Now that tax season is upon us, it's time to better understand the ways in which your investments can cause your tax bill to increase. It's a good idea to think about how to engineer a portfolio in such a way that it gives you the returns you want with a limited tax burden. Here, we'll take a look at four ways to minimize the taxes associated with your investments.
1. Buy and hold
The tax system in the U.S. very much favors those who plan to hold their investments for at least a year after purchase. This discourages day trading and speculative buying, but there is a fair share of investors who still engage in these practices.
If you buy a stock and then sell it after more than a year has passed, you'll pay capital gains tax on any investment gains. Tax rates on capital gains, as they stand in current tax law, range from 0% to 20% depending on your income. If, on the other hand, you sell the stock after only a year or less, you'll pay ordinary income tax on your investment gains. Short-term stock gains also have the potential effect of pushing you into a higher tax bracket.
2. Watch your dividends
Every time your investment (whether it's a stock, bond, or fund) pays a dividend, this will trigger a tax of some kind (note that this happens regardless of whether you take the dividend in cash or reinvest it). If you have high-dividend-paying stocks or corporate bonds in a taxable brokerage account, you'll be taxed every time that investment pays out money. So it's especially important to be aware of the tax status of each account before adding any particular investment -- as we've previously explored.
Additionally, holding your investments for extended periods can push your dividends into qualified dividend status. "Extended period" in this context refers to at least 61 days during the 121-day period beginning 60 days before the investment's ex-dividend date. Like long-term capital gains, qualified dividends get taxed at a lower rate if you've held the underlying investment for long enough. Since ordinary dividends will be taxed at a higher rate, holding on to your investment long enough to "qualify" your dividends is a worthwhile investment of time.
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3. Keep an eye on Roth conversions
Depending on a variety of factors -- including your age, current year income, and tax bracket -- converting some of your pre-tax retirement accounts, like a 401(k), to Roth accounts may be a good idea. But Roth conversions ultimately add to your total taxable income for the year, and will most definitely raise your ordinary tax due.
Before engaging in a Roth conversion, it might be worth it to meet with a tax advisor who can help you plan out your conversions so you are not overpaying tax in any one year. Having money in a Roth account is always nice -- who wouldn't want tax-free growth forever? But know that you'll pay for it up front.
4. Locate the high-cash distributors
Some investment vehicles, like real estate investment trusts (REITs), will advertise high cash payouts to lure income-seeking investors. These are perfectly legitimate investments, but realize that most REIT income will be taxed at ordinary income tax rates if held in a standard taxable brokerage account.
Typically, investments with high cash payouts are better off in tax-deferred accounts, and passive ETFs that derive most of their benefit from capital gains are usually best suited for taxable accounts. Passive funds that track broad indices usually have lower payouts but make up for it by providing long-term price appreciation.
Stick to the basics
You'll go a long way in reducing your investment-related tax bill by simply holding your positions for greater than a year, properly projecting your dividend income, carefully managing any Roth conversions, and putting your high-dividend positions in tax-deferred accounts. These actions work together for you to enjoy the lion's share of investment gains and minimize your obligations to the IRS and related state authorities. You'd be well suited to review this as you prepare your tax return this year.
