Tax Brackets

This refers to the tax rate you fall into. It is determined by your filing status (single, married filing jointly, etc.) and your taxable income (after the exemption, deductions etc.). The following table shows the tax brackets for different taxable income in 2007:

For example, if you are married filing a joint return, and your taxable income is $158,000. Then your federal tax for tax year 2007 is: 24972.5 + (158000 - 128500) * 28%.

Tax Breaks for Investors

You contribution to an employer-sponsored retirement plan (401k etc.) are tax-deferred. That means the money you contributed and its earnings are not taxable before you start to withdrawal money.

If you have contributed to a traditional IRA in the tax year, that contribution is again tax-deferred. However, it might be smarter to contribute to a Roth IRA (which means you can't take the tax break now but the money grows tax-free forever). Check out the Financial Tips page.

If your investment (in a taxable account) lost money, here is your consolation: you can deduct your losses and therefore lower your tax.

Tax Breaks for Everyone

You get exemptions for every person in your household. If the exemption for the tax year is $3000 per person, and there are 3 people in your family, then your total exemption is $9000.

The complicated part is deduction. You can choose either standard deduction or itemized deduction. For people who own a house and pay mortgage, it's almost a no-brainer to use itemized deduction. Other itemized deduction items are medical and dental expense, taxes you paid, gift to charity (church, etc.), casualty and theft losses, etc.

Tax Breaks for Parents

Child tax credit is $500 for each child who is under 17 on the last date of the tax year. A tax credit is an amount you can subtract from your calculated tax. To be eligible for this credit, Annual Gross Income of a couple cannot be over $110,000.

Child and dependent care credit is designed to help working parents who pay for child care (or care of a disabled spouse). The maximum credit is $720 for one child and $1440 for two or more children. There are certain restriction as described in the tax form.

Shifting taxes to children if you are saving for their education. For children under 14, the first $850 of investment income is tax-free. Investment income between $851 and $1700 is taxed at the child's usually lower tax rate. After that, the investment income is taxed at the parents' tax rate, which can be as high as 35%. You can shift taxes to children by establishing a UGMA (Unified Gifts to Minors Act) account with a stock brokerage firm or mutual fund company.

Tax Aspects of Investing

Long-term vs. short-term capital gain taxes. In a taxable account, if you held a stock for more than a year, the capital gain will be taxed at 20% (10% for people in the 15% tax bracket ). If you held a stock for a year or less, then the capital gain is taxed the same rate as your tax bracket.
New Development for capital gain tax: A new rule takes effect in 2001, which lowers the capital gain tax for investments longer than 5 years. If you are in the 28% tax bracket, and acquire an investment in 2001 or later, and hold it for longer than 5 years, the captial gain tax rate will be 18%. If you are in the 15% tax bracket, and hold an investment for more than 5 years (no matter when the investement is acquired), the capital gain tax rate will be 8%.

Taxable vs. other investment accounts. For a tax-deferred (e.g. 401k or traditional IRA) or tax-free (e.g. Roth IRA) account, you don't need to hold a stock for more than a year just because of tax consideration. You should allocate tax-efficient investments (e.g. index mutual funds, municipal bonds) in your taxable accounts. Put investments that have a high turnover rate (e.g. actively managed mutual funds) in a tax-deferred or tax-free account.

Mutual Fund Distributions If you want to invest in mutual funds in a taxable account, be careful about the date for capital gain and dividend distributions. The rule is not to buy right before the distribution date. You are taxed on the distributions you receive. At the same time the share price of the mutual fund will drop to reflect the distritutions. Buying mutual funds right before the distribution will bring tax liability to you but no appreciation for your assets. For example, if you invested $10,000 in a mutual fund at $50 per share, right before the distribution, you get 200 shares. After a distribution of $10 per share, the share prices drops to $40 per share. You end up with 200 shares and $2000, still worth $10,000 (you can choose to reinvest the distributios and end up with 250 shares). All you have is still just worth $10,000. But now you own tax on $2000. Therefore, you should wait until right after the distribution to invest. This rule does not apply to a tax-deferred or tax-free account.