I, we covered some winning strategies for single filers when taking exemptions and deductions. Today, the series continues with more tips to ensure the IRS takes a nibble instead of a chunk out of your income.



4. Invest wisely.

As a single, you are a one-income family. Unless you marry, you won't be able to rely on someone else's pension or Social Security. So it's imperative that you prepare yourself for retirement now. That means investing wisely, part of which is keeping as much of your investment as possible in your pocket and out of the government's. Here are some things you need to know about reducing the tax burden on your investments:


A. Stocks, Bonds, & CDs

This may seem like a page out of Investment for Dummies, but some people get complacent while their securities are plumping up every year at no charge to themselves. When it's time to dig into the cash cow, they forget that that money is going to be added to their annual income for tax purposes. That means if they're teetering on the brink of a higher tax bracket, that cash-out could propel them over the edge. Furthermore, if you want to profit from lower tax rates on long-term capital gains, you must hold an investment for at least a year, beginning the day after you buy it.

If your company has given you restricted stock, you have the option to pay tax on it within 30 days by making the 83(b) election or hold off until it becomes transferable, in which case, if the stock has appreciated, your taxes will be substantially higher. The 83(b) election can be a gamble if the stock does not appreciate, but if you have a reasonable expectation that it will, paying now and reaping the benefits later just makes sense. Restricted stock benefits are usually executive territory, but it never hurts to be prepared. :)

Or maybe bonds are more your style, but you bought them at a premium. If so, you can amortize the premium, which means you can deduct it from the taxable interest the bond generates. Be careful, though, as you travel through the labyrinth of laws on amortization lest you lose the path to a deduction.

Now a word about dividends: If you're interested in buying shares in a company that pays dividends, timing is everything. Every time the company announces that it will pay out a dividend (often quarterly), it sets a date called the ex-dividend date. If you purchase shares on or after this date, you will not get the dividend for that quarter, and you will pay a lower price per share because of it. However, if you buy before the ex-date, you will pay more and get the dividend...and then have to pay taxes on it. This wouldn't be so bad except that after the dividend is paid out, the value of the security falls by the amount of the dividend. The result is that you get nothing more than what you put into it, and you get taxed on it. And perhaps feel a little foolish.

This is a particularly effective way to screw yourself if you're buying the dividends as part of a mutual fund at its year-end payout, when the stocks have been appreciating all year. In this scenario, the long-term shareholders make out good, while someone who buys in just before the dividend pays taxes on an appreciation they never saw. If your brain looks like an egg on drugs after reading that like mine does after writing it, see this page for a better explanation.

Oh, and another page out of Investment for Dummies, The Collector's Edition: If you earn dividends from stocks, bonds, or CDs, you will pay taxes on those dividends even if they get rolled over or reinvested and you never see a penny. I've overlooked this leetle fact once or twice myself, so it can even happen to clever people. ;)


B. 401(k)'s

Be aware of the differences between a traditional 401(k) and a Roth 401(k). The former allows you to contribute tax-free, but this is deceptive since you'll be taxed when you withdraw the money, probably at a higher rate than when you deposited it. The latter doesn't give you a break upfront, but you can withdraw at retirement without taxation. For young singles who don't bring home a hefty paycheck now but might by retirement, the Roth 401(k) is the better deal.

If you're quitting a job with an outstanding 401(k) loan, pay it off before you go and not just so your boss will give you a good reference. If you don't, for legal purposes it will be as though you simply withdrew the cash, and that means you'll get hit with all the relevant taxes and, if you're under 55, a 10% penalty.

In a breakthrough for singles, anyone who inherits a 401(k) from someone other than a spouse can now roll it over into an IRA. That means you can pay tax on the inheritance over the course of a lifetime instead of in one lump sum! (This is a perfect example, by the way, of how the reality of changing demographics can trickle down to the Senate floor.)


C. IRAs

For singles of this generation, who face a bankrupt social security system, the phaseout of pensions, and unstable 401(k)'s, an Individual Retirement Account (IRA) is your best shot at building a nest egg. When it comes to taxes, traditional IRAs and Roth IRAs work like the 401(k) accounts described in B., so again, the Roth is recommended for younger singles with as-yet-unfulfilled earning potential. Plus, you can deduct up to 50% of the first $2,000 you deposit, which just might be the biggest deduction you take off anything, ever. :)


D. Annuities

An annuity is a bit like an IRA or 401(k) underwritten by an insurance company and is an especially good idea for singles who don't have an employer-matched retirement savings account at work. One of the best features of an annuity is that retirees can deduct the money they paid into it once the annuity pays out.



5. Go with a pro.

To play the stock market, you have to know the rules, and most of us don't have time to read the rule book. That's why you can deduct investment management fees for brokers, trustees, or other individuals who fit the bill. (What is and is not tax-exempt here gets complicated, so read this before you deduct willy-nilly.)

When tax time rolls around, unless your finances are very straightforward (think 1040EZ), swing for a professional accountant instead of using TurboTax or a tax preparation service like H&R Block. A CPA can help you find your way through loopholes that faceless tax prep firms might be unaware of or, worse, might be too careless to investigate for you. In addition, a certified accountant can advise you on long-term financial planning strategies. Don't worry. You can deduct his fee next year!



Can you think of any other tax breaks for investments or for the use of professional advisers? Do you know of any tax tips for single filers not mentioned in Part I or Part II of this series?


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