You could save thousands of dollars per year in taxes by following the right investment strategies.
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Most beginner investors focus on making smart investments through high-quality brokers with low fees. These moves help -- but there’s another way to maximize your returns that many people miss.
Taxes can eat up a large chunk of your investment gains. To counteract this, use investment strategies to minimize your tax bill. Here are five ways you do that, starting today.
Note: You should always buy or sell investments based on your belief that they will gain or lose value over the long term. Don’t make investment decisions just to reduce your tax burden.
1. Max out contributions to tax-advantaged accounts
The simplest and most effective way to save on taxes is to put as much of your money as you can in tax-advantaged accounts. These include
- individual retirement accounts (IRAs), and
- health savings accounts (HSAs).
It’s worth noting that you can only open an HSA if you have a high-deductible health insurance plan.
Traditional 401(k)s and IRAs are tax-deferred accounts. You can contribute pre-tax income up to a yearly limit. This essentially means that you don’t pay income tax on the money you invest. Your investment grows tax-free, and you only pay taxes when you make a withdrawal.
In 2019, the yearly limits are $19,000 for a 401(k) and $6,000 for an IRA. (You can get more information on these limits and related tax deductions from the IRS).
HSAs are also tax-deferred, and you don’t pay taxes on withdrawals for qualified healthcare expenses.
2. Use your 401(k) for investments that would add to your tax bill
Certain types of investments add to your taxable income every year. The IRS considers investments that pay dividends or interest periodically to be income. Any dividends you receive count as income -- even if they’re automatically reinvested.
To avoid this, use your 401(k) for investments that would increase your tax liability. Since your 401(k) can grow tax-free, dividends and interest won’t be treated as income. Use it instead of your regular brokerage account to buy dividend- and interest-paying shares.
3. Sell losing investments by the end of the year
Investments that have lost value lower your tax liability. You must report the losses on your taxes, but you can carry losses forward indefinitely and use them any year that you like (we’ll clear this up with an example below).
If you want to deduct your losses from your taxable income, there’s a limit of $3,000 per year. There’s no limit on how much of your previous losses you can deduct from future capital gains.
Let’s say you lose $15,000 on investments in 2019. If you sell those investments before the end of the year, you’ve “locked in your losses.”
Here are two examples to show how you might take advantage of that $15,000 loss:
- You deduct $3,000 from your taxable income every year for the next five years.
- You don’t deduct the losses from your income. In 2021, you earn $20,000 selling your investments. You use your previous losses to lower your taxable capital gains from $20,000 to $5,000. This is called capital loss carryover.
4. Keep your winning investments for at least one year
There are two types of capital gains tax. Short-term capital gains tax applies to investments you sell after less than one year. Long-term tax applies to investments you sell after one year or longer.
Short-term capital gains tax is the same as your income tax rate, whereas long-term capital gains tax is 0%, 15%, or 20%, depending on your household’s income.
Long-term capital gains tax will almost always be the lower of the two rates. For that reason, aim to keep winning investments for a year or more (unless you believe it’s going to dip in value soon).
5. Consider investing in municipal bonds
Municipal bonds are issued by cities, counties, and states to raise money for public projects. Municipal bonds pay interest twice a year.
What makes these bonds so useful is that they’re exempt from federal taxes. When you purchase municipal bonds issued in your state of residence, they’re also exempt from state and local taxes.
While the average return on municipal bonds isn’t near the average you’d get from the stock market, these are low-risk investments that earn money without adding to your tax burden.
Get the highest return on your investments by minimizing taxes
Minimizing taxes isn’t as exciting as earning huge gains. But managing your tax burden is a crucial part of getting the highest return on your investments. Even small savings here and there makes a massive difference decades down the road.
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