Michael Baum, CFP® RICP®
Vice President & Associate Financial Advisor
Benjamin Franklin famously wrote that nothing is certain but death and taxes. That still rings true today, but take heart – although both are indeed a certainty, you’re not powerless to minimize your taxes or to maximize your life. In fact, there are tax-advantaged accounts and investments that can help to reduce your tax liability so you can keep more of your money for the goals you have in life.
While taxes shouldn’t drive investment decisions, they should be one of many variables considered. Here are some ways to limit taxes while investing for the future.
Pay your future self instead of Uncle Sam by taking full advantage of 401K or IRA contributions.
A traditional 401K plan is offered by employers to encourage employees to save for retirement. Employees can fund 401Ks with their gross income (income before taxes are deducted). Doing so reduces the employee’s gross income and the taxes paid on that income.
Here’s a very basic example: If Jane earns $100,000 a year (gross income) and she pays 25% income tax on that amount, her tax bill will be $25,000 and she will take home $75,000 (net income). If Jane contributes $20,000 to her 401K, it reduces her gross income to $80,000 and she will pay only $20,000 in taxes and take home $60,000 of net income. By investing in a 401K, Jane has reduced her tax bill by $5,000.
In some cases, companies make 401Ks even more attractive by offering to match some part of the employee’s 401K contribution. A company with a 5% matching program will contribute $1,000 to Jane’s 401K. Free money!
Money invested in a 401K plan grows tax-free. Even dividends and interest income aren’t taxed while they remain in the 401K, giving Jane more money each year to reinvest. Income taxes are owed when funds are withdrawn from the account, typically upon retirement after age 59½.
Some employers offer Roth 401Ks. The money invested in Roth 401Ks is taken from after-tax net income. There’s no tax savings on day one. But investments grow tax-free and when they are withdrawn at retirement, they aren’t taxed, which could result in substantial savings.
Individual Retirement Accounts (IRAs) and Roth IRAs are taxed-advantaged methods of saving for retirement outside of work. A traditional IRA is funded from gross income and investments grow tax-free. When funds are withdrawn after retirement, they’re subject to income tax. Contributions to Roth IRAs are taken from after-tax net income, so there’s no tax benefit today. But funds grow tax-free and withdrawals at retirement are not taxed, so you’ll have the full benefit of your savings when you need it.
Squirrel away money for college.
Consider saving for college and reducing taxes by funding a 529 savings account. The accounts are funded with after-tax dollars, but their investments grow tax-free and withdrawals aren’t taxed if they are used for qualified education expenses. Some states offer an additional tax deduction for those contributing to 529 savings accounts.
It’s even more important to think about taxes when investing in an account that isn’t tax-advantaged, like a traditional brokerage account. Each year, investors must pay taxes on dividends, interest income, and gains on any securities sold at a profit. One way to limit taxes is to sell strategically. Investments held for more than a year are taxed at a long-term capital rate of 0%, 15%, or 20%, based on an individual’s tax bracket. Investments held for less than a year are taxed at a short-term capital gains rate that’s equal to the investor’s income tax rate. If you’re thinking about selling a security that you’ve owned for less than a year, it’s worth considering the tax treatment. Holding onto it until you’ve reached the one year holding period may significantly lower the capital gains tax owed.
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Harvest investment losses.
Another way to reduce capital gains taxes is by tax loss harvesting—selling a security at a loss. If you have capital gains, they can be offset by losses, and only the remaining gain is taxed. If the losses are greater than the gains, investors can deduct up to $3,000 of the losses from their joint taxable income. If the net losses exceed $3,000, they can be deducted from future tax returns. Note that under the “wash rule” investors cannot buy an investment that’s the same or “substantially similar” to the one that was sold at a loss. If you don’t wait 30 days before repurchasing the investment you sold at a loss, the loss is not valid.
Be smart when buying bonds.
Some bonds offer more tax advantages than others. Municipal bonds’ interest income isn’t taxed by the federal government and sometimes it’s exempt from local and state government taxes, too. Treasury and savings bonds’ interest income is exempt from state and local taxes, but not from federal taxes. The interest paid by corporate bonds is taxed by everyone: local, state, and federal governments. Because the interest paid by municipal, Treasury, and corporate bonds is taxed differently, it’s important to compare the interest rates offered by these bonds on an after-tax basis.
There are also mutual funds and exchange-traded funds that invest in municipal bonds and other tax-advantaged bonds. They offer both the tax advantages of the securities they own as well as diversification.
Talking with an investment advisor about tax strategy can be vitally important to your investment portfolio’s performance today and in the future. That’s why at Weiss, Hale & Zahansky our team considers the entire financial picture for each client as part of our strategic Plan Well, Invest Well, Live Well™ process. If you’d like help planning your strategy so you can put more of your money toward living well instead of paying more taxes, request a complimentary consultation on our website or call us at (860) 928-2341.
Authored by Vice President, Associate Financial Advisor, Michael Baum, CFP® RICP®. Securities and advisory services are offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. These materials are general in nature and do not address your specific situation. For your specific investment needs, please discuss your individual circumstances with your representative. Weiss, Hale & Zahansky Strategic Wealth Advisors does not provide tax or legal advice, and nothing in the accompanying pages should be construed as specific tax or legal advice. 697 Pomfret Street, Pomfret Center, CT 06259 and 392-A Merrow Road, Tolland, CT 06084. 860-928-2341. www.whzwealth.com.