High returns aren’t the only consideration when selecting your investments.
A tax-efficient investment strategy can lead to significant savings on your tax obligations, enhancing your overall investment returns. Review your portfolio to see if you’ve adopted these effective tax-reduction strategies.
1. Maximize contributions to tax-advantaged accounts
Investors have numerous options for saving money effectively. By utilizing accounts that offer tax benefits, such as HSAs, IRAs, and 401(k)s, you can significantly reduce your tax liabilities. Earnings from dividends or interest in these accounts typically do not incur taxes, and selling an investment at a profit usually avoids capital gains taxes as well.
Furthermore, IRAs and 401(k)s provide a tax advantage either when you contribute or when you withdraw funds (depending on whether it’s a traditional or Roth account). HSAs offer a unique benefit by providing tax breaks on both contributions and withdrawals, making them a uniquely advantageous option.
Due to their substantial benefits, the IRS has set contribution limits for these accounts each year. Therefore, prioritize funding these tax-friendly accounts until you reach the maximum limit before turning your attention to standard brokerage accounts.
2. Explore tax-advantaged investments
Some investments inherently provide tax benefits. For instance, treasury securities are exempt from state taxes (though federal taxes on the interest still apply).
Municipal bonds offer even greater tax advantages: they are generally free from federal taxes and potentially state taxes, especially if issued by your home state. Consequently, seek municipal bonds from your state of residence to optimize your tax savings.
However, remember that a tax-advantaged investment might not always yield the best results. Bonds that offer tax benefits often provide lower returns compared to other investments, and depending on your specific circumstances, the tax advantage may or may not compensate for those lower rates. For example, if you live in a state with high taxes, tax-free municipal securities may be very advantageous, while in a state with no income tax, federal tax savings alone may not justify the investment in municipal bonds.
3. Avoid overlapping tax benefits
Municipal bonds are particularly attractive due to their tax breaks; however, if placed within an IRA, the tax benefit is nullified. This is because any interest from bonds, including municipal bonds, deposited into an IRA isn’t taxed at the time of accumulation.
Additionally, real estate investment trusts (REITs) are an excellent investment choice but can lead to significant tax liabilities due to high dividend payouts. Placing your REITs into a tax-advantaged account such as an IRA effectively mitigates this issue, as the generous dividends will not incur taxes as they are received.
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Properly aligning your investments with suitable accounts can shield you from the drawbacks of heavily taxed assets while maximizing the benefits from other investments. This strategy can significantly enhance your experience on Tax Day each year.
