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MONTHLY TAX NEWSLETTERApril 2007
Besides the Fourth of July or perhaps Cinco de Mayo, few dates carry the cache of April 15th. With April 15th quickly approaching, now's the time to either file your tax returns or submit an extension request with the IRS.
Since April 15th falls on a Sunday this year, most people have until Monday, April 16th to file. Anyone living in the Northeast who files with the IRS' Andover Service Center has one extra day to submit their paperwork this year, due to the fact that Massachusetts observes Patriots Day which falls on April 16th.
(What do you expect, since Massachusetts is where Paul Revere made his famous ride on the eighteenth of April in seventy-five. Plus, that's the day for the Boston Marathon, so the roads are all clogged and no one at that IRS center can get to work and check that day's mail anyway.)
Let's look at some of the reasons to file an extension request prior to this year's due date of either April 16th or 17th.
Avoid the Failure To File Penalty
Ever wonder what would happen if you didn't file either your tax return or an extension request prior to April 15th? Expect the IRS to hit you up with a Failure to File penalty equal to 5 percent of your outstanding federal tax liability per month. Owe $5,000 in federal taxes when you file, and the IRS will send you a bill for $250 for each month that has passed since April 15th.
By filing an extension request (Form 4868) prior to the tax return due date, the Failure to File penalty of 5 percent per month is replaced with a much more reasonable Failure to Pay penalty of one-half percent per month. That's a pretty good return on your $.39 stamp used to mail the one-page automatic extension request, Form 4868, to the IRS.
Plus, if you end up owing the IRS no more than than the greater of 10% of your total federal tax liability or $1,000, you should not be assessed any penalties at all, as long as you file your federal tax return by October 15th. In this case, you'll only owe interest to the IRS on your balance due.
Buy More Time To Fund Your Self-Employed Retirement Plan
If you're self-employed, you might benefit by filing for an extension even if you can complete your tax returns by April 15th. That's because you have until the due date of your tax return, including extensions, to fund your retirement accounts for the year. Even if you don't have a retirement plan set up yet, a SEP IRA can be established as late as the extended due date of your return, or October 15, 2007.
By filing a Form 4868 with the IRS, you get an additional six months to fund your retirement plan and deduct the contribution made on your 2006 return. One strategy common to self-employed individuals is to pay the full amount of taxes due with an extension, and then to fund their retirement plans prior to October 15th.
No Extending IRA Due Dates
When it comes to your IRAs, the deadline to put away money for 2006 is April 16th or 17th, 2007, even if you file an extension. This applies for traditional IRAs, Roth IRAs, and Education Savings Accounts.
For 2006, you can contribute up to $4,000 into an IRA. Anyone 50 or older as of December 31, 2006 can put away an extra $1,000. If you're married, both spouses can contribute to an IRA provided one spouse has earned income during the year in excess of the amount to be contributed.
For Education Savings Accounts (formerly known as Education IRAs), you can contribute up to $2,000 per child per year. These accounts grow tax-free, and are more flexible than 529 Plans since you have more control over how the money is invested, and can withdraw money from the accounts to pay for your children's private K through 12 schooling in addition to their college tuition and fees.
To file for an extension, simply complete and mail the IRS a Form 4868. Since these extension requests are automatic, you don't even need to come up with an excuse as to why you need more time to file your tax returns this year.
With an extension request, you now get an additional six months to complete and file your tax returns. It's important to note that when you file for an extension, you are asking for more time to finish paperwork, not more time to pay any money that is due. If you owe taxes as of April 15th, expect to pay interest, and possibly the Failure to Pay penalty of one-half percent per month, on any taxes ultimately owed to the IRS.
The mutual fund companies are at it again. Based on what I saw from my clients this tax season, many funds paid out substantial distributions during 2006.
With a mutual fund, you buy into a managed portfolio of stocks, bonds, and other investments. The beauty of mutual funds is that they provide investors with access to professional management at a relatively low cost. Most funds charge an annual fee equal to one to two percent of the value of your account. Unmanaged funds, such as index funds, charge a much smaller annual fee, usually less than two-tenths of a percent.
One problem with holding mutual funds in a taxable account is that the fund company is required to pay out to its shareholders any interest, dividends, and capital gains earned from the underlying portfolio during the year. And as a shareholder of a mutual fund, you're taxed on these distributions, unless the fund is being held within one of your tax-deferred retirement or education savings accounts.
To make matters worse, these distributions usually don't represent money that you receive. If you elect to reinvest your distributions back into the fund, your total value in the fund doesn't change at all when you receive a distribution. The only thing that changes is that you now have a tax liability.
Let's look at an example where you invest $10,000 in a mutual fund, and purchase 1,000 shares of the fund at $10 per share. The next day, the mutual fund issues a capital gain distribution of $1.00 per share - which equals ten percent of your investment.
You receive a distribution of $1,000, which you use to purchase additional shares of the mutual fund. After the distribution, the fund trades at $9 per share, so your $1,000 reinvested dividend purchases 111.111 new shares. You now have 1,111.111 shares of the fund, trading at $9 per share. And guess what? Your shares in the fund are now worth the same $10,000 that you originally invested. The only problem is that you now owe taxes on the $1,000 you didn't get. (It's starting to sound like an Abbott and Costello routine.)
Before purchasing a fund in a taxable account, it's a good idea to take a look at the tax efficiency of that fund. Simply go to the fund company's website, or to www.morningstar.com, and take a look at the fund's "turnover" rate. The higher the turnover rate, the higher the percentage of the underlying portfolio that is being sold each year, and the less tax efficient the fund will be.
According to Fidelity Investment's site, three of their funds have the following turnover rates:
Based on this information, the unmanaged index fund is the most tax efficient of these three funds, while the aggressive "sector" fund is not very tax efficient at all. Keep in mind that all these funds have different investment goals and strategies, so it's not surprising that they hold onto their underlying portfolios for different periods of time.
Rearrange Your Portfolio
Once you determine whether an investment is tax efficient or tax inefficient, invest some time to rearrange your portfolio to hold the more tax efficient investments within your taxable accounts and the more tax inefficient funds in your tax advantaged retirement or education accounts. By doing so, you should be able to increase the after-tax return of your current portfolio.
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