The recently passed Tax Cuts and Jobs Act (TCJA) gave most Americans a break on their upcoming taxes – but you don’t need legislation to cut your taxes even further with sound investment strategies that focus on tax optimization.
Here are a few ways to help yourself at Uncle Sam’s expense.
1. Shift Toward Capital Gains – The TCJA narrowed the gap between individual tax rates and capital gains taxes, but it’s still preferable from a tax perspective to have investments that rely on price appreciation for returns instead of income generation. Returns on the former are taxed at the capital gains rate (10-20%) while returns on the latter are taxed per the standard income brackets.
2. Qualified Pass-Through Income – The TCJA also handed a huge, albeit temporary, gift to many small business owners by allowing a 20% tax deduction on qualified pass-through business income for tax years 2018 through 2025. Don’t forget to take advantage if this applies to your situation.
2. Take Full Advantage of Retirement Accounts – Contributions to retirement accounts are either tax-deferred or tax-free, depending on whether they are funded with pre- or post-tax dollars. Contribute up to the limit (for 2018, $18,500 for 401(k) plans with a $6,000 catch-up plan for those age fifty and above, and $5,500 for IRAs with a $1,000 catch-up.)At the very least, contribute up to the limits of any employer-matching program.
If you haven’t fulfilled your 2017 IRA limits, you have until the tax-filing deadline (April 17) to make designated contributions to the 2017 tax year.
3. Allocate Your Investments Wisely – If you have a blend of accounts, allocate your investments with taxes in mind. For example, stocks that provide dividend income are better applied to a tax-advantaged account to get the maximum compounding effect and avoid taxation on the dividends as ordinary income.
4. Don’t Overreact on Stocks – Resist the urge to sell during market drops like the recent correction – especially with any stocks or mutual funds that you have held for less than a year. To receive the lower capital gains tax rate on the proceeds, you must have held the stock for at least one year prior to the sale.
5. Use Tax Loss Harvesting – Are some of your stocks underperforming? By “harvesting” losing stocks and selling them off, you can offset up to $3,000 of other capital gains and/or ordinary income. If losses are greater than $3,000, you may be able to carry the excess loss forward to neutralize gains in future years.
6. Choose Passive Funds – Active fund managers must make more trades to stay ahead of the pack in returns. This increases the turnover ratio of your funds and subsequently raises your capital gains taxes. Passive funds are designed to track performance of a given index, and therefore they require less trading than an active account.
7. Check into Health Savings Accounts (HSA) – Assuming that you have a high-deductible health plan (HDHA) and are not enrolled in Medicare, you may contribute funds into an HSA account to pay for qualified medical expenses. The money is invested on a tax-deferred basis and withdrawals for qualified medical expenses are tax-free.
8. Consider Municipal Bonds – Municipal bonds have a “triple” tax benefit because they are one of the few investments that are exempt from all three levels of taxation on their earned interest – federal, state, and local (assuming you are buying local bonds to gain the local exemption). They can maximize tax savings on the lower-risk investment portion of your portfolio.
9. Make Charitable Stock Donations – By donating appreciated stock to a qualified charity, you receive multiple tax benefits. You get to deduct the full current market value of the stock and avoid paying capital gains taxes, regardless of the amount of appreciation.
Why invest your hard-earned money only to give the government an extra portion of the proceeds? Keep an eye on tax ramifications as you manage your investments over time, and you’ll be able to retire knowing that you made the absolute most of your working years.
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