No investor wants to see their profits consumed by the seemingly ever-hungry Uncle Sam. Thankfully, there are several ways to minimize your tax burden in investment situations. Though you’ll still pay out a portion of your profits, you can reduce your liability to more palatable levels.
Start with Tax-Favored Accounts
If you’re new to the investing game, consider starting with tax-favored accounts, such as IRAs and 401(k)s. Whether you open these accounts independently or through your employer, they’re a great way to minimize your long-term tax burden.
But if you open multiple accounts, keep in mind that tax rules can vary to either your advantage or your disadvantage.
With a traditional account, you pay taxes on your withdrawals, not your contributions. Thus, if you think you’ll be in a lower tax bracket a few decades from now, traditional accounts should be your first investment.
On the other hand, with a Roth account, you pay taxes on your contributions, not your withdrawals. Thus, if you think you’ll pay less now than you will in retirement, funding your Roth account first may be to your (tax) advantage.
Harvest Your Losses
When it comes to capital gains, harvesting tax losses is a popular strategy to offset your burden. This process involves selling investments at a loss for the purpose of reporting said loss on your taxes.
Currently, investors can deduct up to $3,000 per year in net capital losses. (If you sustain more than $3,000 in losses per year, you can “carry forward” the loss into future tax years).
However, beware of the wash sale rule: if you sell and repurchase a “substantially identical” security within a 30-day period, any favorable tax consequences are null and void.
Seek Out Qualified Dividends
While international investments help diversify your portfolio, they also come with alternative tax implications. Thus, if you want to minimize your liability to Uncle Sam, consider seeking companies that pay qualified dividends. Remember, qualified dividends come with a lower preferential tax rate than non-qualified dividends.
Note, too, that you may be able to reduce your tax burden by holding nonqualified assets in a tax-deferred account. By keeping domestic stocks in your brokerage account and deflecting the bite, you may lower your tax bill overall.
Hold Your Investments
It’s important to remember that how long your hold your position matters. Holding periods of less than one year often come with a higher tax bill than longer holding periods.
The same is true even of your retirement accounts. If you don’t hold off on withdrawing from your accounts until the age of 59½, you’ll be smacked with additional penalties.