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4 Tax-Smart Investment Strategies

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While taxes are a fact of life, there are ways to reduce your tax burden through tax-smart investment strategies.

Adjusting the type of investment and investment account can make a difference in your tax bill when it's time to settle up with the IRS.


1. Tax-Smart Retirement Accounts

One of the simplest ways to reduce your tax bill, while helping preserve your wealth, is to invest in tax-deductible or tax-advantaged accounts such as traditional or Roth IRAs.


Traditional IRAs

Traditional IRA contributions are tax-deductible on your federal and state returns, but then withdrawals made during retirement are taxed as ordinary income. So, if your income is $50,000 and you contribute $5,000 to a traditional IRA, your taxable income drops to $45,000.

Anyone who is younger than 70-1/2 and has earned income can contribute to a traditional IRA. Eligibility for the IRA tax deduction varies, depending on whether you have a retirement plan at work and your income level.

Your total annual contributions to both traditional IRAs and Roth IRAs cannot be more than $5,500 (or $6,500 if you're age 50 and older) for 2018.


Roth IRAs

Contributions to Roth IRAs are not tax deductible, but then their earnings and withdrawals are generally tax-free.

Unlike traditional IRAs, Roth IRAs are subject to income level restrictions. For 2018, Roth IRA contributions are limited to those making less than $135,000 as a single filer or less than $199,000 as a married couple filing jointly. 


SEP IRAs and SIMPLE IRAs

Self-employed or small business owners may also want to consider SEP IRAs or SIMPLE IRAs. Contributions to these accounts are tax-deductible. Choosing between the two will depend on your income level, the size and structure of your business, and other factors.

A SEP IRA is open to any business with at least one employee and is capped at 25% of compensation or $55,000 in 2018. Contributions to a SIMPLE IRA are capped at $12,500, or $15,500 if age 50 and older, in 2018.

Savvy investors use a combination of different accounts to minimize taxes. If you're not certain what tax bracket you'll be in when you retire, you can consider contributing to both traditional and Roth IRA accounts. Then, once you're in retirement, you'll have more flexibility to withdraw money strategically to lessen your taxes.


2. Tax-Efficient Investing

Different asset classes are taxed differently. Certain investments, such as municipal bond funds or tax-managed mutual funds, generally are not subject to federal income tax, while U.S. Treasury bonds are generally exempt from state and local taxes. On the other hand, gains from stocks and high-yield bonds are subject to taxes, but the tax burden can be reduced if you keep them in tax-deferred accounts such as traditional IRAs.

Part of tax-smart investing means keeping in mind both the asset class and the type of account you keep the investment in. Generally, tax-smart investors:

  • Keep investments that are not as heavily taxed in taxable accounts. This would include stocks that you hold on to for more than a year, tax-managed stock funds, and ETFs or other index funds.
  • Place investments that are less tax-efficient into tax-advantaged accounts. These include stocks that are held for less than a year, real estate or REIT funds, high yield bond funds, and actively managed funds with high turnover.

3. Holding on to Investments Longer

How long you hold on to an investment makes a difference to your tax rate. Gains made on stocks held for less than a year are taxed at ordinary income rates, whereas stocks held for longer than a year are taxed at the long-term capital gains rate of 15% to 20%. That's a sizable difference for high income earners in the 35% tax bracket.

Also, if holding on to certain investments means taking a loss, that might not be a terrible thing either, from a tax perspective.


4. Using Losses to Offset Gains

Losing money is painful, but those losses can be put to good use. If you lose money on an investment in, say, stocks, you can use it to offset any capital gains you have. If you have more capital losses than gains in a year, the IRS allows you to use up to $3,000 of that loss to offset ordinary taxable income.

The combination of using losses to offset capital gains and ordinary taxable income can make a big difference in reducing your overall tax liability for the year. Just beware of “wash sales" in which you realize a capital loss, then go back and buy more of the same or a “substantially identical" investment within 30 days. In that case, the IRS may not allow you to use the loss for tax purposes.

This article was updated in January 2019.


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