Investors in the current volatile tax environment should pay special attention to strategic after-tax investments. Other people in the highest income tax brackets face unpleasant surprises due to changing tax liabilities in the last two years. The extended period of robust stock performance, coupled with the current American Taxpayer Relief Act of 2012, has increased taxes.
The new changes result in a tax increase of about 24% for top ordinary income tax. The typical capital gain rate also increased by 58%. Furthermore, tax planning constantly requires attention. The recent market volatility also resulted in domestic stock changes to experience a sell-off.
Most investors get frustrated with their losses, and advisors seek opportunities to re-position portfolios and reduce clients' tax bills.
Proper tax planning will be more critical going forward in the era of higher taxes. You have several ways to legally reduce, eliminate, or defer taxes on your investment gain and keep more profits. It pays to be smart, minimize your taxes, and have more of your money working for you.
Read on to find the best methods to eliminate or reduce taxes levied on investment income.
How Your Investments Get Taxed
There are tax measures for every investment's income as per The Internal Revenue Service (IRS). Such taxes differ significantly from the IRS tax income coming from working wages. The differences may be the tax rates and when and how the authorities assess taxes on the investment income.
Generally, investments generate income in two broad ways, where each has a unique treatment during taxation:
- Capital gains: Refer to an increase in the price of an asset, such as when a stock or a real estate asset value increases over time. The government will tax the capital gains only after realizing, say, selling an asset for cash.
- Dividends or cash income: These include money received during a year and is subject to taxes when the company gets it.
Investors looking to minimize taxes on their investments have to work around these two broad rules.
Ways to Minimize Taxes on Your Investment
Savvy investors use multiple techniques to minimize taxes on investment gains. These may differ from behaviors and the tax-advantaged discounts required to get an efficient tax code. The most popular methods are:
1. Buy and Hold
The tax systems in the US seem to favor investors who hold on to their investments for at least a year after purchase. According to IRS law, you get taxed only on realized gains after selling and converting your investment to cash. It acts as a loophole you can jump through and minimize taxes in the long run. As long as you hold, you are not liable to capital gains taxes that can be substantial.
The main primary goal of taxing capital gains is to discourage speculative buying or day trading. Unfortunately, many investors engage in such practices. For example, you only pay capital gain tax for all investment gains when you buy a stock and sell it after a year. The current tax rates range from 0% to 20% based on your general income.
On the other hand, when you purchase stock and sell it in less than a year, you are liable to pay ordinary income tax for your investment gains. These short-term stock gains could quickly push you into a higher stock bracket.
It's also possible to buy and hold on to your investments permanently and indefinitely to defer all the taxes on gains.
Another benefit of buying and holding is ensuring your investments perform better in the long haul. According to research, passive investing may outperform active investments after long periods. Still, a hold is a win-win situation both ways. You will make more money and save on taxes payable to the IRS.
2. Start a Business
A side business offers various tax advantages and earns you more additional income. It will reduce the total tax obligation, allowing you to deduct income generated from daily business activities.
The most important tax reduction relating to this is health insurance premiums for self-employed individuals available for people who meet special requirements.
Following the Internal Revenue Service (IRS) guidelines, every business owner can deduct some home expenses with a home office deduction. You can also remove a portion of the utilities and internet you need in your business from income.
You can claim these deductions after making tangible profits from your business. The IRS will evaluate several factors included in Publication 535. Any investor who will realize profits after three of the last five years will be engaged in business for profit.
The SECURE (Setting Every Community Up for Retirement Enhancement) act of 2019 offers tax incentives for employers who join multiple-employer plans and have retirement offers for their employees.
3. Open an IRA
Workers can invest income for retirement to achieve more tax advantages by using an IRA. Using a traditional IRA, you can put away money on a pre-tax basis and reduce your taxes significantly in that year. You can also defer taxes on profits on either dividend for capital gains.
When it reaches the point of taking distributions from your account above 59 ½ years, you can start paying taxes on money withdrawn from the account. You will legally defer taxes from your IRA for decades in the process.
Investors looking to get rid of the IRS can opt for the Roth IRA. With the Roth IRA, you will put away your money on an after-tax basis. You will not receive a tax break that year. However, you can continue increasing your contribution tax-free and ultimately withdraw it tax-free after contributing after 59 ½ years. It's the most common pick top most retirement accounts.
It is essential to be careful when choosing between the traditional IRA and Roth. The right choice will meet your needs and save you yearly fees. Check for the rules required for every option, as it is possible to get hit with penalty fees when you make a misstep. In other terms, don't avoid taxes to fall into another costly trap.
4. Use Tax-Loss Harvesting
Another intelligent way investors eliminate or reduce taxes is using tax-loss harvesting on every taxable capital gain. The IRS allows investors to write off any realized investment losses against gains through tax-loss harvesting. With this, you will owe tax only on the net capital gain.
For instance, investors with a gain of $10,000 for a single investment and a $15,000 loss on another will have a net loss of $5,000. However, the investors can claim only $3,000 for the year's tax return. The remaining $2,000 is only liable for future tax claims.
It is common for most investors to minimize their taxable gains this way. However, you will end up repurchasing the investment when it is valuable in the long term (about 30 days), eliminating a wash sale.
5. Use Tax-Loss Harvesting
An employer-sponsored 401(k) plan is an excellent addition to providing various tax advantages like an IRA and more. Using a traditional 401(k) allows you to defer finances directly from your paycheck on any pre-tax basis. It enables you to reduce tax in the same year. You can also defer taxes on your earnings for dividends or capital gains.
When you make more contributions after 59 ½ years of age, you will continue paying taxes for every withdrawal you make. The best thing to do is defer the investment's profits during the decades when you are still actively working.
A Roth 401(k) has more benefits than using a traditional 401(k) at this level. You can get paycheck deferral, employer matches, and others. However, it only does so on an after-tax basis. It means you are liable to pay taxes on all contributions. The best way to go around this is to grow your account tax-free, then withdraw tax-free when you take distributions. Others even roll it over to the Roth IRA after some years.
Equally important, both the 401(k) plans are common among workers. It is essential to consider the plan that works best for you. Ensure you adhere to the plan's rules, especially for withdrawals, to avoid unnecessary penalties from the IRS.
6. Consider Asset Location
All gains like dividends and other cash distributions you receive yearly are taxable whenever. Anyone using a taxable account will not have an easy way to free you from taxes as you do with capital gains. Always consider where you hold your assets to keep your taxes low on dividends.
For instance, many investors have a tax-advantaged account like an IRA and another taxable brokerage account. If you have any dividend stocks, it is best to keep them within the tax-light confines of the IRA.
It can help you avoid taxes on your distribution day.
Meanwhile, remember stocks with capital gains can be held within any regular taxable account. However, in the taxable account, you will enjoy the top key IRS benefits, tax deferral. The tax deferral will continue until you sell your investments decades later. You can make more financial sense here by considering whether to stuff all dividends into an IRA.
7. Take Advantage of Depreciation
Savvy investors rely on depreciation as it allows them to lower tax bills seamlessly. Many people use this as their significant tax breaks. According to IRS, any typical residential property will depreciate over 27.5 years. The depreciation equals 3.6% of the property's initial value, which will be the deductions each year, reducing the rental income on taxes paid in that year.
Although it is best to recapture deprecation when selling, the recapture is at 25%. The rate is typically lower than the marginal income tax rate. Furthermore, the depreciation doesn't have to be recaptured when you plan to exchange the property under the 1031 exchange to avoid selling it.
8. Go for Lower Long-Term Capital Gains Rates
Tax on investment and wage income invest greatly. It is evident in the way the IRS treats capital gains. Long term taxes on capital gains is at 15%, 20%, and 0%. But you need to adhere to the rules very carefully to avoid costly repercussions.
The tax rates are relatively lower than paying for short-term capital gains. The capital gains are taxable at any typical income rate. However, when you hold an investment for more than a year, you will take advantage of the long-term rates that are significantly lower. It is another benefit of buying and holding assets.
9. Use a 1031 Exchange
As a real estate investor, it makes a lot of sense to use the 1031 exchange when selling a property and investing in another. 1031 works as an exchange to allow you to sell one investment property and defer capital gains as much as you invest the process in another property.
The only issue with using the 1031 exchange is that it has complex rules that govern the process. Every investor must follow them keenly or else lose the tax deferral. Like in any other asset, you can hold on to your property investments and defer your capital gains that have gone on for decades. In addition, you will avoid the typical high real estate commissions.
10. Maximize Your Retirement Plan Contributions
Maximizing your qualified retirement contribution plan or IRA is essential. You have to consider whether to make a Roth or Traditional contribution depending on your age, income tax bracket age, the tax bracket. Anyone looking to get the reduction instantly will go the traditional way. Another critical factor to consider when making the Roth versus Traditional decision is the high stock market.
As stressful as it is for investors to pay taxes, putting your money into a Roth 401(k) or Roth IRA is the best route to minimizing them. After storing your cash, check for chances of market decline to ensure you make appropriate decisions.
The reach of the taxman is becoming longer each day. If you want to lower tax bills, there are a few ways to do so. These investment tips will avoid paying taxes excessively and boost your revenue. Most savvy investors use tax-advantaged accounts as a great way to minimize the tax hit.
The easiest and most reliable way is to buy-and-hold invest. Submit an application to PS Group today to stay in the loop with investor updates.