We know that if you want to grow your money for the long term, investing in the stock market makes the most sense. While there is risk involved, taking on little to no risk with bank savings accounts will not allow our money to grow at the rate we need in order to reach certain financial milestones.
But there is another benefit to investing that many investors overlook. This benefit is saving on taxes. Yes, there are tax benefits from investing.
5 Tax Benefits from Investing
I am going to walk you through 5 such tax benefits from investing. You will see how investing will not only grow your money long term, but will also shelter some of it from Uncle Sam. And the more money you keep invested, the more it can compound and grow into larger sums of wealth. So what are these tax benefits from investing? Let’s get started and take a look.
Lower Income Taxes
When you contribute to your 401k plan at work, the contribution is made pre-tax. This means that the money is invested in your retirement account before Uncle Sam gets his hands on it. Let’s say you are single and earn $40,000 a year. This puts you in the 25% tax bracket. You’d pay $5771 in taxes (not $10,000 because of how tax brackets work).
However, if you were to contribute $3,000 to your 401k plan, your taxable income would drop to $37,000. You would save $750 in taxes at the 25% tax bracket.
Note that I am just keeping this basic here for you to follow along and ignoring exemptions, dependents, etc. There are many other factors that end up determining your tax bill, but this example will give you an idea of how investing in your 401k plan saves you money on taxes.
Health Savings Account
If you are covered by a high deductible insurance plan at work, you most likely have a health savings account. This is an account you put money into to cover you for medical bills. The great thing about a health savings account is that like a 401k plan contribution, a contribution to your health savings account is also made at the pre-tax level.
If you contribute to both your 401k plan and your health savings account, you can really reduce your taxable income. But the tax benefit for health savings accounts doesn’t end there.
In addition to being pre-tax, you can avoid taxes altogether on the money you put in the account. When you use the money on qualified medical expenses, you don’t have to pay any taxes on the money. It is completely tax free!
Another benefit to a health savings account is that you can invest a portion of this money as well. The benefit of doing this is that first, you contribute pre-tax to avoid any taxes. Second, your investments grow tax free, meaning you won’t pay taxes on any dividends or capital gains, and third, if you use the money from your investment health savings account for qualified medical expenses, you can avoid taxes here too. The money is completely free from tax!
This is why many people are using their health savings account as a hybrid Roth IRA. They save and invest the money now and plan to use the money for qualified medical expenses in the future.
Write Off Losses
Another one of the tax benefits from investing is the ability to write off losses. Let’s say you invested in a stock and you lost $1,000 when you sold. In the same year you invested in another stock and made $500 when you sold it. During this tax year you don’t owe any tax on the gain of $500. This is because you are able to write off the gain against the loss you took. Even better, if you don’t have any other gains, you can use the remaining $500 to write off against your earned income
As exciting as this sounds, there are some limitations. You first have to match short term losses with short term gains to get a net short term gain or loss. Then you have to do the same thing with long term gains and losses. After that, you can use short term losses to offset long term gains and vice versa.
From there, any unused loss that you have can be applied to earned income, up to $3,000 per year. In the event you have more than $3,000 in losses, you can carry forward the loss to future years and use the write off then. For example, let’s say in 2016 you had losses of $5,000 and no gains to offset. You can take $3,000 and offset it against earned income and carry forward the remaining $2,000 into 2017. If you have any gains in 2017 you use the $2,000 to offset them and if any loss remains, use it against earned income.
Invest In Tax Exempt Bonds
Bonds are a great way to lower the risk in a stock portfolio and still earn a decent return. The problem with bonds lies with the interest you earn. The IRS considers bond interest to be ordinary income. This means it gets taxed at your earned income tax rate and not a lower investment tax rate.
To overcome this, many investors put bond holdings in their retirement accounts. Since income, dividends and capital gains in retirement accounts such as a traditional IRA or a 401k plan are tax deferred, you don’t have to worry about paying any taxes on bond interest. The same holds true for a Roth IRA, the only difference being is that you won’t pay any tax at all.
Still, sometimes investors want bond exposure in their taxable accounts. What are your options? The best option is to look at tax exempt bond funds. Most times you can invest in treasury bonds and avoid taxes at the federal level. However, many states will still tax the interest income on these bonds.
Another option is to invest in municipal bonds from the state you reside in. Doing so will avoid state income taxes on the interest income, but in some rare cases, you will owe tax at the federal level.
Also note that the discussion only applies to taxing the income from a bond. When you sell a bond, you could owe capital gains taxes even though the bond is tax exempt.
The bottom line is that owning bonds in a taxable account while trying to limit taxes is tricky. Talking it over with your investment advisor or tax accountant is a good first step.
The last of the tax benefits from investing is the savers credit. If you are a low to moderate income taxpayer, the savers credit can help you avoid paying some taxes. All you have to do is contribute money to a retirement plan.
The credit is worth 50%, 20% or 10% depending on your adjusted gross income and is limited to the first $2,000 you contribute to a retirement account.
Doing the math, this means a $1,000, $400 or $200 tax credit just for putting $2,000 into your retirement account.
And the best part about the savers credit is that it works in addition to the tax savings by making a contribution in the first place that we outlined in the first point. So really you are double dipping here.
There you have 5 tax benefits from investing your money. The easiest one to take advantage of is saving for retirement, followed by the heath savings account contribution if you are covered by a high deductible health plan. And of course, if your income is low enough, just saving for retirement could shield an additional $1,000 from taxes.
At the end of the day, the more money you keep for yourself and invest, the more it can grow over time and improve your financial picture. Don’t pay tax when you can legally get around it. These options are simple to use and can save you a significant amount of money on your taxes.
Tax Filing Online
You can file your tax return online with TurboTax.
More Tax Topics
- 5 Ways to Reduce Your Taxes as an Investor
- 2016 Tax Calculator to Project Your Tax Refund
- How Much Money Do You Have to Make to File Taxes?
- Roth Conversion Strategy to Minimize Taxes
- Can You Have a 401k and an IRA at the Same Time?
- When is the Tax Deadline?
- Health Insurance Premium Tax Credit