Everyone has to pay investment tax. However, certain strategies allow investors to significantly reduce their tax burden. It’s perfectly legal to do so and requires a basic understanding of tax structure.
Before discussing such methods, Let’s discuss the primary type of tax you’re liable to pay. Here is an overview:
- Capital Gain Tax: Profit from a sale of an asset is taxable. Assets may include properties, financial assets, and stocks.
- Dividends: Any kind of profit from stock dividends is taxable. It is taxable even if you reinvest the dividend to buy additional stocks.
- Withdrawal From 401(K): The amount that you withdraw from 401(K) is taxable in most instances.
- Tax on Mutual Funds: Income from mutual funds is taxable. Unlike stocks where you pay tax only when you sell a stock, you need to pay tax on the profits and dividends received from mutual funds.
Now that you have some idea of the most basic types of investment tax, here are six ways to reduce taxes on investments:
Sell Your Investment Before the End of the Year
If you’ve invested in stocks, you can get tax benefits by selling stocks that have lost value since the initial purchase. Selling losing stocks before the end of the year means that you don’t have to pay any tax on the potential income you lost.
The resulting amount can be used to offset any taxable capital gain and regular income. In financial terms, this is known as tax-loss harvesting.
While it’s true that you will need to incur a loss by selling losing stocks, you can always buy it afresh if the price is expected to rise in the future. Just make sure to consult with a professional accountant to review any restrictions on the purchase of the same stock within 30 days of selling it.
Use Tax-advantaged Retirement Accounts
You can reduce tax by investing in tax-advantaged retirement accounts. It is wiser to contribute to both the 401(K), tax-deferred accounts, and ROTH IRA, tax-free accounts.
For instance, 401(k)s, 403(b)s, and traditional IRAs are tax-deferred plans, which allow you to defer tax until a certain time in the future. Any contribution to such retirement plans is not taxed unless withdrawn after retirement. The main benefit of such plans is the active contribution from the employer.
Similarly, you can save by contributing to tax-free plans such as Roth IRAs and Roth 401(k)s. After 59 years, you will not be charged any tax on the withdrawals if the account is at least five years old.
Besides these, consider investing in 529 education savings plans and Health Savings Accounts (HSAs, which are also tax-free.)
Diversify Your Portfolio
Diversify your portfolio with tax-efficient investments. For instance, you can get potential tax-free income by investing in exotic instruments such as municipal bonds. While you may have to pay the tax at the state or local level, the federal government doesn’t charge a tax on such investments.
Selecting a tax-managed mutual fund is also a good idea to reduce taxes on investments. Fund managers operating such investments mainly focus on giving maximum tax relief to their clients. This is also true for specific ETFs that are designed to take advantage of the existing tax structure.
Another way to create tax-free assets is by investing in a qualified opportunity fund. You will get massive tax relief by investing in economically disadvantaged areas. The type of investment is particularly beneficial if you’re recognizing substantial capital gains because holding the fund for the long term can help get tax-free profits.
Spread Out Your Losses
Try to spread out your losses by taking advantage of numerous tax provisions offered by the government.
You can get maximum tax breaks by selling your primary residence if you owned the home for at least two years before selling it. If you’re married, filing jointly can give you the chance to exclude up to $500,000 from the home sale. This is a big boost for someone looking to find ways to get out of the debt or reduce the financial burden.
You can also reduce loss by taking advantage of the capital loss in investment. The law allows you to use the investment loss to offset up to $3,000 of other income. Likewise, any type of business expense can also be used to get tax relief. In a nutshell, spreading your loss to different types of investments can help gain maximum tax benefit.
Invest Strategically in Different Types of Investments
There are tons of investment strategies; however, not all of them are tax-efficient. When building an investment portfolio, make sure that you’re not blindly looking at profits only. Instead, focus on long-term strategies that can provide maximum tax breaks.
Besides investing in municipal bonds, treasury bonds, ETFs, and mutual funds, consider tax incentives from real estate, life insurance, annuities, and charity. Investing strategically in different types of investments will help diversify the portfolio, achieve goals, and allow you to take maximum advantage of your investments.
Get Advice From a Professional Accountant
If you’re looking to reduce taxes on investments but you’ve never consulted a professional accountant, it’s time to do so. Accountants are licensed to provide tax advice based on investment goals. They can also work with you to streamline financial resources according to your specific objectives and risk appetite.
While it’s true that there is a lot of literature on the Internet that can help you understand the basics, but it’s not a substitute for hiring a professional accountant. Only a professional can help visualize all the nitty-gritty of tax incentives that you may be entitled to.
Due to the nature of work, professional accountants know existing tax laws. They have a knack for finding tax incentives that can help their clients. Some clients develop long-term professional relationships with their CPA, which also helps in financial planning.
Whatever your goals, just make sure to consult a professional accountant as early as possible. Taking a proactive approach can help save a significant amount on tax this year.