Tax-Efficient Investing Strategies

Investing creates the opportunity to generate passive income and build wealth long-term. However, more income often means more taxes. There are ways to lighten the tax burden, but it usually requires careful planning and understanding of the many tax benefits available to investors. Here are six ways to minimize taxes while investing.

Utilize Tax-Advantaged Accounts

Many different types of accounts allow you to invest in a tax-efficient way. These accounts often have tax benefits the IRS provides to incentivize people to save. While you can’t avoid taxes with these accounts, you can defer your taxes, meaning you pay them at a future date. Another option is to pay the taxes now and enjoy tax-free withdrawals in the future.

Some examples of accounts with tax advantages include: 

• Individual Retirement Account (IRA): Both traditional and Roth IRAs offer tax advantages. Both accounts allow tax-deferred growth on investments. Traditional IRAs give investors an immediate tax break since contributions are deductible, but investors pay taxes on the distributions. Contributions to Roth IRAs are not tax-deductible, but qualified distributions are tax-free.
• Company-sponsored retirement account: Employer-sponsored retirement accounts like 401(k)s, 457(b)s, or 403(b)s can also be tax havens. Similar to IRAs, contributions to these accounts are often deducted from your gross income, reducing your tax burden. Investors can also benefit from their investments growing tax-deferred. 
• Health savings accounts: These accounts offer triple tax benefits, which include tax-free contributions, growth, and qualified withdrawals. 
• 529 accounts: Those who want to earmark funds for education can save on taxes using this account. Funds in 529 accounts grow tax-free, and qualified withdrawals are also tax-free. In some states, contributions are tax-deductible.

Hold Investments Long Term 

Investors who hold their assets for longer than a year can save money on taxes via long-term capital gains tax rates. When an investor holds an asset for at least a year before selling it, they are subject to the long-term capital gains rate. If investors sell before a year has passed, they’re subject to short-term capital gains rates, which are typically the same rate as an investor’s ordinary income. Compared to long-term capital gains rates, this can be higher and eat away at profits made on investments. 

Invest in Tax-Efficient Assets  

In addition to investment accounts having tax advantages, certain investments can ease your tax burden. They include:

• Municipal bonds: Municipal bonds are not subject to federal income taxes, and they may be exempt from state or local taxes.
• Treasury securities: Investors don’t have to pay state and local taxes on Treasury Bills, Treasury Bonds, and Treasury Notes.
• Exchange-traded funds: When passively managed, ETFs can be a tax-efficient investing vehicle. Index funds can also have similar benefits. 
• I bonds: Investors who put money in this savings vehicle aren’t liable for state and local income taxes. However, they must pay Federal taxes.

Utilize Tax-Loss Harvesting 

Tax loss harvesting occurs when underperforming investments are sold at a loss to offset gains from profitable investments. Through tax loss harvesting, investors should be able to reduce the amount they pay in capital gains taxes. While up to $3,000 in losses can be deducted in a single tax year, any additional losses can be carried forward to future years. 

Engage In Charitable Giving 

Donating assets that have appreciated to charity can minimize your tax bill as it relates to capital gains taxes. After doing so, investors can deduct the full fair market value of the stocks they gifted during tax time when itemizing deductions and avoid capital gains taxes.

Likewise, investors can gift loved one’s assets to create generational wealth and provide heirs with tax benefits.

Think About Asset Allocation by Account 

Some investors choose to plan their taxes and minimize them by placing some assets in certain types of accounts. Those accounts can be put into two buckets: tax-advantaged accounts and taxable accounts. 

The general rule of thumb regarding what types of assets go into tax-advantaged accounts is that assets investors plan to hold short-term (less than a year), real estate investment trusts, taxable bond funds, or actively managed funds that could trigger capital gains taxes go in there. In taxable accounts, investors may choose index funds, ETFs, dividend stocks, municipal bonds, or investments they plan to hold long-term.

Planning for taxes while investing can ensure you keep more of the money you’re amassing. A strategy developed with a financial advisor or tax expert can ensure you utilize all the available resources.