Successful investing isn’t just about what you earn, it’s also about what you keep. Investment taxes can take a significant bite out of the profits you generate, greatly reducing your actual rate of return. However, there are multiple ways that you can minimize the tax liability on your investments, from the types of securities you buy to how and when you sell them. While not all of these strategies will apply to all investors, here’s a range of options for you to consider when looking at reducing the tax liability on your 2021 taxes.
Harvesting Tax Losses
No one wants to take investment losses, but when it comes to tax time, they can actually serve a helpful purpose. If you have any realized capital gains, you can sell losing positions to offset those gains. If you have more realized losses than capital gains, you can even use up to $3,000 of your excess losses to offset ordinary income. The bottom line is that harvesting tax losses to offset gains and income can be immensely beneficial to your tax situation. Just be aware of the so-called “wash sale rule,” which prevents investors from buying the same or a substantially identical security within 30 days before or after taking a capital loss. If you violate this rule, your capital loss is disallowed.
Buying Municipal Bonds
Municipal bonds are an income-generating investment that carry the added benefit of paying income that is free from federal taxes. Municipal bond income is also typically tax-free for residents of the state that issues the bonds. Although municipal bonds typically pay lower rates of interest than corporate bonds, the tax-free component of their income can be a huge boon for investors, particularly those in the top tax brackets. Many municipal bonds are also insured and carry AAA ratings, making them among the safest investments available.
Owning Tax-Efficient Mutual Funds and/or ETFs
Some mutual funds and exchange-traded funds create massive tax liabilities at the end of the year. This is because funds are required by law to pass through their investment income and capital gains. However, some mutual fund managers actively take tax consequences into consideration when making trades, and those are the ones you should target as an investor if you’re looking to minimize your tax liability. Exchange-traded funds are often tax-friendly because they are typically passive investments that track an index. Unlike an actively managed fund, in which securities are constantly bought and sold, index-tracking ETFs remain relatively static, thereby creating few, if any, capital gains.
Investing in Tax-Efficient Accounts
Tax-efficient accounts like IRAs and 401(k) plans not only offer tax-deductible contributions, but they also defer taxes on income and capital gains until you withdraw the money in retirement. As such, they are great ways to minimize your tax bite on an annual basis. In an IRA, for example, you can make as many stock trades as you would like, taking an unlimited amount of otherwise taxable short-term gains, and not even have to report them to the IRS in the year you make them. The same is true in 401(k) accounts, although those plans typically carry a roster of mutual funds rather than individual equities.
Donating Appreciated Assets
Sometimes the best way to avoid taxation on heavily appreciated assets is to give them away. By donating an asset to charity, not only can you get a tax writeoff for the value of your gift, but you can also avoid paying tax on its appreciation. Charitable donations also carry a host of ancillary benefits, from helping out a good cause to enhancing your status as a philanthropist. Gifting strategies can get complex, but they can also be a great way to avoid paying taxes on certain assets, particularly for wealthier investors. To understand what options might be best for you, consult with a tax or estate specialist.
Avoiding Short-Term Capital Gains
When it comes to taxation, short-term capital gains are what all investors should try to avoid. Short-term capital gains are taxed at your ordinary income tax rate, which between federal and state taxes in some cases can exceed 50%. It’s hard to consistently generate large profits when you’re forking over more than half of what you’ve earned. If you can extend your holding period to at least one year on your stocks, however, that problem disappears. For most investors, the long-term capital gains rate peaks at 15%, and for some investors, that rate drops all the way to 0%, allowing you to keep everything that you earn.
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