5 Ways You Can Reduce Taxes in Your Investment Accounts
While they’re a necessary and unavoidable part of life, taxes can be a surprising drag on your portfolio over the long run. But this doesn’t need to be the case. There are simple ways you can improve the tax efficiency of your investing — here are five to get you started.
First: use your tax-advantaged accounts!
You should always consider taking advantage of tax breaks when you can. In the case of investments, that means contributing to your qualified retirement accounts and making sure to use the investments that benefit most from a tax shield.
Your IRA or 401(k) offers tax-deferred growth, which means that your investments can grow without incurring tax payments. Every year, money that you would have spent on taxes can be reinvested instead, which can pay major dividends over time. Once you retire, your withdrawals are taxed at normal income tax rates — but if you have a Roth IRA, you don’t pay taxes at all! Contributions to your Roth account are made on an after-tax basis, and growth and distributions are completely tax free.*
While choosing the right kind of account depends on your personal circumstances, you can still make the most of either option. To do so, consider focusing your biggest income-generating investments in these accounts. These might include dividend-paying stocks, real estate investment trusts (REITs), and small cap or actively managed mutual funds.
Depending on your risk tolerance, time horizon, and other factors; Investments that pay out dividends, experience higher volatility, or may traded more often are generally be a good fit for tax-advantaged accounts because they tend to generate realized gains more often. In a qualified retirement account, you won’t pay a penalty for that. Instead, your dividends can be reinvested and realized returns redirected towards future growth.
Second: Plan for capital gains and losses
When you do realize gains in a taxable investment account, see if they can’t be offset with losses. Almost every portfolio has some duds or under-performers which should be replaced, and you can use an annual rebalancing to review your holdings and see if you wouldn’t be better off without some of them.
Of course, it can be hard to accept a loss. In fact, psychological research has shown that we’re hard-wired to avoid losing: one famous study discovered that the pain we feel upon losing $100 is actually twice as great as the pleasure we feel when winning $100!**
Unfortunately, accepting losses is sometimes a necessary part of being an investor. But the good news is that you can make it less painful by using it as a chance to ease your tax burden. That’s because any realized capital gains you make in your portfolio can be reduced with realized losses.
For example, if you sold one holding in an account for a $20,000 gain and another for an $8,000 loss, your net gain would be $12,000. The good part is that you’d only be taxed on that portion. You’d also free up capital from your under performing investment that could be invested elsewhere.
Third: Remember that turnover affects taxes
Those realized gains and losses are generated through trading: every time an investment is bought or sold it generates a trading charge and a realized gain or loss.
When you have a fee-based account, trading fees are usually part of the package, but you still pay taxes on any gains made. This isn’t a bad thing in and of itself, but you do want to keep an eye on the tax implications. In the same way, actively managed mutual funds trade more often, so it’s important for their portfolio managers to keep an eye on the tax balance. When trading strategically, actively managed funds can make the most of their gains while also redeploying capital in a way that minimizes taxes.
Getting help from an advisor can provide you with guidance for making your own trading decisions and choosing managers who know how to manage the tax side of the portfolios. This can mean better performance and more streamlined trading, both of which can help your returns in the long run.
Fourth: Contribute to your retirement accounts
You’ve heard it before, and you’ll hear it again: for many people, contributing to a qualified retirement account is one of the best things you can do for your financial future. Not only do IRA and 401(k) accounts provide you with tax-advantaged long-term growth opportunities, but they help you to reduce your tax burden right here and right now.
Because traditional retirement accounts are funded with pre-tax dollars, any contribution you make is already providing a positive return — instead of paying, say, $150 in taxes on that $500 contribution, you get to keep and invest the whole amount. Not only are you giving your savings the opportunity to grow by shielding them from taxes over time, you’re able to reduce your tax bill today and pay yourself instead of Uncle Sam.
Finally: Make smart charitable contributions
You probably already knew that charitable giving is tax deductible. But did you know that if you donate long-term appreciated securities to charity you can deduct their full market value from your taxes? That is, instead of paying capital gains on what the stock has returned, you’re able to deduct the entire donation from your tax return.
For example, if you bought 100 shares of a stock at $10 and it’s now worth $20, your capital gain from realizing the growth would be $1,000 — on which you would pay a capital gains tax. But if you donate all 100 shares to charity, you can write $2,000 off your taxes.
It’s one of the most tax-efficient ways to give.
The deduction can be taken for amounts up to 30% of your adjusted gross income, and it’s a classic win-win: the cause you support gets an immense gift, and you get the benefit of a deduction on your tax return.
Taxes are a necessary part of life, but there’s no reason to overpay. With these tips, you can help to reduce your overall tax burden while helping to support your objectives and goals. As always, a particular strategy may or may not be appropriate for your specific situation, so be sure to do your homework or speak to a qualified financial advisor before making portfolio management decisions.
United Planners does not provide tax or legal advice
*To qualify for the tax free penalty free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 591/2 or due to death, disability, or a first time home purchase (up to $10,000 lifetime maximum). Before taking any specific action, be sure to consult with your tax professional.
**For an overview of this research, please see “Thirty Years of Prospect Theory in Economics: A Review and Assessment”, specifically page 175. http://faculty.som.yale.edu/nicholasbarberis/jep_2013.pdf