Investing your money wisely can increase your net worth, but the increase doesn’t come without a price. As you reap the gains from your investments, the IRS will want its cut. But there’s no law that says you can’t find ways to lower the amount of taxes you hand over to Uncle Sam.
Savvy investors know about legal tax breaks to minimize the amounts due on their tax filing, and you can, too. Discover tips on how you can follow IRS rules but keep more of your investment earnings at tax time.
1. Hold Stocks for More than One Year
When day trading your investments, any gains you make will be taxed at the same high rates as your ordinary income—all the way up to 37 percent, depending on what you make. That’s because day trading is risky business that rarely ends well for the average investor—it’s more like gambling than investing.
The IRS does not consider day trading to be the same as investing and therefore does not offer the same tax incentives to people who make frequent trades that it offers those who are saving for retirement with a long-term strategy. When you hold an investment for more than one year, therefore, any returns are taxed as long-term capital gains with lower maximum rates of 20 percent.
2. Know Special Rules for Dividends
The requirements for stock dividends to qualify for the long-term capital gains rates are different for dividends. When you’re paid dividends on common stock, you must own the stock for at least 60 days during the 121-day period that starts 60 days before the ex-dividend date. But, if you are paid a dividend on a preferred stock that covers a period of more than 366 days, you must own the shares for at least 90 days during the 181-day period that starts 90 days before the ex-dividend date.
3. Use Losses to Offset Gains
No matter how good of an investor you are, even the best investors have a few losers in their portfolio. Fortunately, the IRS lets you use a capital loss to offset your other investment income, which can lower your tax bill.
But, you have to use short-term losses to offset short-term gains and long-term losses to offset long-term gains first. Then you can use the excess of one type to offset gains of the other type.
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4. Use Losses to Offset Limited Ordinary Income
Your tax breaks for losses don’t stop with offsetting all of your capital gains for the year. Instead, you can use up to $3,000 of capital losses — $1,500 if you’re married filing separately — to offset ordinary income, such as wages or interest income. If your capital losses exceed your gains by more than the limit, you can carry over the excess to future years.
5. Watch Out for Wash Sales
To prevent taxpayers from selling an investment to claim a loss and then immediately repurchasing it, the IRS has specific rules for what it considers “wash sales.” When you repurchase an investment within 30 days of the sale, you can’t claim the loss on your taxes. These rules also apply if your spouse, your IRA or entity you control purchases the investment.
According to the IRS:
“A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade,
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.”
6. Utilize Tax-Friendly Investments
Depending on your tax bracket, you might consider partially tax-free bonds in your portfolio. For example, municipal bond interest isn’t subject to federal income taxes, and U.S. savings bonds aren’t subject to state income tax. Though these investments might not have as high a stated rate as corporate bonds, you might come out ahead after calculating how much you’ll save in taxes.
As a rule of thumb, it benefits lower-income earners with lower tax obligations to invest in corporate bonds because of their higher returns. Higher-income earners are advised to buy muni bonds for their tax-exempt classification. There’s a simple formula for determining the so-called tax-equivalent yield, which will tell you which kind of bond is right for you. Find the tax-equivalent yield by dividing the tax-free muni bond yield by 1 minus your tax rate. Sound complicated? Don’t worry, many sites offer free and simple tax-equivalent yield calculators.
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7. Maximize Contributions to Retirement Accounts
Investing in tax-deferred retirement accounts, including 401ks and IRAs, offers significant tax breaks for your investment income. Whether you use a traditional or Roth IRA account, the money grows tax-free in the account. That means that each time you sell an investment in the account, you can reinvest the entire sale proceeds rather than having to pay a portion of the proceeds in taxes.
It’s important to note that Roth IRAs and traditional IRAs function differently and are designed for different kinds of investors. Basically, Roth IRAs are funded with money that has already been taxed and therefore can be withdrawn—both contributions and earnings—tax-free in retirement. Traditional IRAs work the other way. They’re funded with pre-tax money withheld from your taxable income. You pay your taxes when you make withdrawals in retirement, same as with a 401k.
8. Use HSAs for Saving for Medical Expenses
Utilize a health savings account to save for future medical expenses if you are covered by a high-deductible health insurance plan. Your contributions to the HSA are deductible on your taxes, the money in the account grows tax-free as you invest it and when you take distributions for qualified medical expenses, you don’t pay any taxes on the distributions.
HSAs are also versatile. Whatever you don’t spend is yours to bring into retirement, where you can make withdrawals with no tax penalty for qualified medical expenses. You can continue contributing to an HSA all the way up to the time you enroll in Medicare. The triple tax advantage of HSAs is without equal in terms of retirement vehicles. You can put the money away pre-tax like a 401(k) or traditional IRA, you can make withdrawals tax free like a Roth IRA, and they are not subject to Medicare and Social Security taxes like all the other investment vehicles you have at your disposable. Many experts consider them the ultimate investment vehicle.
9. Use 529 Plans for Educational Savings
You can reduce the taxes on your investments by saving the money in a 529 plan for future higher education expenses, such as a college fund for your children. Although you can’t deduct your contributions to a 529 plan from your federal taxes, you might receive a state income tax break. Plus, the money grows tax-free in the account and comes out tax-free when you use it for qualified higher education expenses.
If you’re interested in planting a seed for a future college education, the sheer volume of fund choices can be overwhelming, so be warned—but don’t be discouraged. Highly regarded and reputable organizations like Morningstar offer concise, plain-English breakdowns of the top 529 funds.
10. Calculate Taxable Gains Correctly
When you sell an investment, you don’t pay taxes on the entire sales price. Instead, you subtract your basis — what you paid to acquire the investments — from the sales proceeds to figure your taxable gain. For example, if you sell stock for $1,600, but it cost you $1,200 to purchase, you only pay taxes on $400 of gains.
11. Include Trading Costs When Calculating Gains
When you calculate your basis and your sales proceeds, don’t forget to include any trading costs, such as transaction fees or commissions. For example, if you buy a stock for $1,190 but you pay $10 in fees, your basis is $1,200. Or if you sell it for $1,610 but pay another $10 fee, your net proceeds are only $1,600.
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12. Make Estimated Tax Payments if Needed
When you have significant gains from your investing, you might need to make estimated tax payments during the year. To avoid interest and underpayment penalties, your withholding for the year must be within $1,000 of the tax you owe, at least 90 percent of what you owe for the current year or at least 100 percent of what you owed for the prior year.
If you are required to make quarterly payments, you’ll have to get your tribute to the IRS by the following dates:
- April 15
- June 15
- Sept. 15
- Jan. 15
13. Donate Appreciated Stock Instead of Cash
Consider donating appreciated stock to your favorite charities instead of donating cash. That way, you never pay taxes on the gains and, as long as those gains would have been treated as long-term capital gains, you receive a tax deduction equal to the fair market value of your donation.
14. Deduct Investment-Related Expenses
The 2017 Tax Cuts and Jobs Act dramatically overhauled the way the IRS treats the deduction of expenses you incur through investing. Miscellaneous itemized deductions—like expenses from IRA custodial fees and accounting costs—are no longer allowed. If you borrowed money to purchase investments that are taxable, however, you might be able to reduce your taxable investment income by deducting the interest from those loans.
15. Don’t Let Taxes Dictate Investment Strategy
Using tax tips to maximize the portion of your investment income you get to keep versus having to pay to the IRS is great for your pocketbook. But don’t let taxes drive your investing strategy or you could find yourself with a portfolio that doesn’t reflect your needs or goals.
While each investor is unique and each investing strategy can be custom tailored in an infinite number of ways, there are five main strategies that apply to most investors:
- Growth: The pursuit of securities that you believe are poised for big returns.
- Value: The pursuit of securities that you believe are underpriced.
- Momentum: The opposite of value investing, this strategy involves following the herd to securities that are already on a roll.
- Income: This strategy focuses on income-generating securities, like stocks that pay hefty dividends.
- Contrarian: Contrarians bet against the market trends. Many, for example, believe that the market as a whole is currently in a bubble on the verge of popping and are therefore shorting the market instead of investing long.
Click through to read about the ins and outs of unrealized capital gains and losses.
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Andrew Lisa contributed to the reporting for this article.