One of the biggest mistakes many investors make is not considering the effects of taxes on their returns. Local, state and federal taxes can take a big bite out of your investment earnings.
This makes it critical to formulate strategies for minimizing the impact of taxes on your investments. Here are six strategies that can help you reduce taxes on your investments:
- Concentrate on tax-efficient investments. The more tax-efficient your investments, the higher your after-tax return will be. Different types of investments can be placed all across the spectrum of tax efficiency — from highly tax-efficient to grossly inefficient.
In general, investments that rely on price appreciation to generate return tend to be more tax-efficient than investments that rely on income to generate return. This is because investment income is taxed at ordinary income tax rates just like wages are, while price appreciation may be taxed at lower capital gains rates if the investment is held long-term (usually defined as more than one year).
Municipal bonds are probably the most tax-efficient investment available: Interest earned is generally exempt from not only federal income tax, but also state and local income tax for residents of the municipality. Common stocks, real estate investment trusts (REITs), investment-grade corporate bonds and convertible bonds are other tax-efficient investments. Meanwhile, junk bonds, straight preferred stocks and convertible preferred stocks tend to be among the most inefficient investments.
- Invest using tax-advantaged accounts. In the same way that some types of investments are more tax-efficient than others, some types of investment accounts offer more tax advantages than others do. There are three types of accounts from a tax perspective: taxable, tax-deferred and tax-free.
Regular investment accounts (both joint and individual), money market accounts and bank accounts are all taxable accounts. College savings accounts like Section 529 plans are tax-deferred, while retirement accounts can be tax-deferred or tax-exempt — traditional IRAs and 401(k)s are tax-deferred, while Roth IRAs and 401(k)s are tax-free. In general, investments that are tax-inefficient should be held in tax-deferred or tax-free accounts in order to minimize investment taxes. Conversely, tax-efficient investments should be held in taxable accounts.
- Hold onto stocks and mutual funds for at least one year. As described above, the gains realized on investments that are held for more than one year benefit from a long-term capital gains tax rate that is lower than ordinary income tax rates. The top long-term capital gains rate is currently 20%, and most people will pay a maximum rate of 15%. However, capital gains realized on investments held for one year or less are taxed at ordinary income tax rates, which could be as high as 39.6%.
- Harvest some tax losses. You might be able to offset some of your investment gains by selling other investments at a loss, a strategy known as tax-loss harvesting. For example, if you have realized a healthy gain in ABC stock but XYZ stock is down, you could sell XYZ stock, book the loss, and then reduce the amount of your taxable capital gain in ABC stock by the amount of your loss in XYZ.
You can use up to $3,000 of investment losses not only to offset capital gains, but also to reduce ordinary income. If your losses exceed $3,000, this amount can be carried forward to offset capital gains or reduce income in future years. Important note: You cannot sell an investment to harvest tax losses and then buy essentially the same investment again within thirty days — this is known as the wash-sale rule.
- Pay attention to the turnover ratios in mutual funds. In most mutual funds, the fund manager actively buys and sells securities, creating taxable gains if the fund is held in a taxable account. The more trading the fund manager does, the higher the fund’s turnover ratio — and the higher your capital gains taxes.
Index funds are the exception. These funds seek to track the performance of a common index, which keeps active trading — and thus capital gains taxes — to a minimum.
- Donate appreciated securities. This is more of a charitable giving strategy than an investing strategy, but it is still worth noting here. If you hold investments that have appreciated in value and plan to make a charitable contribution, consider donating the investment to the charity. The charity can then sell the investment and receive the full value without the burden of capital gains taxes. You will also avoid paying taxes on the gain and can deduct the investment’s full value as a charitable donation, if the charity meets the definition of a 501(c)(3) organization.
When it comes to investing, “it’s not what you make, but what you keep,” as the old saying goes. Put these six strategies into practice to keep more of your investment earnings in your pocket — not Uncle Sam’s.