Here’s a riddle: Jennifer and Mark are both 30-year old, single Americans with no kids. Jennifer and Mark both earn exactly $60,000 a year. But Mark pays $9,000 (15%) in federal income taxes and Jen pays just $5,000 (about 8%).
What’s the difference?
No, Jennifer isn’t doing anything shady. And no, Mark isn’t making egregious errors on his tax return.
It’s just that Jennifer is taking advantage of investing strategies that can legally reduce her taxes. Mark isn’t.
The results are striking: Jennifer gets to keep an additional $4,000 of her money that Mark doesn’t.
How is that possible? There are various strategies to make it happen – here are eight you can use to reduce your taxes.
1. Tax-advantaged accounts: IRAs, 401(k)s, 403(b)s, HSAs
If you’re not participating in a tax-sheltered retirement account, you should be. It’s potentially the biggest tax break you’ll get. Not only will investment earnings within the account be tax-deferred, but your contributions will generally be deductible from your taxable income.
If your employer offers a defined contribution plan, like a 401(k), 403(b), or a 457 plan, you should sign up if you haven’t already. If you have, maximize your contribution. The IRS allows you to contribute up to 100% of your earned income, up to $19,500, or $26,000 if you are 50 or older.
If you don’t have an employer-sponsored plan, open a traditional IRA. You can contribute – and deduct – up to $6,000 per year, or $7,000 if you’re 50 or older. And if you’re self-employed, you should definitely investigate opening a plan specifically for the self-employed. That includes a SIMPLE IRA, SEP IRA, or even a Solo 401(k) plan. The SIMPLE IRA permits a contribution of up to $13,500, or $16,500 if you are 50 or older.
The SEP IRA and Solo 401(k) have even more generous contribution limits. The maximum is 25% of your net business income, up to $57,000 per year for both plans, and an additional $6,000 on a Solo 401(k) if you are 50 or older.
You can open all types of retirement accounts through a full-service investment broker, like E*TRADE. They offer both traditional and Roth IRAs. And if you’re self-employed, they can also accommodate a Solo 401(k) account and SIMPLE and SEP IRAs.
What’s more, E*TRADE offers the best in commission-free trading of stocks, options, and exchange-traded funds (ETFs), as well as several managed investment accounts in case you don’t want to do the job yourself.
2. Hold investments for at least a year
The tax law makes an important distinction between short-term capital gains and long-term capital gains. Short-term capital gains are taxed at ordinary income tax rates, which can be as high as 37%. But long-term capital gains – investments held for more than one year – are generally capped at 20%. However, most taxpayers will pay a long-term capital gains rate of either 0% or 15%.
That being the case, you should plan on holding your investments in taxable accounts for a minimum of one year before selling. The tax benefit on large gains will be substantial.
3. Sell losses to offset capital gains or reduce your taxable income
Continuing on the topic of capital gains, you can sell losing positions to generate losses that can offset gains on winning positions. If you’ve lost money on an investment, you may as well get a tax benefit from the security.
You can deduct capital losses up to the amount of capital gains you have during the tax year. And if those losses exceed your gains, you can write off up to $3,000 against non-investment income. Either outcome will reduce your capital gains income, whether long-term or short-term, and that will lower your tax liability.
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4. Hold your interest and dividend-bearing investments in a tax-sheltered account
Stocks that pay dividends are an important part of most investors’ portfolios because they provide reliable income despite stock market ups and downs. But as with any investment income, dividends are taxed. Here are two tips to optimize your dividend-paying investments for taxes.
Your IRA is the best place for high dividend-paying stocks
If you can, hold dividend-paying stocks and funds in an IRA and other tax-advantaged accounts. Because these accounts grow tax-free, you won’t pay taxes on dividends that are reinvested every year.
Watch out for the “wrong type” of dividends.
The IRS categorized dividends into two categories: qualified and non-qualified dividends.
What you need to know is that qualified dividends receive special tax benefits whereas non-qualified dividends are taxed at your regular income tax rate. You’ll want to take that into account before choosing an investment that pays non-qualified dividends such as real estate investment trusts (REITs).
5. Invest in funds with lower turnover
Investment funds can be a wellspring of capital gains, which can be a problem at tax time. The best way to avoid this is by investing in funds that have low investment turnover.
“Turnover” refers to the frequency with which stocks within the fund are traded. An actively managed fund may have a trading frequency of 80% or 100%. That means the entire portfolio is traded within the course of a year.
A better option, from a tax standpoint, is to go with low turnover funds. The best are generally index funds. They trade stocks only infrequently since the portfolio is tied to an underlying index. In fact, securities are traded only when the composition of the underlying index changes. Since that’s infrequent, they’ll generate far less in the way of capital gains than actively managed funds.
What’s more, the capital gains they generate are more likely to be of the long-term variety, which will result in a lower tax rate on those gains.
6. Open a Health Savings Account (HSA)
To qualify for an HSA, you must participate in what’s known as a high deductible health plan, or HDHP. That’s defined as a health insurance plan, with a minimum annual deductible of $1,400, or $2,800 for a family plan.
The plan must also have a maximum out-of-pocket limit of no more than $6,900, or $13,800 for a family plan.
But if you qualify based on your health insurance plan, you can open an HSA account and contribute up to $3,550 per year, or $7,100 for a family plan. Your contributions are tax-deductible against earned income. Meanwhile, any withdrawals taken for approved out-of-pocket medical costs can be taken tax-free.
But any funds you don’t spend during the tax year can be retained in the plan and invested. While banks and credit unions are popular HSA plan sponsors, you can also hold the plan with an investment brokerage, where you can invest the money, much as you would in an IRA.
7. Invest your taxable fixed income portfolio in municipal bonds
If you have a taxable investment account, and some of that money is invested in fixed income securities, switching some of those positions into municipal bonds – or municipal bond funds – will be a way to provide tax-free interest income.
Not only is municipal bond interest tax-free for federal income tax purposes, but it’s also free from state income tax if the bonds are issued by an agency or municipality located in your state of residence. This is what’s known as “double tax-free.” It can be a serious benefit if you live in high tax states, like New York or California.
For example, if you’re in the 22% federal income tax bracket, and 10% for state income tax purposes, municipal bonds will save you a 32% tax hit on your interest income.
If you’re going to be earning interest on your portfolio, you may as well make it tax-free.
8. Work with a financial advisor to provide comprehensive tax planning
If you’re in one of the higher tax brackets, and especially if you have a significant amount of investment assets, it may be time to work with a financial advisor. In addition to providing investment management, they offer other services, including comprehensive tax planning.
If you think hiring a financial advisor is expensive, think again. Just as the internet has revolutionized almost everything in the financial universe, it’s also made significant changes in the financial advisor space.
There are two web-based services available to help you find the right financial advisor at a price you can afford:
The Paladin Registry is a free directory offering you a choice of both financial planners and registered investment advisors. You’ll provide information indicating the type of advisory you’re looking for, and you’ll be provided with as many as three advisors that match your criteria.
You can then choose what you believe to be the best match for you. Best of all, each financial advisor is fully vetted to make sure they meet quality standards and have the skills and experience to get the job done for you.
Facet Wealth is an online financial planning firm, offering their services at an affordable price. Unlike traditional financial planners, they don’t charge fees based on the size of your assets under management. Instead, they charge a series of flat fees, based on the service level you choose.
You can choose whatever type of financial planning service you’re interested in. Options include retirement planning, education plan, asset management, and estate planning, among others. They also offer income tax planning, which is designed to minimize the impact of taxes on your investing activities.
Even if you are unable to take advantage of the above tax strategies in 2020, don’t sweat it. You can begin implementing the changes for the 2021 tax year.
That should serve as a reminder that tax strategies to lower your tax liability aren’t something that only happens at year-end, or during tax season. Strategic tax planning should take place throughout the year, so you’ll avoid the last-minute year-end and tax season crunches that generate so much stress.