We all have different investment goals. But, in the end, we all want to minimize the taxes we pay to the Internal Revenue Service (IRS) and maximize our returns. Investors will want to pay attention to potential taxes on investments. Understanding ways to reduce, defer or eliminate taxes owed on investment gains allows you to keep more of your investment returns toward your financial goals. While this article focuses on federal taxation on investments, remember state and local taxes will often be levied on net investment income.
Key Takeaways
- Taxes are commonly the most significant expense on investments.
- Tax-efficient investing is a good strategy, especially for high-net earners.
- Tax-advantaged accounts offer numerous advantages.
How Are Investments Taxed?
The IRS taxes money made on investments but does this differently from earned wages. These differences include tax rates and when and how taxes are levied on investment income.
There are two ways investments generate income, and they are taxed differently.
- Capital Gains. A capital gain is an increase in the price of an asset, such as the value of a real estate property going up. The government typically taxes capital gains when realized and sold for cash.
- Dividends or cash income are monies received during the year and are typically taxed in the year they are received.
These are the primary rules investors must work around to minimize taxes owed and maximize profit.
Types of Investment Accounts
Many factors come into play when picking investments for your portfolio. While picking the right investment is important, you want to put those investments in the correct account. There are two primary types of investment accounts: taxable and tax-advantaged accounts.
Taxable accounts
Taxable accounts, such as brokerage accounts, offer fewer restrictions and more flexibility than tax-advantaged accounts. Taxable account returns are taxed on how long they were held before they were sold. Investments held longer than one year are subject to long-term capital gains rates, depending on the investor’s tax bracket. If an investment is held for less than a year before selling, it is subject to short-term capital gains and taxed based on the investor’s ordinary income tax bracket.
Tax-advantaged Accounts
Tax-advantaged accounts can be tax-deferred or even tax-exempt. Tax-deferred accounts, like traditional IRAs and 401(k) plans, provide an immediate tax break. Upon retirement, you’ll pay tax on distributions, which is tax-deferred.
Tax-exempt accounts work a different way. Contributions to Roth IRAs and Roth 401(k)s are made with after-tax dollars. The advantage is these investments grow tax-free, and you don’t pay taxes on qualified withdrawals. However, there are restrictions and penalties for withdrawals made before retirement, so make sure you understand your account restrictions.
8 Tax-Efficient Investment Strategies
There are numerous ways to minimize taxes on investment gains, whether behavioral, tax-advantaged accounts or efficient use of the tax code. The most popular tax-efficient investment strategies include:
1. Buy-and-hold Investing
The government only taxes you on realized gains, the money you make from selling an asset. This rule is a big loophole you can benefit from when practicing tax-efficient investing. If you don’t sell, you don’t pay capital gains taxes. Capital gains taxes can be substantial. Legally, you can hold investments indefinitely and permanently defer tax on gains. Another benefit of a buy-and-hold investment strategy is that long-term investments typically perform better. You make more money and pay less in taxes.
2. Open an IRA Account
Individual retirement accounts are a great way to invest your working wages for retirement while getting tax advantages. A traditional IRA puts money away on a pretax basis, reducing your yearly taxes. You get to defer taxes on profits like capital gains and dividends. In addition, you won’t have to pay taxes until you begin taking distributions after age 59 ½. It’s important to remember a tax-advantaged IRA has an annual contribution limit. For 2024, individuals can contribute $7,000 to an IRA or $8,000 if over age 50.
A Roth IRA allows you to put money away on an after-tax basis. While you won’t get a tax break on your working income that year, you can grow your contributions tax-free. And, you get qualifying distributions after age 59 ½ tax-free. Roth IRAs are a top pick among financial experts for retirement planning.
Remember the rules when considering which IRA plan is best for your retirement portfolio. If you make a mistake, you could be hit with heavy penalties.
3. Contribute to a 401(k)
An employer-sponsored 401(k) offers many of the same benefits as an IRA. Traditional 401(k) contributions can be made pretax, reducing your federal taxable income, while Roth 401(k) contributions are made after tax, offering tax-free growth potential. Like a traditional IRA, 401(k)s have an annual contribution limit. Investors can contribute up to $23,500 or $30,500 with the catch-up contribution. The combined employee/employer contribution cannot exceed $69,000, or $76,500 with the catch-up contribution.
4. Prioritize Asset Location
Maximize tax efficiency by putting investments in the right account. Since dividends and other cash distributions are generally taxed in the year you receive them, there’s no good way to avoid taxes. But you do have some options, like where you hold your assets.
A tax-advantaged account like an IRA may be a good option if you have dividend stocks. You’ll reap the benefits of tax deferrals by avoiding taxes on distributions today. Then, you can keep stocks with probable capital gains in a regular taxable account. You can still get tax deferral benefits since you won’t be taxed until you sell your investment.
| Types of Tax-efficient Assets in Taxable Accounts | Types of Less Tax-efficient Assets in Non-taxable Accounts |
| Index mutual funds, tax-exempt bond funds, individual bonds or individual stocks | Actively managed mutual funds, taxable bond funds or individual bonds |
Consult a tax advisor to help decide where to place your investments to best align with your financial goals.
5. Take Advantage of Tax-Loss Harvesting
Tax harvesting is a smart way to reduce or eliminate taxable capital gains. The IRS lets you write off capital losses to offset capital gains, which means you only pay taxes on your net capital gains. For example, you have one investment with a gain of $10,000 and another with a loss of $8,000. If you offset them, you’ll have a taxable gain of $2,000 and a smaller tax bill.
You can even offset more than you gain, up to a net loss of $3,000 per tax year. So, if you have an investment with an $8,000 gain and another investment with a $14,000 loss, you’ll have a net loss of $6,000. You can claim a $3,000 net loss on that year’s tax return, and the remaining $3,000 can be claimed in future tax years.
Tax harvesting is a common practice among investors. To avoid a wash sale, you can split net losses over the years and buy back an investment after 30 days. Consult a financial advisor to minimize taxable gains.
6. Utilize a 1031 Exchange
This strategy is for real estate investors. It can benefit those selling a property (not their residence) who want to reinvest in another. 1031 is a like-kind exchange; it allows investors to sell a property and defer capital gains if they invest the proceeds in another investment property. You can defer capital gains for decades while avoiding high real estate commissions.
Complex rules apply to 1031 exchanges and must be followed precisely. Make sure you understand all rules and restrictions to avoid losing tax deferral. This is a tax-efficient investment strategy that benefits from the expertise of a professional financial advisor.
7. Benefit From Lower Long-term Capital Gains Rates
While it's not the best strategy to hold onto an investment simply to avoid paying taxes, it does pay off in one case. While the IRS taxes gains on stocks held for a year or less at ordinary income tax rates, gains held for longer than a year are taxed at long-term capital gains rates: 0%, 15% and 20%. Waiting to sell appreciated stocks until they qualify for long-term capital gains may make the most sense, especially as a tax-efficient investing strategy for high earners.
8. Maximize Charitable Giving
If you plan to make philanthropy part of your investment goals, qualified charitable distributions may be a tax-efficient investment strategy. A few standard tax-efficient charitable giving options include:
- Gift-appreciated securities, like mutual funds, exchange-traded funds (ETFs) or individual stocks, to minimize future capital gains. Not all charities accept investment donations, so do your research before donating.
- If you don’t plan to use the standard deduction, you can itemize cash donations on your tax return for tax deductions. The annual deduction limit for 2024 is up to 30% of adjusted gross income (AGI) for non-cash asset donations and up to 60% of AGI for cash donations.
- For individuals over 70.5 years of age, you can donate up to $105,000 annually from your IRA to a qualified charity from a qualified charitable distribution.
Invest Smart, Maximize Your Bottom Line
Tax-efficient investing is a common practice for many individuals, including those with high net earnings, to achieve their overall financial goals. Minimizing tax liabilities by strategically leveraging tools such as Roth IRAs, 401(k)s, tax-loss harvesting and other tactics can maximize your after-tax returns. Whatever strategy you use, understanding the tax restrictions and applying informed strategies is essential for maximizing wealth.
Consulting a qualified tax planner, financial advisor or tax specialist will help you navigate these complexities confidently. Contact an LTax financial advisor today for personalized guidance tailored to your financial goals.
LEGAL OR TAX: The information herein is not legal, such as trust or estate planning, advice, or tax advice. Any such information is provided for illustrative purposes only and must not be relied upon without the benefit of the advice of your lawyer and/or tax professional. Lido specifically disclaims any liability from any reliance on such information. Lido is not a legal service provider or tax professional and does not offer legal or tax advice. Should you desire to obtain tax or legal services or advice, you must enter into your own, independent engagement agreement with a licensed attorney or tax professional.