Now that tax season is around the corner, it is time to better understand how your investments can cause your tax burden to grow. It’s a good idea to think about how you can design a portfolio so that you can get the returns you want with a limited tax burden. Here we’re looking at four ways you can minimize the taxes associated with your investments.
1. Buy and hold
The tax system in the US greatly favors those who plan to hold onto their investments for at least a year after making the purchase. This discourages day trading and speculative buying, but there is a fair share of investors who still engage in these practices.
If you buy a stock and sell it again after more than a year, you pay capital gains tax on all investment gains. The tax rates for capital gains under current tax law are between 0% and 20%, depending on your income. On the other hand, if you sell the stock after only a year or less, you will pay normal income tax on your investment gains. Short-term stock gains also have the potential effect of moving you into a higher tax bracket.
2. Watch your dividends
Every time your investment (whether it’s a stock, bond, or fund) pays a dividend, a tax is raised (note that this happens regardless of whether you take the dividend in cash or reinvest it). If you have high dividend paying stocks or corporate bonds in a taxable brokerage account, you will be taxed every time that investment pays off. So it’s especially important to know the tax status of each account before adding any particular investment – as we’ve already researched.
If you hold your investments for an extended period of time, your dividends can also be upgraded to qualifying dividend status. “Extended Period” in this context means at least 61 days during the 121-day period beginning 60 days prior to the ex-dividend date of the investment. As with long-term capital gains, qualified dividends are taxed at a lower tax rate if you’ve held the underlying investment long enough. Since ordinary dividends are taxed at a higher rate, holding your investment long enough to “qualify” your dividends is a worthwhile investment.
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3. Keep an eye on Roth conversions
Depending on a variety of factors – including your age, current year income, and tax bracket – it can be a good idea to keep some of your pre-tax retirement accounts, such as: B. a 401 (k) to convert into Roth accounts. But Roth Conversions will ultimately add to your total taxable income for the year and will definitely add to your normal tax due.
Before doing a Roth conversion, it may be worthwhile to meet with a tax advisor who can help you plan your conversions so that you won’t pay taxes in a year. Having money in a Roth account is always nice – who doesn’t want tax-free growth forever? But do you know that you will be paying upfront for this.
4. Find the high-cash distributors
Some investment vehicles, such as Real Estate Investment Trusts (REITs), will advertise high cash payouts to attract income-seeking investors. These are perfectly legitimate investments, but it is clear that most REIT income will be taxed at normal income tax rates when held in a standard taxable brokerage account.
Typically, investments with large cash withdrawals in deferred tax accounts are better suited, and passive ETFs, which derive most of their benefit from capital gains, are usually best suited to taxable accounts. Passive funds that track broad indices typically have lower payouts but make up for this with long-term price increases.
Stick to the basics
You will go a long way toward reducing your investment-related tax burden by simply holding your positions for more than a year, properly projecting your dividend income, carefully managing all Roth conversions, and placing your positions with high dividends in deferred tax accounts. These measures work together so you can enjoy the lion’s share of the investment returns and minimize your obligations to the IRS and related government agencies. You are well placed to check this when you prepare your tax return this year.