Five Strategies for Tax-Efficient Investing
After factoring in federal income and capital gains taxes, the alternative minimum tax, and possible state and local taxes, your investments' returns in any given year may be reduced by 40% or more.
Here are five ways to potentially lower your tax bill.1
Consider Tax-Deferred and Tax-Free Accounts
Tax-deferred accounts include employer-sponsored retirement accounts such as traditional 401(k)s and 403(b) plans, individual retirement accounts (IRAs), and annuities. In some cases, contributions may be made on a pretax basis or may be tax-deductible. More important, investment earnings compound tax-deferred until withdrawal, typically in retirement, when you may be in a lower tax bracket. Contributions to nonqualified annuities, Roth IRAs and Roth-style employer-sponsored savings plans are not deductible. Earnings that accumulate in Roth accounts may be withdrawn tax-free if you have had the account for at least five years and meet the requirements for a qualified distribution.
Withdrawals prior to age 59½ from a qualified retirement plan, IRA, Roth IRA or annuity may be subject to ordinary income taxes and an additional 10% federal tax. In addition, early withdrawals from annuities may be subject to additional charges by the issuing insurance company.2
Note that, in general, annual withdrawals from traditional IRAs and employer-sponsored retirement plans must begin by April 1 of the year after you reach age 70½. The penalty for not taking the required minimum distribution (RMD) can be steep: 50% of what you should have withdrawn. Withdrawals from Roth IRAs, however, are not required during the owner's lifetime.
Consider Government and Municipal Bonds
Interest on U.S. government issues is subject to federal taxes but is exempt from state taxes. Municipal bond income is generally exempt from federal taxes, and municipal bonds issued in-state may be free of state and local taxes as well. Sold prior to maturity, government and municipal bonds are subject to market fluctuations and may be worth less than the original cost upon redemption.
Look for Tax-Efficient Investments
Tax-managed or tax-efficient investment accounts are managed in ways that can help reduce their taxable distributions. Investment managers can potentially minimize portfolio turnover, invest in stocks that do not pay dividends and selectively sell stocks at a loss to counterbalance taxable gains elsewhere in the portfolio.
Put Losses to Work
You may be able to use losses within your investment portfolio to help offset realized gains. If your losses exceed your gains, you can typically offset up to $3,000 per year of the difference against ordinary income. Any remainder can be carried forward to offset capital gains or income in future years.
Keep Good Records
Maintain records of purchases, sales, distributions, and dividend reinvestments so that you can properly calculate how much you paid for the shares you own and choose the most preferential tax treatment for shares you sell.
Keeping an eye on how taxes can affect your investments is one of the easiest ways you can enhance your returns over time.
1This information is general in nature and is not meant as tax advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.
2Before investing, investors should consider the investment objectives, risks, charges, and expenses of an annuity and its underlying investment options. Guarantees are based on the claims-paying ability of the issuer and do not apply to a variable annuity's separate account or its underlying benefits.
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