Tax Expert: 5 Ways To Reduce Taxes on Investments and Maximize Savings

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Taxes are a part of life, and everyone has to pay them. Whether it’s active income earned from work, passive income earned from dividends or gains from the sale of an asset, Uncle Sam wants his share. However, experts say it’s possible to reduce the taxes on your investments and maximize the amount of money you get to keep.
One of those experts is Bill Harris, former CEO of Intuit (the makers of TurboTax) and PayPal, and the founding CEO of Evergreen Money, a development-stage multi-asset financial service that gives users a simple way to grow and manage their money. In an interview with GOBankingRates, Harris explained some of the most important steps you can take to reduce taxes on investments.
5 Ways To Reduce Your Tax Liability
Based on Harris’ new book, “Investment Tax Guide: How To Slash Your Taxes,” here are five ways to effectively reduce your tax liability:
Tax Loss Harvesting
Tax loss harvesting is the practice of selling off a losing asset to offset your tax liability on the sale of an asset that has made significant gains. Harris explained that it’s better to sell a losing asset before selling an asset you made significant gains on. This way, you’ll be able to keep more of the money earned from the gains.
“Tax loss harvesting is a powerful tool for reducing taxes. Selling underperforming investments generates valuable tax benefits, while cashing out on short-term winners can yield high tax penalties,” Harris said. “Capital gains and capital losses offset each other, so strategically timing when you sell winners and losers can ease, or even eliminate, your tax burden.”
Tax-Deferred Accounts
A retirement account such as a 401(k) or individual retirement account offers tax advantages when planning your financial future.
A 401(k) retirement account consists of pre-tax contributions, so you defer tax liability on earned income in the present. What’s more, some employers match employee contributions. If yours is one of them, it’s crucial to take advantage of that as well.
Traditional and Roth IRAs also provide tax-advantaged savings. You fund a traditional IRA with pre-tax income, like with a 401(k), and pay tax on withdrawals in retirement. A Roth IRA consists of after-tax contributions, so gains earned on investments within a Roth IRA are 100% tax-free once you turn age 59.5.
“You should first prioritize maximizing your employer match to your 401(k) — it’s free money,” Harris advised. “Then, it’s all about putting the right assets in the right places. Determining if a traditional or Roth IRA is better is a question of your expected income; if you think you’ll be making more when you retire than you do now, Roth accounts are far more advantageous.”
For some, a combination of retirement accounts could prove to be the best strategy, depending on your current and future income projections.
Avoid Short-Term Gains
Buying and selling stocks quickly to turn a profit may seem lucrative. However, you’ll need to consider the tax implications of short-term vs. long-term gains. The key difference is in how the money gets taxed.
Short-term capital gains are taxed at your ordinary income tax rate, which could be as high as 37%, while long-term capital gains tax rates only go as high as 20%. Harris strongly recommended holding your investments for the long term.
“A short-term capital gain is an investment you sell within 12 months of purchasing,” Harris said. “They’re taxed at a higher rate than long-term capital gains, and the tax penalty for selling a short-term capital gain is almost always higher than the potential decline in price during the rest of the period. Unless you can offset the tax burden with capital losses, you should avoid selling short-term winners.”
Avoid Actively Managed Mutual Funds
Mutual funds contain a basket of assets, such as stocks or bonds, and they come in several different forms. Two of the most common are actively managed funds and index funds.
With actively managed funds, fund managers take a hands-on approach to trading the fund’s stocks or other assets in order to maximize returns. Index funds, on the other hand, track a particular index, such as the S&P 500 — Fund managers aim to match the index’s performance, not beat it.
Harris explained that actively managed mutual funds typically have higher fees and lower diversification, and they’re tax-inefficient compared to other types of investments. The reason is that they’re taxed “inside the fund” on their own dividends and capital gains, and they’re taxed “outside the fund” when you sell.
“Most [actively managed] mutual funds have high turnover ratios — 75% of their holdings are sold and replaced every year — so they are taxed as short-term gains, leading to unnecessarily high taxation,” explained Harris.
Harris suggested opting for index funds, which offer low fees, high diversification and better tax efficiency.
Charitable Giving
Last but not least, Harris described one other powerful tool to reduce tax liability: charitable giving. You can either donate to your favorite charity directly or through a donor-advised fund. The latter may be to your financial advantage.
“A donor-advised fund delivers almost all the benefits of a traditional charitable giving foundation at a fraction of the cost,” Harris explained. “Charitable deductions are valuable because if you donate your appreciated securities as opposed to donating cash, you will never be taxed on the appreciation on those securities. At the same time, if you itemize, you can write off the amount of the gift as a tax deduction, so it can serve as a double benefit from a tax point of view.”
Consider Harris’ five tips to maximize your tax savings and start keeping more of your money. After all, it’s often less about how much money you earn and more about how much money you get to keep.