High returns aren’t the only consideration when selecting your investments.
An efficient tax strategy can significantly enhance your investment returns by reducing your tax liability. Consider reviewing your portfolio for the following tax-saving strategies.
1. Fully utilize your tax-advantaged accounts
Investors have numerous avenues to shelter their funds. By investing through accounts designed for tax benefits, such as HSAs, IRAs, and 401(k)s, you can substantially decrease your taxable income. Returns in these accounts are exempt from taxes on dividends from stocks or interest from bonds, and you also won’t face capital gains taxes when selling at a profit.
Moreover, IRAs and 401(k)s offer tax incentives either on contributions or withdrawals, depending on whether the account is traditional or Roth. HSAs provide tax advantages on contributions and distributions, making them the only type of account with triple tax benefits.
Such accounts are highly advantageous, which is why the IRS limits annual contributions. Prioritize your investing funds into these tax-advantaged accounts until you reach the maximum limit; only then should you concentrate on augmenting your standard brokerage accounts.
2. Explore tax-advantaged investments
Certain investment vehicles come with inherent tax savings. Treasury securities, for instance, are exempt from state taxes (although federal taxes on interest still apply).
Municipal bonds provide an additional layer of tax relief: they are typically exempt from federal taxes and may also be free from state taxes if issued in your state of residence. If you’re considering municipal bonds, choose those from your home state to maximize tax efficiency.
However, not every tax-advantaged investment is the ideal option. Bonds that offer tax benefits often yield lower returns compared to their taxable counterparts, and depending on your personal circumstances, the potential tax savings may not compensate for these lower yields. For example, if you reside in a state with substantial taxes, tax-free municipal securities can be beneficial, but in states with no income tax, the federal tax exemption alone may not justify the investment.
3. Avoid overlapping tax benefits
While municipal bonds offer significant taxation advantages, placing them within an IRA negates these benefits. This is because interest from any bond held in an IRA is not subject to taxes, regardless of whether it is from a municipal bond. Consequently, investing in municipal bonds within a tax-advantaged account is ineffective.
Likewise, real estate investment trusts (REITs) can subject you to high tax liabilities due to their substantial dividend payouts. However, placing REITs in a tax-advantaged account like an IRA alleviates this taxation issue, as the dividends produced by REITs won’t be taxed upon receipt.
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Strategically aligning your investments with the appropriate accounts can protect you from the implications of heavily taxed investments while maximizing the benefits from tax-efficient options. This approach can result in a much smoother experience when filing taxes each year.
