Tips for Tax-Efficient Investing – Millennial Money



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There’s no getting around it: If you invest, you’re going to have to pay federal income taxes. The sooner you come to terms with this, the better. 

The main reason you need to pay attention to taxes as an investor is that they can diminish your annual returns — stifling gains and making it that much harder for you to achieve your financial goals. If you’re not careful, taxes can derail your retirement plans and leave you with much more taxable income than you anticipated.

Add it all up, and it’s obvious that tax efficiency is one of the best things that you can do to preserve your wealth. This article explores some strategies you can take to reduce the impact of taxes on your investment income.

Taxable vs. tax-advantaged accounts

There are two types of investment accounts: taxable and tax-advantaged accounts. 

Taxable accounts

Taxable accounts do not have any tax advantages. In other words, you’ll pay taxes on any capital investment returns — or realized gains — that you make. You’ll also receive a tax bill for qualified dividends and any interest income you accrue.

For example, a brokerage account is a taxable account. This type of account can provide direct access to stocks, municipal bonds, index funds, exchange-traded funds (ETFs), mutual funds, and real estate investments.

Brokerage accounts are flexible, as they are generally liquid. However, you have to pay taxes on the money that you make in this account when you trigger a taxable event (e.g., selling stock for a profit).

When you have a brokerage account, it’s important to pay attention to how long you hold your investments. If you hold your investments for less than a year — meaning you trade a stock and make money on it within 12 months — you’ll have to pay a short-term capital gains tax based on your ordinary income tax bracket. 

If you hold an investment for more than one year, you’ll pay a long-term capital gains rate of 0%, 15%, or 20%. Your capital gains tax rate will correlate with your tax bracket. 

Tax-advantaged accounts

Tax-advantaged accounts still require you to pay taxes. However, they give you tax benefits in the form of more flexibility by letting you choose when you pay Uncle Sam. Still, there are a number of nuances between the different account types, so it’s important to do your due diligence to see what options are available to you.

Tax-exempt accounts 

Tax-exempt accounts like Roth IRAs and Roth 401(k)s allow you to contribute after-tax dollars to fund your retirement. In other words, you won’t be able to receive an immediate tax break when you use either of these Roth accounts.

The tradeoff is that your investments can grow on a tax-free basis for decades until you reach retirement age. Once you begin taking required minimum distributions during retirement, you won’t have to pay any taxes on those funds.

Tax-deferred accounts

Tax-deferred accounts like traditional 401(k)s and traditional IRAs work a bit differently. With these types of accounts, you receive an upfront tax break, meaning you can write them off for a lower tax bill. However, you’ll have to pay taxes when you touch the    money in retirement. The tradeoff is that you’ll have more funds to grow over time while lowering your income tax rate in the near term.

Tax-smart tips for investors

Now that you have a basic idea of how taxes work, here are some ways to reduce what you owe.

1. Maximize tax-deferred retirement accounts

There’s nothing wrong with opening a brokerage account. Investors often do this to fund short- to medium-term savings. 

For example, you may open a brokerage account if you’re saving for a house or a car. A brokerage account can produce strong gains that exceed the interest you would otherwise make by keeping your cash in a savings account. 

However, as an investor, you need to think longer than five or 10 years down the road. It’s critical to maximize your retirement savings so that you can take care of your future self. By putting your money into 401(ks) and IRAs, you can reduce the amount that you have to pay upfront and/or in the future. 

How contribution limits work

An important thing to keep in mind when opening a tax-advantaged account is that there will be limitations on how much you can contribute. 

For example, a 401(k) comes with an annual contribution limit of $20,500 for the tax year 2023 — meaning that’s the maximum amount that you can contribute to the account without facing a penalty. This is on top of any money your employer might put in your account.

Roth IRAs and traditional IRAs have much lower contribution limits of $6,000. You can have a Roth IRA and a traditional IRA, but your total contributions for both accounts must not exceed a combined $6,000. 

If you work for yourself, you may be eligible for a Simplified Employee Pension (SEP) IRA, which has a contribution limit of $61,000 for the 2022 tax year. 

If you are eligible for a 401(k) through work, you should strongly consider participating in the plan while opening an IRA on the side. Focus on maxing out your 401(k) and putting additional income into your IRA. 

How a 401(k) rollover works 

If you’re switching jobs, you’ll need to figure out what to do with your 401(k). 

Some employers let you keep a 401(k) open after you leave. However, you may have to switch your account to another 401(k) or an IRA in a process that’s called a 401(k) rollover

A 401(k) rollover is nothing to stress over. But from a tax standpoint, there is one thing you’ll want to be aware of: You’ll most likely have the option to perform a direct or an indirect rollover. 

In a direct 401(k) rollover, the bank automatically transfers the funds into another tax-advantaged retirement vehicle. The check gets written out to the other bank and the customer doesn’t have to intervene, apart from arranging the transfer. 

In an indirect 401(k) rollover, the bank sends the money to the customer. The customer then has 60 days from the date of the transfer to deposit the money into another tax-advantaged account. 

Here’s the catch: If you do an indirect rollover, the employer has to withhold 20% for taxes. So you’ll have to pay back the 20% that was withheld and put the money into the new account or you could face a 10% penalty. At the same time, you could lose any further tax advantages on the account.

As you can see, it’s much easier to do a direct rollover when transferring 401(k) balances to another account.

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What is a 529 college education account?

A 529 plan is another type of tax-advantaged savings plan that investors can use to maximize growth. Also known as qualified tuition plans, a 529 account allows contributions to grow on a tax-free basis. 

You can take tax-free withdrawals of up to $10,000 for tuition expenses for public, private, or religious elementary and secondary schools. Student loan payments and apprenticeships are now also qualified education expenses. 

So if you have kids or are considering having them someday, consider putting your money into a 529 account. It’s a good way to spread your investment allocation around.

Health savings accounts 

Another type of tax-advantaged account to consider is a health savings account (HSA), which is basically a savings account that you can use for qualified medical expenses — everything from medicine to surgery to BandAids.

To qualify for an HSA, you have to qualify for a high-deductible health plan (HDHP). In 2022, the annual deductible threshold is $1,400 for self-only coverage and $2,800 for families. You also aren’t allowed to enroll in Medicare, and nobody else can claim you as a dependent. 

The maximum HSA contribution you can make is $3,650 (individual) and $7,300 for families in the 2022 tax year. And if you’re 55 or older, you can make an annual catch-up contribution of $1,000. These figures include employer contributions.

There are three major tax advantages to using an HSA. First and foremost, you can make tax-free contributions through pretax payroll deductions. Or you could make contributions on your own and then claim contributions as tax deductions — meaning you don’t need an employer’s help. Self-employed individuals can also contribute pre-tax dollars to an HSA. 

HSA contributions can grow tax-free, and you can also invest them if you’re so inclined. Plus, when you take the money out to pay for qualified medical expenses, the money is tax-free. And when you turn 65, the HSA can function as a traditional IRA. In other words, you can withdraw funds for whatever purpose you deem fit. However, the money is taxable when you make withdrawals. 

Using life insurance 

Most people view life insurance as a way to provide a death benefit for a beneficiary. However, there are also plans that can provide living benefits and tax-deferred savings over time. It can also help you with respect to diversification.

For example, with a permanent life insurance policy, gains are not taxed until you withdraw them. Just as with an IRA, you can maximize gains over many years and grow your funds. 

In addition, some plans come with tax-free dividends and let you take out cash withdrawals without making a full surrender.

Plans tend to vary from company to company. Talk with an insurance agent about whether a life insurance policy can help you gain better tax treatment. 

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2. Look into tax-loss harvesting 

In addition to maximizing tax-advantaged accounts, you should also look into reducing taxes for a brokerage account. This is possible through a strategy called tax-loss harvesting. 

What is tax-loss harvesting?

Tax-loss harvesting is a strategy that lets you reduce taxes by offsetting capital gains taxes or up to $3,000 of ordinary income when filing jointly as a married couple with investment losses.

Just keep in mind that the IRS prohibits wash sales — or the practice of deducting capital losses from the sale of securities against capital gains distributions on the same security. Under the wash rule, a write-off is allowed only if you buy the same security, an option or option to buy a security, or an identical one within 30 days before or after you sold the investment that produced a loss. If you break the wash rule, the IRS may impose penalties. 

This is another area where it pays to consult with a tax professional before proceeding. It’s necessary to thoroughly review your portfolio and determine whether it makes sense to sell a security and write it off or keep it for future growth. 

Oftentimes, investors choose tax harvesting for investments that do not fit their strategy or have little to no growth potential or dividend yield.

3. Use a 1031 exchange for tax-deferred real estate growth 

If you have a real estate investment, you’ll face a capital gains tax whenever you sell a property. 

A capital gains tax is a levy for selling an asset that has appreciated in value since you purchased it. If, for example, you buy a house for $200,000 and sell it for $300,000, there is a capital gain of $100,000. 

Assuming you sell a property more than a year after buying it, capital gains taxes can be 0%, 15%, or 20% depending on your filing status and your income. 

You can potentially defer capital gains taxes on an investment property if you trade property for another of equal or lesser value.

How a 1031 exchange works

A 1031 exchange refers to section 1031 of the U.S. Internal Revenue Code. It’s meant for investment purposes and properties must be considered similar by the IRS.

From a tax standpoint, a 1031 exchange can be an incredible benefit as it can enable you to defer capital gains taxes indefinitely. In theory, you can avoid paying taxes under a 1031 exchange until your demise. At that point, if you pass along the property to an heir, the property will return to fair market value. 

A 1031 exchange is an excellent option for real estate investors who have owned a property for longer than 27 ½ years and are no longer eligible for depreciation tax credits. By completing a 1031 exchange at this point, you can potentially trade a property like a house for a portfolio of smaller investment properties. 

Further tips for tax-efficient investing 

Watch out for funds 

If you’re investing in mutual funds and exchange-traded funds, it’s important to know how they’re taxed. 

You pay taxes on any gains that you make when selling these funds — just as with individual securities. 

At the same time, you may have to pay taxes if the fund you own increases in value. This occurs when you sell securities for more than the original purchase price. Unfortunately, this means you could face taxes even if you don’t sell any shares. Net gains get passed on to shareholders annually. 

Cryptocurrency is not exempt from taxes

If you buy or sell cryptocurrency like Bitcoin and make a profit, you’ll have to pay taxes on it. 

Cryptocurrency taxes depend on two factors: how long you have held the currency and your income. 

The rule of thumb is that if you hold a cryptocurrency for more than a year, you’ll benefit from the lower capital gains rate. If you hold cryptocurrency for less than a year, you’ll face short-term capital gains taxes and will pay more.

Reduce taxes through charitable donations

Yet another way to reduce taxes is to make charitable donations. The U.S. tax code incentivizes charitable giving, meaning you can collect kickbacks in exchange for helping others. 

There are many strategies for reducing taxes through donations. For example, if you contribute appreciated stock instead of cash to a public charity, you can receive a fair market deduction. Or you can contribute real estate and potentially avoid capital gains taxes. 

Frequently Asked Questions

What are tax-efficient investments?

Tax-efficient investing is an investment strategy that involves strategically picking investments and putting them into certain accounts to maximize the amount you have to pay to the government. For example, putting your money into a retirement fund is an example of tax-efficient investing. 

What is a loss carryforward?

A loss carryforward is an accounting strategy that involves applying your current year’s net operating loss to a future year’s net income to offset profit. You may choose to do a loss carryforward if your expenses exceed revenue or if your capital gains are less than your capital losses. Talk to a financial advisor or tax advisor to see if this strategy is right for you.

What happens if you open a 529 account and your child doesn’t go to school?

This is a common question that investors ask when looking into 529 accounts, and rightfully so. After all, not all kids go to college. 

Regardless, a 529 college savings plan provides a great deal of flexibility for parents. You may have to pay a 10% penalty on these funds if you decide to withdraw them. However, you’ll still be able to collect tax-free gains for as long as the money remains in the account. 

What’s more, you can change the beneficiary for a 529 account and pass the money along to another family member for school. 

What happens if you exceed HSA contributions?

If you exceed HSA tax contributions, the IRS will impose a 6% excise tax on your excess contributions. The general thing to do in this situation is to leave the money in the account and pay the excise tax rather than take it out. 

The Bottom Line

No matter how you invest your money, you need to understand the tax consequences of your decisions. Keep careful track of what you owe throughout the year and use the above tips to reduce your tax burden. And don’t hesitate to hire a qualified tax advisor. 

If you’re diligent about investing tax-efficiently, you could potentially save a lot of money at the end of the year, with less overall tax liability on your investment decisions. 

And that’s the ticket to a stronger, more diversified portfolio that helps you on your journey toward financial freedom.





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