How to Invest and Avoid Taxes

Investing is without a doubt a fantastic way to grow your net worth. However, those earnings can quickly be eroded away by taxes.

As with all investment income, the IRS expects to collect their fair share of what’s owed. However, with so many rules and variations in the tax code, it’s possible for some investors to legally pay much less than others.

In this post, we’ll go through a few of the best ways to invest and responsibly avoid paying more in taxes than what is necessary.

Contribute to Tax-Advantaged Accounts

Every year, the IRS gives U.S. households several opportunities to reduce their tax bill by investing in what’s known as tax-advantaged accounts. Eric Brotman, a CFP and CEO of BFG Financial Advisors, shares some of his favorite tools.

Roth IRAs

Roth IRAs are ideal for people whose tax rate will likely be higher than it is currently (during their working years) once they retire. This can be especially true for younger workers or those who haven’t reached their full earning potential yet.

They’re also great for people who want to reduce their taxes in retirement or want to leave some money to their heirs tax-free. Unlike traditional IRAs where contributions are deductible when they’re made but then taxed upon withdrawal, Roth IRA contributions are not deductible. However, those contributions will grow tax-free meaning that there will be money collected when they’re withdrawn (so long as the plan rules are followed).

529 College Savings Plans

529 college plans were initially created to help families save money for higher education expenses. While many people use these plans for that purpose, there are other considerations that can make them fantastic vehicles for avoiding different types of taxes. 

When you fund a 529 plan, there is no federal tax deduction. However, some states have enacted tax parity which allows limited deductions from state income taxes for contributions. Other states offer a state income tax deduction only for specific plans.

Even though the federal estate tax rules have very strict guidelines surrounding the use of gifts to avoid taxation, the 529 plan is an exception to that rule. Balances are considered to be outside of the owner’s taxable estate when he or she dies. There are no capital gains or ordinary income taxes assessed on money in a 529 plan. 

When the money is withdrawn, as long as it is used for a qualified purpose, there are no taxes due whatsoever. After-tax money goes in and grows just like in the Roth IRA. So if it gets used properly, the funds will never be taxed again.

Health Savings Accounts

Health savings accounts or HSAs allow people with high-deductible medical plans to receive tax-preferred treatment on the money they spend for medical expenses. You get to make contributions that are currently tax-deductible at the federal and state level, and the withdrawals are tax-free if used for qualified expenses. 

In addition to this tax deduction, HSA contributions can grow tax-free indefinitely. There are no 1099s generated, no capital gains, and for qualified withdrawals, no income tax on the distributions, whether they are made to a medical provider directly or sent as reimbursement to the account holder. 

Although there is usually a minimum account balance required by a financial institution before funds in an HSA can be invested (typically $2,000), the HSA fund doesn’t have to sit in cash savings. The money can be invested in mutual funds like any investment account and grow without capital gains.

Short-Term vs Long-Term Capital Gains

While stock trading apps and discount platforms have made it easy to sell securities almost as fast as they were purchased, it’s important to realize that these actions could have unintended tax consequences. 

Matt Hylland, a financial planner at Arnold and Mote Wealth Management in Cedar Rapids, Iowa recommends that investors know the difference between what’s called short-term and long-term capital gains, and how the IRS treats them.

  • Short-term capital gains are the earnings you make from securities that are held for one year or less. 
  • Long-term capital gains are the earnings you make from securities held for more than one year.

The main difference between the two is the tax rates that will be applied. Long-term capital gains are taxed to a lower, more favorable tax rate than short-term capital gains. For most middle-class investors, earnings will be taxed at either 0 or 15 percent. 

By contrast, short-term capital gains are taxed like ordinary income. This is typically at 22 or 24 percent for most middle-class households.

Savvy investors will want to avoid the frequent trading of stocks because it can lead to higher tax bills. Even those people who have held an asset for 11 months and are considering selling it may want to wait just one more month and a day. By making it to this threshold, the earnings will qualify as long-term and enjoy the reduced tax rate.

Tax-Shelter Your Dividend Payments

With as many fluctuations as there are in the stock market, it can be a good idea for investors to put their money into stocks and ETFs that pay dividends. Dividends are the earnings that a company or fund distributes back to its shareholders.

Dividend income is considered taxable. However, there are some ways that these taxes can be reduced or avoided altogether. Kevin Cook, the Chief Product Owner at TrackRight, suggests two money-saving strategies.

The first is to invest so that you’ll receive what’s known as qualified dividends. These are dividends that meet specific IRS criteria such as coming from a qualified company and meeting a certain number of holding days. The great thing about these dividends is that, similar to long-term capital gains, they’re taxed at a lower rate than ordinary income or non-qualified dividends (such as those from REITs).

Secondly, investors can avoid (or rather defer) these taxes altogether by filling their traditional IRAs and 401k plans with high-dividend stocks and ETFs. For as long as these assets are in the account, you won’t have to worry about paying taxes on them. In fact, you can reinvest those dividends and compound your opportunities for future growth.

Sell Your Losses

It’s not fun when your investments lose money, but it’s also inevitable that it will happen from time to time. The good news is that when they do, you can strategically use failing investments to counterbalance the gains from your winners.

According to Kenny Kline, President & Financial Lead at BarBend, if you’re going to lose money on an investment, you might as well obtain a tax break. Capital losses are deductible up to $3,000. If you don’t have any capital gains to offset the capital loss, then you could also use it to offset your ordinary income (also up to $3,000 for the year). 

If your capital losses exceed this $3,000 threshold, then they can be carried over into the following tax years up to the maximum allowable amount. To give you a simple example, if your losses were $9,000, then you could apply $3,000 this year, next year, and the year after that.

In all instances, the net result is that you’ll reduce your long-term or short-term capital gains income. This will then lower your overall tax liability.

Keep Track of Your Investments

With so many different online financial providers and trading apps, it can be difficult to keep track of them all and know how your investments are performing. That’s why we recommend using a helpful app like Buxfer to bring them all into one place.

Buxfer can be used to automatically sync with over 20,000 financial institutions and report your latest portfolio values. This means instead of checking half a dozen different platforms, you can consolidate them all into one, easy-to-read dashboard.

Click here to find out more about how Buxfer can be used to monitor your portfolio.

Image credit: Pexels

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