5 Tips to Simplify Investment-Related Taxes
For some people, investment activity really complicates annual tax return preparation. In fact, without too much trouble, some people manage to so complicate their tax returns due to their investing, that the investor has no hope of preparing such a return themselves and may need to go to high-priced professional for tax return preparation.
Fortunately, a few simple tricks can greatly simplify the tax accounting related to person's investment activities. And the tricks may allow an investor to prepare his or her return him or herself or at reasonable cost.
Tip #1: Trade in tax-advantaged accounts
If you're going to actively trade (regularly and actively buying stocks and bonds), move that activity to a tax-deferred account such as a self-directed IRA.
Taxable trading creates lots of work on a tax return — including lots of detail on Schedule D (of Form 1040), Capital Gains and Losses, and the related Form 8949, Sales and Other Dispositions of Capital Assets. But by moving the trading into tax-deferred account, all of this work evaporates. This approach also eliminates one of the common triggers for IRS correspondence audits: mismatched broker proceeds due to investment activities.
Tip #2: Trade a given security within a single account
If you must trade in a taxable account, be sure to trade any given security (shares in Apple, Inc., for example) only in a single account.
In other words, if you have a Schwab account, an E*Trade account, and a Fidelity account, don't trade shares in Apple across all three accounts. You won't be able to easily apply the wash sale rules if you spread your trading. And you won't be able to avoid having a competent accountant check for wash sales—which will be expensive.
Tip #3: Avoid foreign accounts
Congress has greatly increased the cost of U.S. investors investing money in offshore accounts. Accordingly, you therefore want to avoid these options so you can avoid annually preparing Form 8938, Statement of Specified Foreign Financial Assets, and Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts.
Tip #4: Don't DRIP in a taxable account
Lots of people like to use dividend reinvestment programs, or DRIPs, to grow their investments in dividend paying stocks. Such programs are convenient and add up over time.
However, if you participate in DRIPs inside a taxable account, you create a bunch of work for yourself. You need to carefully track increments on a regular basis over the time you hold the shares and reinvest the dividends so you can someday calculate your gain or loss.
The trick here, then, is to either avoid DRIPs, or use them inside tax-deferred accounts where you don't have to worry about the capital gains calculations.
Tip #5: Understand how partnership accounting works
Before you invest in a partnership be sure you understand how partnership accounting works. Most small investors don't. And as a result, they sometimes get terrible surprises at tax time.
For example, you probably owe any of the states in which an investment partnership operates a nonresident tax return. So be sure you're ready for that.
Another example: None of the complexity of what's going on inside a partnership is hidden. That complexity simply flows through the partnership tax return and then onto the individual partner's tax returns via the partnership Schedule K-1.
Accordingly, if you're investing in oil and gas partnership with depletion allowances or hedge funds with reportable transactions, you want to first make sure you know how to deal with all of this stuff. Or, make sure you're comfortable paying someone else to deal with this stuff.