Taxes are capable of eating up a large chunk of investment gains. Investment strategies to minimize your tax bill should be used to manage this. It is however important not to make investment decisions for the sole purpose of reducing tax burden.
Below are eight strategies that can be used to minimize your stock tax bill and save money.
1. Contributing to tax-advantaged accounts
This is the simplest and most effective way to save on taxes and it involves putting as much of your money as you can in tax-advantaged accounts. These include:
· individual retirement accounts (IRAs), and
· health savings accounts (HSAs).
You can only open an HSA if you have a high-deductible health insurance plan.
Traditional 401(k)s and IRAs are tax-deferred accounts. You can contribute pre-tax income up to a yearly limit. This essentially means that you don’t pay income tax on the money you invest. Your investment grows tax-free, and you only pay taxes when you make a withdrawal.
Presently, the yearly limits are $19,000 for a 401(k) and $6,000 for an IRA. HSAs are also tax-deferred, and you don’t pay taxes on withdrawals for qualified healthcare expenses.
2. Losing investments should be sold by the end of the year
Investments that have lost value will lower your tax liability. You must report the losses on your taxes, but you can carry losses forward indefinitely and use them any year that you like.
For instance, if you want to deduct your losses from your taxable income, there’s a limit of $3,000 per year. There’s no limit on how much of your previous losses you can deduct from future capital gains. If you lose $15,000 on investments in 2019, and sell those investments before the end of the year, you’ve “locked in your losses.”
3. Keep winning investments for at least one year
There are two types of capital gains tax. Short-term capital gains tax applies to investments that are sold after less than one year. Long-term tax applies to investments you sell after one year or longer. Short-term capital gains tax is the same as your income tax rate, whereas long-term capital gains tax is 0%, 15%, or 20%, depending on your household’s income. Long-term capital gains tax will almost always be the lower of the two rates. For that reason, aim to keep winning investments for a year or more (unless you believe it’s going to dip in value soon).
4. Invest in municipal bonds
Municipal bonds are issued by cities, counties, and states to raise money for public projects. Municipal bonds pay interest twice a year. These bonds are useful because they’re exempt from federal taxes. When you purchase municipal bonds issued in your state of residence, they’re also exempt from state and local taxes. While the average return on municipal bonds isn’t near the average you’d get from the stock market, these are low-risk investments that earn money without adding to your tax burden.
5. Hold on to Your Stocks for long term periods
Another good argument for the buy-and-hold strategy is that short-term capital gains (less than one year) are always taxed at a higher rate than long-term ones. The difference between the tax rates of long-term and short-term capital gains can be 13% or more in some states and countries. When you consider the long-term effects of compounding on reduced income taxes incurred today, it can prove beneficial to hold onto your stocks for at least one year.
6. Always match Your Profits/Losses
In many cases, it is a good idea to match the sale of a profitable investment with the sale of a losing one within the same year. Capital losses can be used against capital gains, and short-term losses can be deducted from short-term gains. Also, if you have a particularly bad year, you can carry $3,000 of your loss over to future years. This may seem counter-intuitive, but it works very well.
7. Reinvesting Dividends
Reinvesting dividends, by increasing your investment in a fund, effectively reduces your taxable gain. For instance, if you originally invested $5,000 in a mutual fund and had $1,000 in dividends reinvested in additional shares over the years. If you then sold your stake in the fund for $7,500, your taxable gain is $1500 ($7500 less than the original $5,000 investment and the $1,000 reinvested dividends).
For investors who invest in small business ventures or are self-employed, there are many operating expenses that can be written off. For example, if you take business trips during the year that require you to obtain accommodations, the cost of your lodging and meals can be written off as a business expense, within specified limits dependent upon where you travel. If you travel frequently, forgetting to include these types of seemingly personal expenses can forfeit a lot of tax savings.