What are your plans for the future?
A vacation home? International travel? A college fund? Laid back retirement? Financial security?
Whatever your goal, investments can help you get there. There are many paths to take. For instance, when it comes to tax liability, not all investments are created equal. Tax-efficient investing lets you put more money towards your dreams.
If you plan carefully, you can limit the taxes you pay on investments… which means more money towards that house on a lake.
Giving You a Hand
The IRS wants its’ cut on your profits — capital gains — from investments. But maybe the IRS likes plans, or perhaps the bureau is just trying to do you a favor. In any case, you pay lower taxes on investments you have for at least one year.
If you participate in shorter-term ventures, you’ll owe a greater percentage. For example, if you buy and sell a stock in less than 12 months, taxes hit your dividends harder. If you’re in no hurry, though, the IRS essentially rewards you for sticking with an investment.
If you leave them alone, retirement accounts are a good way to reduce taxes. The IRS won’t expect anything for a standard 401(k) plan, individual retirement account or annuity — IRA— until you draw from it at retirement. The same holds true for 403(b) plans, which are common for employees of public schools, non-profit institutions and churches.
Most of these aren’t tax-free investments, but taxes aren’t due until you’re a senior citizen. By then your earnings may have dropped, and you’d be in a lower tax bracket.
A Roth IRA is one notable exception. Because your contributions are taxed before they go into your account, you’ll have no tax liability when you make withdrawals at retirement.
The IRS isn’t coming after the same money twice. Just don’t pull the money out before you’re 59½ years old, or you’ll pay the price: regular taxes, an extra 10 percent federal tax and, perhaps, the investment company penalty’s for early withdrawal. Follow the intentions of the plan, and you’ll get a good chunk of change at retirement.
Bonding with Municipal Bonds
When you buy municipal bonds, you’re essentially, lending money lending to city, county or state governments. Because you’re so generous, the federal government collects no taxes on interest you earn. Some states also skip the taxes if you do them a solid and buy a bond.
If your state doesn’t, check the tax rate. If it’s high, you might not get a good return on a municipal bond investment.
The IRS will expect payment if you invest in:
- Treasury bills, notes or bonds
- Securities from some federal agencies, such as the Federal Farm Credit Banks Funding Corporation and Federal Home Loan Banks
However, state tax bureaus give you a pass on these.
The Feeling Is Mutual
When you put money into mutual funds, you join forces with other investors to buy multiple securities, such as stocks or bonds. Unless you’re using a specific tax-favored plan such as an IRA, you could pay taxes on both dividends and capital gains when you sell. There’s lots of opportunities to pay, because trading is frequent. Tax-wise, you’ll typically owe less with an:
- Index fund, which contains stocks or bonds within one particular index, such as the Russell 2000 index. This covers 200 small companies.
- Exchange-traded fund. This must be bought and sold through a brokerage account, so investors pay significant commissions.
These investments generally trade less often than mutual funds, so you’re taxed less frequently.
If You’re at a Loss
When you’ve done well with your investments, you can also help manage tax liability by selling stocks or bonds at a loss. That hit helps balance your market earnings. There’s more good news. You can also
use a loss to adjust up to $3,000 of standard income. If you’ve lost money but have nothing to offset, don’t worry. You haven’t give up your advantage. The IRS les you apply the loss against gains in the future.
Spread the Love
Diversifying your investments based on how they’re taxed gives you flexibility and options.
For instance, if you begin investing early, you may not be able to predict what income you’ll be able to generate when you’re ready to retire. Having a standard 401(k) as well as a Roth IRA covers all bases.
And if you’re planning really far ahead, a variety of investments lets you make thoughtful decisions about your beneficiaries’ tax liability during estate planning. For instance, heirs don’t owe taxes on Roth IRAs.
Keep an eye on your investment portfolio through the year. You may have to make changes to keep it balanced and high performing.
Investing to minimize taxes takes some thought, but if it gets you where you want to be more quickly, it’s worth the time and effort.
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