How Can You Reduce Taxes on Your Investments?
6 min read •
30 sec brief
Investing success often gets boiled down to the size of your portfolio. But that misses the mark. It’s not what you earn, but what you get to keep after paying taxes that matters most. And taxes can take a sizable bite from your investing portfolios.
Investing success often gets boiled down to the size of your portfolio. But that misses the mark.
It’s not what you earn, but what you get to keep after paying taxes that matters most.
And taxes can take a sizable bite from your investing portfolios.
If you are saving for retirement in Traditional 401(k)s or IRAs, you will owe income tax on every penny you withdraw in retirement. You also owe tax on interest and dividend income in taxable accounts. If you sell an investment in a regular taxable account that you have owned for less than a year, for a profit, you will owe income tax on the gain. If you profited from selling an investment you owned for more than a year, you will pay the long-term capital gains tax. For most investors, that’s either 10 percent or 15 percent.
The good news is that there are many ways to reduce, and even eliminate, the tax hit to your investments.
Consider Tax-Free Investing Options
- Contribute to a Health Savings Account. If you have a high deductible health plan (HDHP) you are eligible to contribute to a Health Savings Account (HSA). The money you save in an HSA delivers unmatched tax breaks. The money you contribute is eligible for a tax deduction, your money is not taxed as long as it is in your account, and if you ultimately spend money from the account to cover qualified health care costs you will not owe a penny on tax.
You can use money in your HSA to pay current health-care bills, or you can invest the money with an intention to use it for retirement health care costs. The triple-tax break on HSAs makes them a more valuable retirement savings plan than Traditional or Roth accounts, which require you to pay tax at some point.
- Invest in Municipal Bonds. If you have investments in regular (taxable) accounts, and you want to earn a steady income, the interest paid on municipal bonds is exempt from federal tax. And if the bond was issued by your state –and your state has an income tax—you will not owe any state income tax. There are many low-cost municipal bond funds and ETFs you can invest in to own a diversified portfolio of muni bonds. Keep in mind that it’s just the interest income that is tax-free; any gains on the value of your muni bond portfolio are taxable.
Avoid Taxes While Your Money is Invested.
Compound growth is the secret sauce for investing. Over the years, as your portfolio grows you earn gains on a bigger sum. For example, if you start with $1,000 and it grows 10 percent you have a $100 gain, and a portfolio value of $1,100. If you earn another 10 percent on that $1,100, your gain will be $110, not $100. Let that play out over years and decades and compound growth is going to be a major force in reaching your financial goals.
Your goal should be to pay as little tax as possible in the years your money is invested. The less you pay in tax, the more money that can keep compounding.
- Save for retirement in IRAs and 401(k)s. All retirement plans let your money grow without any tax bill while the money stays inside the account. This is what is called tax-deferred investing.
- Be a passive mutual fund investor. If you own mutual funds in a regular (non-retirement) account, you run the risk of being hit with a tax bill from the fund every year, even if you didn’t touch your money. Mutual funds that are “actively managed” by a pro who is buying and selling stocks and bonds, tend to make these taxable distributions. Mutual funds that take a passive approach and track an index, typically do not generate a tax bill until you sell. Like index mutual funds, exchange-traded funds (ETF) are also very tax-efficient.
Be on the Prowl for Ways to Reduce Your Tax
- Use Losses to Offset Gains. When you sell an investment in a taxable account for less than you paid for it, you have a taxable loss. That loss can be used to offset any investment gains you have from a sale, which will reduce your tax bill. Long-term losses are used to offset long-term gains, and short-term losses are paired with short-term gains. If you don’t have gains you can deduct a loss from your income. (The annual limit is $3,000 but you can roll over bigger losses into subsequent years.)
Using losses to reduce your gains is called “tax-loss harvesting.” It can be a valuable way to reduce the tax hit on regular investment accounts.
- Look farther into the future. Human nature sets us up to gravitate to what feels the best today, and not think much about what might feel best in the future. But one of the smartest tax-saving moves you can make as an investor is to consider when you want to pay tax on your 401(k) and IRA accounts.
There is no way to avoid paying tax once on retirement accounts. With a Roth IRA or Roth 401(k), you pay the tax when you invest: the money you contribute to those accounts have already been taxed. With a Traditional IRA or 401(k) you pay the tax when you want to use the money in retirement: the money you contribute is made with pre-tax dollars that reduce your tax bill for the current year, and then in retirement you will owe income tax on every penny withdrawn from your traditional retirement account.
Clearly, investing in a Traditional IRA or 401(k) feels better right now: you get an upfront tax break! But if you step back and think about the long-term, having savings in Roth accounts can set you up for a less taxing retirement: all withdrawals will be 100 percent tax-free. And with Roths, you will not be hit with Required Minimum Distributions in retirement. RMDs are mandated on all traditional retirement accounts once you turn 70 1/2, even if you don’t need the money. Why? So Uncle Sam can collect taxes.
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