Investing is the process of growing your financial assets. There are various ways to do this: investing in assets that provide a cash flow, rising prices, or both, is only the most obvious way. Another way, one that complements a growing investment portfolio, is keeping investment expenses low.
But possibly the biggest single investment expense is income tax.
So what are the best ways to reduce taxes on investments?
Capital Gains Should Be Long-Term
There are various strategies floating around for generating big investment returns through short-term trading. An extreme example is day-trading, a practice by which you try to maneuver your money in and out of various investments at hopefully opportune moments.
The problem with all short-term trading strategies is the exposure to maximum income tax liability. Short-term trading means short-term capital gains.
Any time you sell a capital asset in under one year, any profit you earn on the sale is added to your total income and taxed at ordinary rates. If you are taxed at the highest rate (39.6%), the taxes incurred will take a big chunk out of any profits you earn.
A better strategy -– one earning you bigger profits by default -– is to invest for long-term capital gains. Even if you are at the top tax rate, the tax on long-term capital gains will be no more than 20%.
And if you are in the 15% tax bracket or less ($72,500 for married filing jointly, and $36,250 for single filers) your long-term capital gains tax liability will be zero.
Any capital assets you hold outside of a tax-sheltered account should aim specifically for long-term capital gains to minimize your tax liability.
Keep Your Portfolio in Tax Sheltered Accounts
Tax-sheltered investment accounts, primarily retirement accounts such as 401(k)s, 403(b)s, and various IRA plans, offer the opportunity to allow your investments to grow free from tax considerations.
They aren’t tax-free, but they are tax deferred, and will enable your portfolio to grow much more rapidly than it would in a taxable account. You won’t have to deal with tax considerations until you begin making withdrawals when you’re retired, and by then you should be in a lower income-tax bracket.
These are the best accounts for interest and dividend earning investments, as well as the type of investing that produces short-term capital gains. Your money will accumulate without creating the tax liability these types of investments normally produce.
Invest in Municipal Bonds
Municipal bonds are the one definite exception to holding interest bearing investments in a tax-sheltered account. Interest earned on municipal bonds is free from federal taxation, as well as from taxes within the issuing state.
If your state has a particularly high tax rate, you should favor municipal bonds issued by your own state. Any municipal bonds that originate from other states will be subject to income tax in your home state.
Consider Real Estate Investments
Real estate offers the potential for both current income (positive rent income), as well as capital appreciation in the form of rising property values. It also offers three major tax advantages:
- A positive cash flow (rent minus expenses) is typically offset by depreciation for income tax purposes.
- The value of the property can rise for many years but will not be subject to income tax until the property is sold.
- Once the property is sold, it will have the benefit of qualifying as a long-term capital gain, subject to lower income taxes.
Real estate isn’t the most liquid asset, but it has been a solid performer over the past half-century. And the combination of tax advantages it offers can be comparable to a tax-sheltered portfolio.
Try Index Funds
Surprise, index funds is a great way to reduce taxes on investments. Not many investors think of index funds in this way, but it is actually one of best their functions.
They aren’t tax-free, they aren’t even tax-deferred, but they most certainly qualify as tax efficient investments.
As index funds are established to match the underlying index — say, the S&P 500 — they don’t trade individual stocks until and unless the index makes a reallocation. This doesn’t happen all that frequently, so trading is kept to a minimum.
Everything else in the portfolio is kept constant. This means very little selling of stocks and the tax liability it generates. And even when they do sell, it produces tax favored long-term capital gains.
Contrast these with actively managed funds, which trade stocks frequently in an attempt to beat the market. These types of funds will not only generate capital gains, but will often generate short-term capital gains, which do not enjoy the same tax advantages the long-term variety do.
Index funds can grow over many years, with little income tax impact at all.
Consider the impact of taxes in all of your investments and invest accordingly. There are ways to get around most investment related tax burdens, or at least to keep them to an absolute minimum.
What’s another way you can reduce your taxes on your investment portfolio?