- Managing, deferring, and reducing taxes shouldn’t be the primary driving force behind your investing strategy.
- Consider the role of losses, investment timing, and investment selection when managing federal income taxes.
- When appropriate, tax-deferred accounts can help you keep more of your money invested and working for you, and you can then pay taxes on withdrawals in the future.
- A 529 plan can be used to fund education expenses as well as reduce taxes by donating appreciated securities.
The research process for stocks, bonds, and mutual funds with good return prospects can take untold hours for some investors. A lot of investors overlook one way to potentially increase their returns: tax efficiency. They read articles, watch investment shows, and ask friends for advice.
Although taxes shouldn’t be the primary driver of your investment strategy, better tax awareness can help you boost your after-tax returns. Investing tax-efficiently doesn’t have to be complicated, but it does take some planning. Based on Morningstar estimates, for the period 1926 to 2018, an average investor lost 1% to 2% of his or her return to federal income taxes per year. Assuming a portfolio earns 8% instead of 6%, that extra 2% return would result in $1 million after 40 years on a $100,000 portfolio. Here are some tips on how to make this one of the best investment decisions of your life this year or any other.
The federal income tax can be managed in several ways: by choosing investment products, choosing the right time to buy and sell, choosing accounts, taking advantage of losses, and by implementing specific strategies such as charitable giving, all of these factors can be combined into a cohesive approach that can help you manage, defer, and reduce taxes.
As part of your investment decision, you should consider your goals, financial situation, timeline, and risk tolerance. But factoring in federal income taxes may allow you to build wealth more quickly.
You can impact your tax burden by choosing investments and when to buy and sell them. You should not let tax considerations drive your investment strategy, but you should incorporate these concepts into your ongoing portfolio management process.
A loss on the sale of a security can be used to offset any realized investment gains, resulting in up to $3,000 in annual taxable income. It is important to follow Internal Revenue Service (IRS) rules regarding wash sales and tax treatment of gains and losses when using tax-loss harvesting strategies when rebalancing the portfolio in order to take advantage of losses for their tax benefits.
Carrying Forward Losses
If the realized loss exceeds the deduction limits in the year it occurs, the tax loss can be carried forward to offset future realized investment gains.
Increases in capital
Long-term gains or losses are taxed at 23.8% with a top federal rate of 23.8% (versus 40.8% for short-term gains). It is important to be aware of holding periods before you trade if you want to avoid paying high tax rates. Taxes are not the only consideration. Before trading, you should take into account the risk and return expectations for each investment.
Distributions of funds
Mutual funds distribute earnings from interest, dividends, and capital gains every year to their shareholders. No matter how long the fund has been held by a shareholder, they will incur a tax liability if they own it on the distribution date in a taxable account. In order to decide whether to buy or sell a mutual fund, investors may want to consider the distribution date.
Securities exempt from tax
Investing in tax-exempt securities differs depending on the type of investment. Municipal bonds, for example, are usually exempt from federal taxes, and in some cases receive preferential state tax treatment. Municipal bonds often offer better after-tax returns than traditional bonds. Real estate investment trusts and bonds interest, on the other hand, are taxed as ordinary income. Qualified dividends can also be a good option for investors as they weigh their investment options. In addition to long-term capital gains, qualified dividends are taxed at lower rates than ordinary income. (For more information, see Qualified Dividends.)
Selection of funds or ETFs
In general, passive funds tend to generate fewer taxes than active funds. Mutual funds and exchange-traded funds (ETFs) differ in terms of tax efficiency. Mutual funds are generally actively managed, ETFs are usually passive, and index mutual funds are passively managed. As a result, there is considerable variation in terms of tax efficiency within these categories, so make sure to consider a fund’s tax profile before investing.
In addition to deferring taxes, retirement savings accounts, such as 401(k)s, 403(b)s, and IRAs, also offer a number of other tax benefits. Tax-deferred annuities, which have no IRS contribution limits and do not require minimum distributions (RMDs), may be a good option if you want to increase your tax-deferred savings. By deferring taxes, you may be able to grow your wealth faster by retaining more of it and potentially growing.
Tax-advantaged retirement savings accounts may already be familiar to you.
Selecting an account
You should locate and hold investments that generate certain types of taxable distributions in a tax-deferred account rather than one that is taxable. They may benefit from that approach.
If you itemize taxes, you may deduct the value of your gift from your taxable income. These tax-aware strategies can help you maximize giving:
- You may even be able to eliminate capital gains taxes when you donate appreciated stock or mutual funds to a public charity. In total, you can donate 23.8% more if you don’t pay capital gains taxes.
- You may also be able to take an income-tax charitable deduction and eliminate capital gains taxes by donating real estate or private business interests (such as C-corporations and S-corporations; LLCs and LPs).
- By making charitable contributions to a donor-advised fund, you can offset the high tax rates associated with a high-income year. Consider contributing multiple years of your charitable contributions to charity in the high-income year if you plan on giving to charity for years to come. Then you’ll have money to support charities in the future when your income is high and will maximize your tax deduction.
Roth conversions or Roth IRA contributions may accelerate taxes instead of deferring them (read Viewpoints on Fidelity.com: Roth conversion questions).
Save with 529s
When it comes to saving for a child’s education, there are no shortcuts, but there are a few tax-efficient options you can consider. When you use a 529 account for qualified expenses, such as college and, since 2018, K–12 tuition costs, you can save after-tax but get tax-deferred growth potential and federal income tax-free withdrawals.
A health savings account (HSA)
Your retirement health expenses can be saved with a health savings account. Contributions to these accounts may be deducted from your taxable income, your savings can grow tax-deferred, and you may be able to withdraw your savings tax-free, if you use the funds for qualified medical expenses.
There is more to your financial strategy than taxes, but by taking advantage of the potential opportunities to manage, defer, and reduce taxes, you may be able to improve your finances.