Steve Nicastro for Nerd Wallet / NASDAQ writes" Who doesn’t want to pay less money to the taxman? With some careful planning, you can legally reduce taxes owed to the IRS on investment gains — which means more dough in your pocket to invest or spend as you please.
While some investors wait until November or December to even think about tax-saving strategies, you can be the early bird that gets the worm — or in this case, the lower tax burden. Here are three tax-sensitive investment strategies that can minimize your taxes and maximize your returns.
Increase contributions to tax-advantaged accounts
Putting more money in tax-advantaged retirement accounts is like killing two birds with one stone. You’ll save more money for your retirement, while potentially lowering your tax bill.
For example, contributions to a 401(k) are taken directly out of your paycheck, before you even get paid or taxed on earnings. With a traditional IRA, your contributions may be tax deductible — which could further reduce your taxable income, potentially minimizing your tax bill when it comes time to write Uncle Sam a check.
Let’s say you’re 30 years old, single and earn $100,000 a year from your job — but contribute the maximum 401(k) limit of $17,500 a year. Since you’re contributing $17,500 in pre-tax dollars to the plan, your taxable income before deductions would actually be $82,500 instead of $100,000.
So instead of being in the 28% ordinary income tax bracket, you would be in the 25% bracket, which lowers the amount of tax you’ll pay on your earnings. At the same time, this also lowers the amount you have to pay on gains from the sale of assets held under one year (short-term capital gains), from 28% to 25%, since short-term capital gains are taxed at ordinary income rates.
But there’s another huge benefit: Dividends and interest earned in these accounts are subject to taxes only when you withdraw the money at retirement. As long as you keep the money in your plan and follow the rules, you likely won’t have to pay a dime in taxes on any returns until it comes time to withdraw.
Focus on asset location
Investors should keep in mind that certain types of investments are better suited for tax-deferred qualified retirement accounts — such as a 401(k) or a traditional IRA — rather than in taxable brokerage accounts, says Robert Reed, a financial advisor in Columbus, Ohio.
“Asset location is just as important as asset allocation,” Reed says. “The tax advantage of these accounts means that it’s a great place to keep bond funds and the like … all the income these investments throw off will be tax-free, until you pull money out of the account.”
What if you want to hold income-producing assets in a taxable brokerage account, for income to help pay for your living expenses? One idea is to focus on buying municipal bonds — debt issued by states or local governments to fund projects — since these bonds are usually exempt from federal taxes and from most state and local taxes, says Melissa Joy, a certified financial planner in Southfield, Michigan.
“You can get exposure to bonds without a big tax hit by putting municipal bonds in your taxable account,” Joy says.
Sell your losers — and delay selling your winners
Do you have that one stinker in your portfolio that’s down 25% on the year, while the rest of your portfolio is riding high? Instead of sulking over the losing investment, why not use this opportunity to both cut your losses and lower your tax burden?
Selling part or all of the losing investment will offset the gains you’ve realized from your winners, which means fewer gains to report to the IRS. For example, if you’ve already locked in $10,000 in gains on winning trades — but sell $5,000 worth of losses in the stinker — you now only have to report $5,000 worth of gains instead of $10,000. With a long-term capital gains tax-rate of 15%, this means a potential $750 tax savings.
What if you want to deduct the loss, but think your losing stock will turn things around? This is where the “wash-sale” rule comes into play. The IRS says you can sell a stock for a loss, buy it back 30 days after the sale and still be able to deduct the previous losses. However, buy it back anytime before the 30-day period, and the deduction of your loss isn’t allowed.
Keep in mind that if you have losses on your stocks, you may be able to take up to $3,000 in losses to deduct against your ordinary income, according to the IRS. This means if you made $39,000 from your job, but deduct $3,000 in losses from a brokerage account, your taxable income would be $36,000, which drops you into the 15% tax bracket instead of 25%, for single filers. You also may be able to carry forward any losses on investments incurred over $3,000 from earlier years.
Perhaps the easiest way to delay or lower your taxes is by simply not selling your winning positions — or at least waiting to sell until you’ve owned the shares for one year. The reason is simple: Long-term capital gains are taxed at significantly lower rates (0% to 20%, depending on your income level) than short-term capital gains (ordinary income rates).
So if you bought a stock 10 months ago that has appreciated in value, but you think it has even more upside ahead, it may be worth it to hold onto the stock at least two more months to lock in the long-term tax rate. But if you think the stock has gotten a bit too far ahead of itself — or feel the company has poor fundamentals and could fall in value — it might be best to lock in profits, regardless of the tax consequences.
For more guidance, it’s a good idea to seek help from an investment advisor, certified financial planner or tax professional.
By taking a proactive stance on your taxes, you can keep more money in your pocket and grow your wealth at a faster pace. So don’t be afraid to start a little early.
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