Taxes are an unavoidable reality of investing. While they may not be your top priority when you’re focused on returns, how much you pay in taxes can be a “significant headwind to long-term returns,” he says. Faithfulness.
Paying attention to how much of your investment income goes to taxes can not only save you money on that expense, but it can also increase your returns, since “money not paid in taxes can remain invested, offering the potential for further growth and compounding.” Over time, this “can have a significant impact on the total value of your portfolio,” Fidelity says.
1. Understand when you pay taxes on your investments
The first step to saving and investing tax efficiently is understanding the different types of investment taxes that exist and when you’ll be paying them. “Most investments are taxed in two different ways: first, on the cash flows generated by the investment, and second, on the sale of the investment itself,” says Logan Aleck, CPA and founder of tax relief company Choice Tax Relief. time.
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The first is taxes on dividends and interest earned on your portfolio. “Interest and ‘ordinary dividends’ are taxed at your income tax rates (except for income from municipal bonds, which are exempt from federal tax and may also be exempt from state tax).” ElevestOn the other hand, “‘qualified dividends,’ which must meet certain IRS criteria, are subject to long-term capital gains tax rates.”
The sale of the asset itself triggers what’s called a capital gains tax. In essence, “the money you make selling any of these items is a capital gain” and you’ll pay tax on that gain, he said. Nerd WalletHowever, the rate you pay “will vary somewhat depending on how long you held the asset before selling it.” You’ll pay 0%, 15%, or 20% on assets you held for more than a year, but “capital gains tax on most assets you held for less than a year is equal to your ordinary income tax rate.”
2. Invest in tax-efficient assets
After all, “some assets that regularly generate interest, dividends, or distributions subject to capital gains tax are inherently less tax efficient than others,” Fidelity said. Examples of such assets include “bond and fixed-income funds,” “real estate investment trusts (REITs),” and “actively managed equity funds.”
Meanwhile, Fidelity said other investments “produce little or no taxable income,” including “municipal bonds and ETFs,” “passively managed index funds and ETFs,” and “tax-efficient actively managed mutual funds.”
Of course, “a tax-efficient portfolio starts with the right asset mix that matches your investment time horizon and risk tolerance,” Fidelity says, quoting Naveen Marwal, institutional portfolio manager at Strategic Advisors LLC. But you can always factor in tax-saving decisions that align with that bigger vision, too.
3. Take advantage of tax-advantaged accounts
Similarly, it can be beneficial to invest in tax-advantaged types of accounts, like retirement 401(k) plans and IRAs. With a traditional IRA or employer-sponsored 401(k) plan, contributions “are made pre-tax, lowering your taxable income for the year,” Time magazine says. Plus, “your investments grow tax-free, and any money you withdraw in retirement is subject to income tax.”
There are also Roth IRA and 401(k) options that offer other tax benefits: Contributions are “not deductible,” but investments “grow tax-free and you don’t have to pay taxes on distributions in retirement,” Time says.
4. Aim to buy and hold
“An important note about IRS tax rules is that you are only taxed on the capital gains you realize when you sell your investments for cash,” he said. BankrateIn other words, “you won’t owe a lot of capital gains tax unless you sell.”
Even if you don’t want to hold your investment forever, holding it for more than a year can still pay off, because long-term capital gains tax rates are “generally lower than the rates you pay on short-term capital gains, which are taxed at your ordinary income tax rates.”
