Investing comes with many decisions, and some of the most important ones have to do with taxes. Although tax considerations shouldn’t be the only part of the equation, there are investing strategies that you can use to minimize the impact taxes will have on your finances in both the long- and short-term.
Here are six suggestions for making sure your investments are as tax-efficient as possible. To determine which strategies might work best for you and your financial situation, be sure to consult with your tax professional.
Take full advantage of tax-advantaged accounts
As long as you’re eligible, contribute to tax-advantaged retirement accounts. It can be helpful to look at these accounts based on their current and future tax implications.
For example, contributions to a traditional IRA may be tax-deductible in the tax year you contribute. Contributions to a traditional 401(k) are made pre-tax, thereby reducing your taxable income for that year.
When it comes to future tax impact, contributions to a traditional IRA or 401(k) grow tax-deferred, meaning that you’ll pay taxes on that money when you withdraw it. On the other hand, your contributions to a Roth IRA or Roth 401(k) will grow tax-free; these contributions are usually made with after-tax money and are not tax-deductible.
Think long-term—long-term capital gains, that is
Investing is generally best thought of as a long game, and that can also be the case when it comes to capital assets. That’s because long-term capital gains come with favorable tax treatment. If you hold a capital asset for longer than a year, your tax rate will be 0%, 15%, or 20%, depending on your income. However, if you hold an asset for less than one year, you’ll be taxed at your ordinary income rate.
For 2021, married couples earning up to $80,800 and single individuals earning up to $40,400 will be taxed at 0% for long-term capital gains. That tax rate increases to 15% for married couples earning in the $80,801 to $501,600 range and single filers earning between $40,401 and $445,850. Taxable income above those ranges means the capital gains tax rate is 20%.
Use the tax-loss harvesting technique
This involves using any investment losses to offset your gains in a given year. Where your losses exceed your gains, you are able to offset up to $3,000 of earned income each year, and carry additional losses forward to future tax years.
Tax-loss harvesting offers even more value if you are a high-income earner because of the long-term capital gains tax rate plus the additional net investment income tax of 3.8%.
Aim for tax diversification
Diversification isn’t just a risk-management investment strategy. It’s an important strategy for tax-efficient purposes, as well. Tax diversification refers to spreading your contributions or savings across types of accounts that are taxed differently, such as a traditional IRA, Roth IRA, 401(k), and a brokerage account.
Here’s why it matters: When you invest in more than one account type, you can draw income from different sources in retirement in such a way to minimize your taxes. This is especially helpful because it’s difficult to predict what impact tax laws will have on your retirement decades in advance.
Consider tax-exempt investments
Income earned from municipal bonds is typically free from federal tax, and sometimes state and local taxes. Other options include tax-exempt mutual funds (which hold municipal bonds and other governments securities) and tax-exempt exchange-traded funds.
This goes along with tax diversification. While it wouldn’t be smart to invest everything in municipal bonds, for example, it’s certainly worth discussing how and where to include these kinds of investments with your advisor.
Make sure your wealth advisor and tax advisor can work as a team
Lastly, it’s always ideal if your wealth advisor and tax professional are on the same page when it comes to your financial plan. Your investment accounts and your taxes aren’t mutually exclusive. When your entire financial team is positioned to collaborate for your benefit, they’ll find greater efficiencies and ways to help you reach your financial goals.
Would you like to make sure you’re set up for tax-efficient investing? Our team of wealth advisors and tax professionals are here to help you minimize your tax burden and maximize your investment potential. Contact us to get started today.