One effective strategy to increase your savings over time is to invest. One drawback, though, is that you usually have to pay taxes on the profits from your investments. Naturally, you keep less of your returns the more in taxes you pay. However, you can reduce the amount of taxes you pay on your investment earnings by using the appropriate technique.
Certain retirement accounts, such as Roth IRAs, offer tax-free investments, while some types of investments are not taxed at all. Think about incorporating these crucial tax-saving measures into your portfolio as you construct it. Consult a financial counselor if you have any questions about any of these tax-efficient investments.
The unfortunate truth about earning investment income is that you’ll never be able to avoid taxes altogether. Uncle Sam will always get his cut one way or another. But how much the government will charge you depends heavily on what investments you choose and how long you hold them.
For starters, investment taxes are called capital gains. These come in both long-term and short-term categories. Long-term capital gains mean you’ve held your investment for at least one year. Short-term capital gains, conversely, means you’ve held them for less than a year. If you can reach the long-term threshold, your tax treatment will be significantly better. That’s because short-term capital gains taxes are levied based on normal income tax brackets, whereas long-term capital gains have much lower rates of 0%, 15% or 20%.
Consequently, attempting to stick to long-term investments is the primary strategy for becoming a tax-efficient investor. This entails cutting back on day trading and other erratic investing strategies. Of course, you might already want to stay away from those things if you’re saving for retirement.
Apart from this fundamental tax-efficiency guideline, you can select particular investments with unique tax advantages. You may occasionally be able to use accounts with tax benefits as well. These are seven key tax-efficient investments that you should include in your portfolio.
1. 401(k) / 403(b) Employer-Sponsored Retirement Plan
Employer-sponsored retirement plans offer great ways to invest for long-term periods. Your pre-tax contributions are deducted from your paycheck which lowers your adjusted gross income (AGI). Many companies will match your contributions up to a set amount and may even offer profit-sharing plans. The earnings accrue tax-deferred and can be withdrawn after retirement when in a lower tax bracket. There are limited contribution amounts and penalties for withdrawing funds early.
You might also consider a Roth 401(k) which uses after-tax money for contributions but offers tax-free growth and tax-free withdrawals in retirement. Although contribution limits are spread between a 401(k) and a Roth 401 (k), you can contribute to both if desired. A diversified retirement portfolio will provide more withdrawal options and benefits.
Employees of nonprofit companies may have access to a 403(b) retirement plan instead of a 401(k). Both use pre-tax dollars and grow tax-deferred; however, the nonprofit employer may not offer matching contributions. Generally, a 403(b) has lower administration costs associated as well. These employer-sponsored retirement plans are excellent ways to invest tax-free and should be one of the first methods considered, especially if price matching is available from the employer.
2. Traditional IRA / Roth IRA
An Individual Retirement Account (IRA) should also be considered for tax-conscious investors as these plans offer tax-free growth. Both traditional and Roth IRAs allow annual contributions up to $5,500 (under 50) and $6,500 (over 50). However, income limits and company retirement plans can impact eligibility and the deductions available.
High-income earners can still utilize the benefits of these options with a little more work. Traditional IRAs allow pre-tax money to be invested tax-free and withdrawn in a lower tax rate at retirement. However, traditional IRAs also come with drawbacks such as mandatory disbursements after a certain age and other issues.
Read Also: How do I Pay Residential Property Tax?
In contrast, a Roth IRA uses after-tax money and is tax-free at retirement but has income eligibility requirements. High-income earners may not be able to invest directly into a Roth IRA. This can be circumvented by first investing in a traditional IRA and then converting to a Roth IRA. Before considering this method, there are tax implications to consider, especially if you already have an IRA. Consult with a financial advisor today if you have any questions about IRA investments.
3. Health Savings Account (HSA)
Tax-conscious investors can also utilize a Health Savings Account (HSA) to invest in tax-deferred and tax-free earnings on eligible spending. In addition to decreased medical costs for upfront spending and saving for medical expenses, a health savings account offers tax benefits as well. Pre-tax contributions can be tax deductible, and interest earned is tax-deferred.
Money will grow until it is used and does not expire. When utilizing an HSA for eligible medical expenses, withdrawals can be tax-free. You can also consider additional HSA accounts for family members or a family HSA plan but beware of annual contribution limits.
Also, HSA accounts are limited to high-deductible insurance plan holders. Current healthcare spending trends seem to favor high-deductible plans. Insurance companies and employers are also keen to pass on more costs to plan holders in order to ensure responsible healthcare spending. Investing in an HSA account offers many tax and healthcare spending advantages, making high-deductible healthcare plans more attractive, especially if your employer offers matching contributions.
The great thing about HSA accounts is if you don’t use them, you can roll them over into retirement and use them to pay for health care expenses incurred in old age. This can be very beneficial when combined with programs such as Medicare. What is Medicare? It’s the federal health insurance program for people aged 65 and up.
4. Municipal Bonds
Called a “muni” for short, a municipal bond is issued by a state, city or county to finance spending. Since these bonds are backed by government entities, they are generally safer but typically offer a lower return. Municipal bonds are sometimes called triple tax-free bonds because some are exempt from federal, state, and city taxes depending on where you live. However, not every muni is exempt from taxes so consider your options carefully.
In other cases, investing in municipal bonds may cause the Alternative Minimum Tax (AMT) to apply which can greatly impact your taxes. When considering investing in a bond, carefully research the returns and taxes associated to determine if the investment would be worth your time. These bonds do offer tax incentives for high tax bracket individuals, especially if issued by the city or state where you reside.
However, in some cases, a taxable account may offer better after-tax returns than a municipal bond with tax-free returns. Before you automatically forgo taxable investments in lieu of tax-free options, ask a professional to make sure you are choosing smart investments.
5. Tax-Free Exchange Traded Funds
In the pursuit of tax-efficient investing, you should certainly consider exchange-traded funds (ETFs). ETFs usually have lower costs than mutual funds and offer more flexibility as well. The tax benefit depends on the types of bonds held by the ETF. For example, U.S. government bond ETFs may be free from local and state tax but are subject to federal tax. In contrast, municipal bond ETFs are possibly free from federal, state, and local taxes.
There are many different ETFs available, and many providers or exchanges offer them. The best ETFs depend on your age, income level, retirement goals, risk, and other factors. Consult with a tax advisor to determine the best investments for your financial status and eligibility.
6. 529 Education Fund
Another investment to consider is a 529 education plan. This allows you to set money aside for school tuition and higher education. Contributions are after-tax and not deductible, but some accumulated tax is deferred. In addition, distributions for eligible college or higher education costs may be tax-free at the federal level but only tax-free in some states. Before starting a 529, you should consider the benefits based on your location and planned usage.
Spending money on non-qualified expenses is subject to income tax, plus a penalty on earnings. Money invested into a 529 is not as liquid as other investments without facing those penalties. However, you can change the beneficiary of a 529 plan if the intended recipient decides not to go to college. For example, you can transfer the beneficiary to yourself or to another dependent if desired.
7. U.S. Series I Savings Bond
U.S. Series I savings bonds offer another investment option, albeit one that may not be as advantageous as other tax-free investment plans. While exempt from state and local taxes, you will be liable for federal tax on interest income. However, you or a qualified dependent may be able to pay for some educational expenses tax-free using these bonds, depending on income limits and other restrictions.
8. Charitable Donations
Charitable donations are another method of tax-free investing. You can gift stocks to a charity in order to pass on capital gains tax. A charitable donation can also provide tax deductions when itemizing your taxes. Research this method carefully as there are restrictions, time limits, and downsides. However, in some situations, especially for high-income earners, it may prove beneficial. Another option is to gift money to a dependent.
Uniform Gift to Minors Act (UGMA) provides tax-free and lower tax bracket options for certain investments. It is important to note that these gift amounts have the potential to impact the child’s future financial aid eligibility. There are also complicated gift tax laws to consider. While this method may not be as tax-efficient as other methods discussed, it bears further scrutiny.
9. 1031 Exchange
1031 exchanges are a form of tax-free investing that involves changing an investment without paying on the capital gains. Typically, this method is seen in real estate where one property investment is replaced by another and gains are reinvested. The capital gains tax may be deferred to later dates as there are no limits on the number of 1031 exchanges that can be made.
However, there are limitations on which investments can be exchanged. There are also taxes due for amount differences between investments. Since there are many complications that can arise from this method, it is highly recommended that you seek expert financial advice before reinvesting. The Anderson Advisors Real Estate Tax Guide is a great source for general information on real estate taxes.
Tax-free investments can minimize your tax liability and let you keep more of the money you earn. Financial investing carries both risks and rewards, and it’s important to determine the best or most efficient investing strategy for your specific needs. If you are considering tax-free investing, be sure to research your options carefully or speak to a tax professional. There are many tax-free investment options available to investors that use proper tax planning strategies.
Some of these options provide better benefits and more comprehensive tax advantages than others. Start with the best options, such as your employer’s 401(k) or 403 (b) retirement plans, or an IRA/Roth IRA. You can also invest money tax-free through an HSA account or by buying tax-free municipal bonds. Another option is investing in tax-free ETFs.
In some cases, it may be worthwhile to consider a 529 education plan for yourself or a qualified dependent. Also, U.S. Series I savings bonds, charitable donations, and 1031 exchanges all provide some form of tax incentive. Be sure to consider the alternative minimum tax (AMT) which can impact your taxes greatly, if applicable.
When pursuing investments with tax advantages, it’s best to find the optimal mix of investments that provide the highest tax advantages with the lowest disadvantages. Due to the complexity of taxes and related laws, it can be difficult to research and file correctly. A financial tax expert with experience in tax-free investments can help you choose the most effective strategy to achieve your goals and protect your family’s wealth.