I recently had my tax appointment with my accountant and realized just how much of a tax savings I had because of the smart things I did with my investments. The great thing here is that the things I did to help keep my tax bill low weren’t difficult to do.
Ways to Reduce Taxes through Investing
Here are some tips to reduce taxes through investing for you to take advantage of before the tax deadline.
Put Money Aside for Retirement
I know, we’ve all heard this one, but you hear it because it works. For me, it works especially well since I’m self employed and contribute to a solo 401k. This allows me to not only put away the typical $18,000 limit as an employee, but I can contribute more as an employer.
In the couple years I’ve been working for myself, I never have been able to contribute the absolute max to this plan, but I sock away as much as I can. If you are in the 25% tax bracket and contribute $4,000 to your 401k at work, you just saved yourself $1,000 in potential taxes. To me this is no-brainer. You save for retirement and you save on taxes.
Pick Smart Investments
Mutual funds are a good option for many investors. You invest with a little bit of money and get professional management and are diversified from the start. But mutual funds don’t allow you to control capital gains.
Even if you don’t sell any of your holdings during a given year, chances are you still will have capital gains. It might look nice to get a couple hundred dollars when a mutual fund distributes a capital gain, but the downside is that you are taxed on that money.
To avoid this, you should look into exchange traded funds (ETFs). Many of these don’t pay out capital gains, only dividends. This will help you to keep your tax bill in check at the end of the year.
Now, don’t go run out and change all of your investments. You should slowly transition over to ETFs because if you sell your holdings in a taxable account, you will owe taxes on any gains you have.
This doesn’t apply to investments held in retirement accounts, since any income you earn from investments is tax deferred until you begin to withdraw the money.
Pay Attention To Asset Allocation
Asset allocation is making sure your portfolio is well diversified and working at the best it can to grow for you over time. One area that is sometimes overlooked by investors is what investments are where. This is important because it can have a large impact on your taxes.
In general, you should have assets that are the least tax efficient in retirement accounts and those that are most tax efficient in non-retirement accounts. So what does this mean?
If you invest in a bond portfolio that doesn’t hold government or municipal bonds, you want to make sure this is held in a retirement account. This is because bond funds pay off interest each month and that income is treated as ordinary income. So if you are in the 25% tax bracket, the monthly distribution the bond fund pays is taxed at 25% as well if you don’t have it in a retirement account.
Furthermore, you want to keep high turnover holdings in a retirement account too. These funds tend to throw off lots of capital gains, which you owe taxes on. You can find out what you fund turnover is by looking at a site like Morningstar.
Read More: What is a Backdoor Roth IRA?
Sell Some Losers
Another way to save on taxes through investing is to sell some holdings that declined in value when you have any realized gains. You are allowed to use the losses to “cover” the gains. In other words, when you add the loss to the gain, it will result in a lower ending number. This lower ending number is what you owe taxes on.
The nice thing is that you can use these losses to offset other income too, but only to an extent. The IRS allows you to offset $3,000 of ordinary income each year with capital losses.
So let’s say you have a capital gain of $5,000 and a capital loss of $10,000. You can use $5,000 of that loss to offset the $5,000 gain, bringing it to zero. You can then take another $3,000 of your capital loss to offset your ordinary income. This leaves you with a loss of $2,000 which you are allowed to carryover into future years. You can either use it on capital gains next year or against ordinary income.
Read More: 3 Benefits of Tax Loss Harvesting
One final option for investors to reduce taxes through investing is to donate securities. In this option, you can donate your holdings to a donor advised fund. With this option, you simply transfer holdings over to a donor advised fund. Once the assets are in this fund, you can instruct how you want the money to be divided up or what charity or charities you want it to go towards.
The reason this is a smart option is because you don’t have to realize any gains you earned when you donate. For example, let’s say you want to donate $10,000 to a charity. You have an investment that you bought for $2,000 and it is now worth $10,000. If you donate that $10,000 investment from your portfolio, you get to write off the $10,000 as a charitable deduction.
If you were to sell the holding and then make the donation, you would still get to deduct the $10,000 charitable donation, but you would also have to pay taxes on the $8,000 gain you realized when you sold the investment.
When it comes to taxes, there are many ways you can reduce your taxes through investing. Not all of these options will apply to everyone, but you should be able to use a couple of them to your advantage. Make sure you are doing all you can to keep your taxes low. The less you pay in taxes, the more money you keep in your pocket.