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Smart Ways to Spend Your Tax Refund

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As of April 2014, the average tax refund for is $2,831, according to the IRS.  While it might be tempting to use this windfall for something fun, like a vacation to someplace warm and exotic, there are better ways to spend your refund that can help improve your finances for years to come.  Yes, you can call me a kill-joy, but delaying gratification can have its rewards in bigger and better ways, like being able to buy your dream home sooner than expected, or being able to take that once in a lifetime vacation that you never thought you would be able to afford, or retiring early.  Laying a solid foundation first will enable you to then focus on the perks in life.  So, before you call your travel agent and book a trip to Cancun consider these three less exciting, but more rewarding ways to spend your tax refund (if you’re not getting a tax refund, look to address these items as you get some spare cash):

  • Get Rid of Credit Card Debt.   Even if your bill is bigger than your refund, it pays to get rid of as much debt as quickly as possible.  If your card charges 18% interest and you pay off all or some of that debt, it is the same as if you earned 18% on your money.  Remember to see which cards carry the highest rates.  Pay those off first and stop using all cards.  If you absolutely must charge, make sure you use a card carrying the lowest rates. 
  • Add to Your Emergency Fund.  It is recommended that you have six months’ worth of      income stashed away in a liquid account (bank account, money market, etc.) in case of illness, or unemployment.  In the event of an emergency, how long could you go on paying your bills?  If your account seems thin, beef it up.
  • Fund Your Investment Accounts.  As part of your monthly budget, it is recommended that      10% of your take home pay goes towards savings.  In addition to adding to your emergency fund and other general savings, this 10% can be satisfied in a number of ways: 
  1. Fund retirement through an employer-sponsored plan.  This has enormous benefits, because the investment often times can be made with pre-tax dollars (lowering your income taxes) and the investment can grow without the effect of taxes, provided you withdraw the money in retirement.  Also, many employers help you save toward retirement by matching a percentage of your contributions.  That is called free money – and it’s hard to find.
  2. Fund an IRA or a Roth IRA (contributions can be made for non-working spouses).  Again, tax-deferred growth is a key  benefit here.  Check with your tax advisor if you qualify for a Roth IRA, as it has unique benefits such as tax-free withdrawals, and the ability to withdraw for reasons other than retirement, such a first-time home purchase, or to meet college costs.  Contribution limits are $5,500 ($6,500 if you are at least 50 years old). Contributions for 2014 can be made until April 15, 2015 (for both IRAs and Roth IRAs).
  3. Add to your child’s college savings.  Whether you open a specific college savings account, such as a Coverdell account or a 529 Plan, or opt for a more general account, such a mutual fund or savings bond, you can take an important step in securing your child’s future.

 If it makes it easier to get started, think of it this way:  you wouldn’t give your kids dessert before they had dinner.  This list is dinner, and there’s no telling what kinds of dessert await you if you take care of this very necessary business first.

Myths and Facts about Social Security

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Myth: Social Security will provide most of the income you need in retirement.

Fact: It’s likely that Social Security will provide a smaller portion of retirement income than you expect.

There’s no doubt about it–Social Security is an important source of retirement income for most Americans. According to the Social Security Administration, more than nine out of ten individuals age 65 and older receive Social Security benefits.  But it may be unwise to rely too heavily on Social Security, because to keep the system solvent, some changes will have to be made to it. The younger and wealthier you are, the more likely these changes will affect you. But whether retirement is years away or just around the corner, keep in mind that Social Security was never meant to be the sole source of income for retirees. As President Dwight D. Eisenhower said, “The system is not intended as a substitute for private savings, pension plans, and insurance protection. It is, rather, intended as the foundation upon which these other forms of protection can be soundly built.”  No matter what the future holds for Social Security, focus on saving as much for retirement as possible.  You can do so by contributing to tax-deferred vehicles such as IRAs, 401(k)s, and other employer-sponsored plans, and by investing in stocks, bonds, and mutual funds. When combined with your future Social Security benefits, your retirement savings and pension benefits can help ensure that you’ll have enough income to see you through retirement.

Myth: Social Security is only a retirement program.

Fact: Social Security also offers disability and survivor’s benefits.

With all the focus on retirement benefits, it’s easy to overlook the fact that Social Security also offers protection against long-term disability. And when you receive retirement or disability benefits, your family members may be eligible to receive benefits, too.  Another valuable source of support for your family is Social Security survivor’s insurance. If you were to die, certain members of your family, including your spouse, children, and dependent parents, may be eligible for monthly survivor’s benefits that can help replace lost income. For specific information about the benefits you and your family members may receive, visit the SSA’s website at www.socialsecurity.gov, or call 800-772-1213 if you have questions.

Myth: If you earn money after you retire, you’ll lose your Social Security benefit.

Fact: Money you earn after you retire will only affect your Social Security benefit if you’re under full retirement age.

Once you reach full retirement age, you can earn as much as you want without affecting your Social Security retirement benefit. But if you’re under full retirement age, any income that you earn may affect the amount of benefit you receive:

• If you’re under full retirement age, $1 in benefits will be withheld for every $2 you earn above a certain annual limit. For 2014, that limit is $15,480.

• In the year you reach full retirement age, $1 in benefits will be withheld for every $3 you earn above a certain annual limit until the month you reach full retirement age. If you reach full retirement age in 2014, that limit is $41,400.

Even if your monthly benefit is reduced in the short term due to your earnings, you’ll receive a higher monthly benefit later. That’s because the SSA recalculates your benefit when you reach full retirement age, and omits the months in which your benefit was reduced.

Myth: Social Security benefits are not taxable.

Fact: You may have to pay taxes on your Social Security benefits if you have other income.

If the only income you had during the year was Social Security income, then your benefit generally isn’t taxable. But if you earned income during the year (either from a job or from self-employment) or had substantial investment income, then you might have to pay federal income tax on a portion of your benefit.  Up to 85% of your benefit may be taxable, depending on your tax filing status (e.g., single, married filing jointly) and the total amount of income you have. For more information on this subject, see IRS Publication 915,Social Security and Equivalent Railroad Retirement Benefits.

What Is Your Full Retirement Age?

If you were born in: Your full retirement age is:

1943-1954                  66

1955                           66 and 2 months

1956                           66 and 4 months

1957                           66 and 6 months

1958                           66 and 8 months

1959                           66 and 10 months

1960 and later            67

Note:  If you were born on January 1 of any year, refer to the previous year to determine your full retirement age.

The information contained in this material is being provided for general education purposes and with the understanding that it is not intended to be used or interpreted as specific legal, tax or investment advice. It does not address or account for your individual investor circumstances. Investment decisions should always be made based on your specific financial needs and objectives, goals, time horizon and risk tolerance.

The information contained in this communication, including attachments, may be provided to support the marketing of a particular product or service. You cannot rely on this to avoid tax penalties that may be imposed under the Internal Revenue Code. Consult your tax advisor or attorney regarding tax issues specific to your circumstances.

Neither Ameriprise Financial Services, Inc. nor any of its employees or representatives are authorized to give legal or tax advice. You are encouraged to seek the guidance of your own personal legal or tax counsel. Ameriprise Financial Services, Inc. Member FINRA and SIPC.

The information in this document is provided by a third party and has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial Services, Inc. While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use or reliance upon this service.

Why are taxes hidden?

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Not surprisingly, hidden taxes largely go unnoticed. The result may be that this can make it difficult for us to choose wisely the goods and services that we purchase, or to have a true accounting of our total tax burdens.

Sin taxes

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A seemingly favorite way for government to tax is with the so-called “sin” taxes. Ostensibly, these taxes are imposed to reduce behavior that society considers unhealthy, immoral, or just undesirable in some way. That is why there is a tax on soda, alcohol, tobacco, gambling, and ammunition and firearms. According to the Alcohol and Tobacco Tax and Trade Bureau, revenue collected in 2011 for just some of the above-referenced items totaled approximately $26 billion. (Source: Statistical Release, December 1, 2011, www.TTB.gov)

Planes, trains, and automobiles

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Many hidden taxes are associated with travel. For example, when you pull up to the pump, you can clearly see the price for the gas, but the “taxes included” disclosure is usually posted somewhere else. How much of what you pay goes to tax revenue? Well, it varies by each state and its tax policy at the time, but it can range from 8¢ per gallon (Alaska) to 47.7¢ per gallon (California). (Source: Tax Foundation, Tax Data, February 25, 2011)

Taxes associated with traveling by air can include ticket excise tax, flight segment tax, arrival and departure fees, September 11 security fees, passenger facility fees, and–if your travel is international–agricultural inspection, customs, and immigration user fees. There are 16 or more fees that can add up to $61 (or 20% of your total cost) or more. (Source: Airlines for America, www.airlines.org, 2012) And those are just the U.S. taxes; there can be foreign taxes as well.

Car rental, hotel, and meal taxes can also add up. The GBTA Foundation, the education and research foundation of the Global Business Travel Association (GBTA), reported from its 2011 annual study of the top 50 U.S. travel destination cities that the travel taxes and fees imposed on travel-related services increased the traveler’s cost an average of 56% over and above any general sales taxes paid, and that taxes for a single night at the national average room rate of $95.61 were $13.12. The combined lodging taxes levied by state, county, and city averaged 13.73%. (Source: News Release, July 21, 2011, www.gbta.org).

How taxes are hidden

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Taxes are hidden in many ways. For example, you see the payroll taxes that are deducted from your payroll check each pay period. What you do not see are the taxes that your employer pays. For example, in addition to income tax, your employer pays half of the Social Security tax as well as unemployment tax on your wages. Like all costs paid by your employer, these taxes get passed on to you as an employee (as a factor in compensation paid), as well as to shareholders and to clients and customers. And if you’re receiving dividends from a corporation, keep in mind that taxes have already been paid on that income.

But most hidden taxes are paid by consumers. Sometimes these taxes are disguised as fees, surcharges, tariffs, duties, assessments, dues, excises, levies, licenses, and tolls, among others. And sometimes they’re simply rolled into the price of goods and services and are either completely undisclosed or they appear somewhere in the fine print, which is often left unread by the consumer.

Hidden Taxes: What Is Your True Cost?

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We are pretty well aware of the taxes we must pay as U.S. citizens; income taxes, payroll taxes, sales taxes, property taxes, and gift and estate taxes, to name a few. We can easily see these taxes on our pay stubs, tax bills, and sales receipts. But there are other taxes imposed on us that you may not be aware of. They are “hidden taxes.” And when you add them together with visible taxes, you may be surprised about how high your taxes really are. Here’s the rundown on hidden taxes.

Investment Tax Planning

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Introduction

Investment planning can be important for several reasons. However, any discussion of investment planning is incomplete without a thorough understanding of the applicable income tax ramifications. Tax planning can help you reduce the tax cost of your investments. Once you’ve created an investment plan to work toward your various financial goals, you should take advantage of the tax rules to ensure that you maximize the after-tax return on your investments. In other words, your goal is to select tax-favorable investments that are consistent with your overall investment plan.

In order to engage in investment tax planning, you need to understand how investments are taxed (including the concepts of capital gain income and ordinary income) and how to compare different investment vehicles. You also need to know how your own tax situation (i.e., your tax bracket, holding period, and tax basis) affects the taxation of your capital assets.

Caution: Investment choices should not be based on tax considerations alone, but should be based on several factors including your time horizons and risk tolerance.

Caution: Starting in 2013, a new 3.8 percent unearned income Medicare contribution tax will be imposed on the investment income of high-income individuals (generally, married individuals filing jointly with modified adjusted gross income (MAGI) exceeding $250,000, married individuals filing separately with MAGI exceeding $125,000, and single individuals with MAGI exceeding $200,000).

How does investment tax planning work?

Similar investments may carry substantially different tax costs. It is important to identify the differences and evaluate the costs. Consider the following points:

Investment earnings are taxed in different ways

A myriad of investment vehicles are available to you. For instance, you can invest in stocks, bonds, mutual funds, money market funds, real estate, commodities, or your own business. Investment earnings are taxed in many different ways. Consequently, some investments earn less after tax than others. By taking advantage of these differences, you may save money. In addition, your tax savings can preserve your investments and, as a result, enhance future investment growth.

Investment tax planning can maximize your wealth

Tax investment planning involves maximizing the after-tax return on your investments. This is beneficial because the wealth that remains after you pay your taxes is ultimately more important to you than the value of your investments. It’s the after-tax payout that enables you to finance a home, a child’s education, a vacation, or your retirement. Thus, one goal of investment tax planning is to maximize future wealth. To do so, you need to know a little bit about taxes. In particular, you need to know the following:

  • How your investments are taxed
  • The before- and after-tax rates of return on your investments
  • How to compare investments in light of after-tax return
  • How are your investments taxed?
  • In order to understand how investments are taxed, you first need to become familiar with the following basic concepts:
  • Capital gains and losses
  • Qualified dividends
  • Ordinary (investment) income
  • Investment expenses
  • Tax-exempt income
  • Tax-deferred income
  • Capital gains and losses

While you hold a capital asset (e.g., your home, stocks, bonds, mutual funds, real estate, collectibles), you will not pay taxes on any increase in value. However, when you sell or exchange the asset, you will realize a capital gain (if you sell it for a profit) or loss (if you sell for less than the asset’s cost). If you sell an asset after only a year or less, you will have a short-term capital gain. Short-term capital gains are taxed at ordinary income tax rates (i.e., your marginal income tax rate). If you own an asset for more than a year before you sell it, you will have a long-term capital gain.

Long-term capital gains tax rates are generally more favorable than ordinary income tax rates. Currently, the highest ordinary income tax rate is 35 percent whereas the highest long-term capital gains tax rate (for most assets) is 15 percent (for sales and exchanges on or after may 6, 2003). That’s a difference of 20 percent. Thus, holding an asset for long-term growth is a tax-saving strategy.

Caution: The Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act), the Tax Increase Prevention and Reconciliation Act of 2005 (2005 Tax Act), and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Act) reduced long-term capital gains tax rates for sales and exchanges made on or after May 6, 2003 and before January 1, 2013. These rates are 15 percent for taxpayers in marginal tax brackets higher than 15 percent, and 5 percent (zero percent in 2008-2012) for taxpayers in the 15 percent and 10 percent marginal tax brackets. In 2013, the rates revert to pre-2003 Tax Act levels–20 percent and 10 percent, respectively. Thus, investors may want to time the sale of highly appreciated assets to take advantage of the lower rates.

You may offset capital gains with capital losses (short-term losses against short-term gains and long-term losses against long-term gains). If you have more losses than gains in a given year, you may offset up to $3,000 of ordinary income ($1,500 if married filing separately). Any remaining losses can be carried forward into future tax years. Thus, timing losses to offset gains is a tax-saving investment strategy.

Tip: You may also elect to include net capital gains from property held for investment as ordinary (investment) income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you don’t have capital losses, but do have investment interest expenses. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made–if you do not make the election, the IRS will classify the income as capital gain income.

Capital gain is computed by subtracting the sale price from the asset’s basis. Basis is your cost and includes the price you paid for the assets plus the cost of capital improvements. The higher your basis, the smaller your capital gain and the smaller your tax liability. Thus, you should keep careful records of the basis of an asset. This is especially important if you buy shares of stock in the same company at different times and different prices. This will allow you to control the tax consequences by picking particular shares to sell or hold.

Tip: If you want to sell an asset now but defer the recognition of the gain until later tax years, you may be able to arrange an installment sale with the buyer (but not for stocks or bonds). That way, you report and pay tax on the income as you receive it.

Qualified dividends

Qualified dividends are dividends received during the tax year by an individual shareholder from a domestic corporation or a qualified foreign corporation. Under the 2003, 2005, and 2010 Tax Acts, effective for tax years 2003 through 2012, such dividends are taxable at the same rates that apply to long-term capital gains. This tax treatment applies to both regular tax and the alternative minimum tax. Absent further legislative action, dividend tax rates revert to pre-2003 Tax Act levels (i.e., they will be taxed at ordinary income tax rates) beginning in 2013.

Eligible dividends include dividends received directly from a domestic corporation or a qualified foreign corporation as well as qualified dividends passed through to investors by stock mutual funds, other regulated investment companies, partnerships, or real estate investment trusts (REITs). Thus, it may be advantageous to invest in vehicles that pay qualified dividends, especially if you need current income.

Distributions from tax-deferred vehicles, such as IRAs, retirement plans, annuities, and Coverdell education savings plans, do not qualify even if the funds represent dividends from stock. Thus, holding investments that pay qualified dividends within a tax-deferred plan may no longer be desirable.

Tip: Though qualified dividends are taxed at long-term capital gains tax rates, they cannot be offset by capital losses. However, as with capital gains, you can elect to include these dividends in investment income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you have investment interest expenses in excess of investment income. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made–if you do not make the election, the IRS will classify the income as net capital gain.

Ordinary (investment) income

Ordinary investment income consists of any investment income that is not capital gain income, qualified dividends, or tax-exempt income, and is taxed at ordinary income tax rates. Investment income is generated by investment property such as bonds and bond mutual funds. Examples of ordinary investment income include interest and dividends that are actually interest (and therefore don’t qualify for taxation at long-term capital gains tax rates).

Generally, ordinary income tax treatment is not as favorable as long-term capital gains tax treatment.

Investment expenses

If you borrow money to buy investment property, you probably pay investment interest. Investment interest may be used to offset investment income only. Excess investment interest may be carried forward to future years. Other investment expenses (e.g., commissions, fees) are deductible as an itemized deduction on Schedule A and are subject to the 2 percent limit.

Passive income and losses

A passive activity is an investment in a business in which you are not an active participant. Rental real estate and limited partnerships are two common examples. Income generated by a passive activity and gain from the sale or exchange of a passive activity is included in passive income and taxed at ordinary income tax rates. Generally, losses from passive activities may offset income from passive activities only–they cannot be used to offset ordinary income or capital gain income. However, excess losses in a given year can be carried forward into future tax years.

Tax-exempt income

There are a number of tax-exempt investment vehicles. One of the more common vehicles is the municipal bond. Usually, interest paid on municipal bonds is not subject to federal or state tax (at least not in the state of issue). When deciding whether to invest in taxable bonds or tax-exempt bonds, it is important to compare the after-tax rate of return on municipals with that on taxable bonds with similar risk.

Caution: While the interest on municipal bonds is tax exempt, capital gains tax may be imposed when you sell the bonds.

Caution: The interest on U.S. Government bonds is not exempt from federal income tax. However, the interest on federal securities is tax exempt at the state level.

Tip: Roth IRAs, although technically vehicles for holding investments and not truly investments themselves, should be discussed under the heading of tax-exempt income. A Roth IRA is a vehicle in which you can invest a limited amount of money each year for retirement and certain other limited purposes (assuming that you satisfy certain criteria including adjusted gross income (AGI) limits). The income and gains on the account are not taxed at all as long as you follow all applicable rules. Be aware, though, that if all applicable rules are not followed, withdrawals will not only be subject to tax, they may also be subject to a penalty. Tax-free growth is clearly one of the most powerful investment tools available for creating wealth. However, you must use after-tax dollars to make the initial investment and subsequent contributions. No IRA deduction is allowed for contributions to Roth IRAs.

Tax-deferred income

Tax-deferred investments produce earnings that are not taxed until withdrawn. These earnings are reinvested and continue to fuel investment growth. This is one of the most powerful investment tools available. First, there is a time-value of money advantage. The longer you can keep the money in your own pocket and out of the hands of the IRS, the greater the potential benefit will be to you. Second, since our income tax rates are progressive, you may find yourself in a lower tax bracket in the year the earnings are finally taxed. If so, the actual amount of tax paid on those investment earnings will be less. On the other hand, if you find yourself in a higher tax bracket in the year the earnings are finally taxed, the amount of tax paid on the earnings will be higher (assuming all else is equal).

Caution: Many retirement vehicles are designed to provide tax-deferred growth. The downside of this benefit is that all distributions from the retirement plan are taxed at ordinary income rates rather than at capital gains rates. This can result in potentially higher taxation in light of the progressively higher ordinary income tax rates.

What are before- and after-tax rates of return?

To compare investments, you must understand before- and after-tax rates of return. Ultimately, you want to compare the after-tax rate of returns of similar investments. The rate of return is the ratio of the annual amount an investment earns compared to the cost of the investment. Thus, if an investment cost you $10 and earned $1, the rate of return is 10 percent.

Before-tax rate of return

The before-tax rate of return is the annual market-rate of return. For example, a $10 bond that pays $1 per year in interest and is sold for $10 earns a 10 percent before-tax rate of return.

After-tax rate of return

The after-tax rate of return is the ratio of the after-tax income and gain to the amount invested. With the exception of tax-free investments, this rate is always lower than the before-tax or market rate of return. What do you need to know to compute the after-tax rate of return? Generally, you need to know the following:

What is the tax treatment of your investments (ordinary income, capital gains, tax exempt, tax deferred)?

What is your tax situation (your marginal tax rate, your holding periods, whether you’ve invested in tax-deferred retirement accounts)?

How do you comparison shop for investments?

Comparison shopping for investments allows you to compare the after-tax return on two similar investments. In order to effectively make this assessment, you must consider two other issues:

Tax classification of the investment

Your tax situation

Tax treatment of the investment

You need to know whether the investment vehicle generates capital gains, ordinary income, tax-free, or tax-deferred income. There are two components to the after-tax rate of return: the portion attributable to earnings (such as interest) and the amount derived from a subsequent sale. You also need to know whether any capital gains will be treated as long-term or short-term capital gains.

Special rules can apply to certain kinds of investments such as wash sales, qualifying small business stock, short sales, installment sales, like-kind exchanges, and others. In addition, you may wish to know about market discount rules, anti-conversion rules, and tax shelters.

Your tax treatment

Your investment tax situation depends on several factors. In particular, you’ll need to know the adjusted tax basis of your capital assets, the sale price of the assets, the holding period, the amount of the capital gain or loss, the amount of your ordinary investment income or losses, and your marginal tax bracket.