Based on the most recent IRS (Internal Revenue Service) report, as of 2023, individuals earning over $578,125 fall into the highest tax bracket and are subject to a marginal tax rate of 37%.
Investors must be mindful of the tax consequences associated with their investments, as taxes can substantially affect their overall returns. While no one enjoys parting with a significant portion of their earnings to the government, fulfilling tax obligations is a responsibility for everyone.
Taxes exert a substantial influence on taxable investment accounts, exerting effects on both overall investment returns and the accumulation of wealth. Capital gains, dividends, and interest income earned from investments are subject to taxation, leading to a reduction in realized gains. To mitigate tax burdens and foster the attainment of long-term financial objectives, the implementation of tax-efficient strategies and thoughtful planning is imperative.
The IRS introduced tax brackets to establish a progressive tax system where tax rates increase as income rises. This means that individuals with higher incomes are subject to higher tax rates, with the specific rate determined based on the corresponding tax bracket.
For those in higher tax brackets, exploring tax-efficient investments can provide opportunities to leverage specific tax advantages and optimize their financial gains.
Here are five strategies to minimize your tax bill and boost after-tax returns in taxable investment accounts,
Tax-Loss Harvesting
Tax-loss harvesting takes advantage of the fact that capital losses can be used to offset capital gains. It is the timely selling of securities at a loss to offset the amount of capital gains owed from selling profitable assets. The strategy is commonly used to limit short term capital gains, commonly taxed at a higher rate than long term capital gains, commonly taxed at a higher rate than long term capital gains, to preserve the value of the investor’s portfolio while reducing taxes.
Tax-loss harvesting is a tool for reducing overall taxes. This strategy includes using the proceeds of selling unprofitable investments to buy similar investments that preserve the portfolio's overall balance.
Roth IRA
Roth IRA is a special type of tax advantaged individual retirement account to which you can contribute after tax money. Your contributions and earnings on those can grow tax free and be withdrawn tax-free.
One can put the money which they’ve already paid in taxes into Roth IRA. It will then grow and after your serving age, you won’t have to pay any further taxes.
The Roth IRA contributions must be only made in cash including checks and money order, they can’t be in the form of securities or property. The Internal Revenue Service (IRS) limits how much can be deposited annually.
Tax-Efficient Funds
It is usually a mutual fund structured to reduce tax liability. In a tax efficient fund, the structure and operations of the fund are designed to reduce the tax liability that its shareholders face.
Tax efficient funds have low tax ability, so they are good investments to make outside of a tax deferred account. This is because there is a minimal amount of tax to be deferred and the space in an investor’s tax-deferred account is better suited for high taxed securities, such as dividends.
Tax-Advantaged Accounts
The term "tax-advantaged" refers to an account that is not subject to taxation, offers tax deferral, or provides other tax benefits. These accounts include investments such as municipal bonds, partnerships, UITs, annuities, as well as savings plans like IRAs and qualified retirement plans like 401(k)s.
Tax-exempt status involves using after-tax money to invest in assets where any gains or income generated are not subject to ordinary income tax. It also involves using pre-tax income to fund investments, where taxes will be paid at a later date based on the prevailing tax rates during that time.
Many high-income taxpayers are attracted to tax-free municipal bond income, while employees often contribute to IRAs or employer-sponsored retirement plans to lower their tax liabilities. These strategies allow individuals to effectively reduce their tax bills.
Long-Term Investing
The taxation of capital gains is determined by the duration for which the assets are held before their sale. Consequently, capital gains are categorized as either long-term or short-term, and are subject to corresponding tax rates.
Long-term capital gains are consistently taxed at a lower rate compared to short-term capital gains, which fall within a tax bracket ranging from 0% to 20%. On the other hand, short-term capital gains are taxed at ordinary income tax rates, which can go as high as 37%.
Therefore, adopting a buy-and-hold approach proves to be more tax-efficient, as holding assets for over a year results in reduced capital gains tax liability as opposed to being subjected to ordinary income tax rates. Pursuing tax efficiency in taxable accounts can lead to optimal outcomes in investment, thus promoting the principles of long-term, patient investing, which hinges on well-established and successful strategies.
Conclusion
Every prudent investor must possess the knowledge of optimizing tax planning alongside maximizing investment opportunities. Seeking guidance from certified investment planners, financial advisors, or tax specialists is highly recommended, as they offer invaluable insights and expertise in tailoring tax strategies that align with individual financial circumstances and goals.
While these tax-saving strategies are widely acknowledged, a significant portion of investors still become aware of them primarily through the assistance of financial advisors. At BankQuality, our mission revolves around delivering exceptional financial insights that go beyond common knowledge, targeting both the majority of individuals who are unaware of these strategies and those who may be aware but remain uncertain about implementing them.