How to Reduce Tax on Your Investments

The process of growing your financial assets is called investing. Investing in assets that provide cash flow, rising prices, or both, are some various ways to do this. Keeping investment expenses low is another way that complements a growing investment portfolio. But, income tax is possibly the biggest single investment expense. To reduce taxes on investments, what are the best ways?

Long Term Capital Gains

Through short-term trading, there are various strategies floating around for generating big investment returns. Maneuvering your money in and out of various investments at hopefully opportune moments or day-trading is an extreme example. 

The exposure to maximum income tax liability is the problem with all short-term trading strategies. Short-term capital gain is the meaning of short-term trading. 

Any profit that you will earn when you sell a capital asset in under one year will be added to your total income and will be taxed at ordinary rates. The taxed incurred will take a big chunk out of any profits you earn if you are taxed at a higher rate (39.6%).

Investing for long-term capital gains is a better strategy and it will also earn you bigger profits by default. The tax on long-term capital gains will be no more than 20% even if you are at the top tax rate. 

Your long-term capital gains tax liability will be zero if you are in the 15% tax bracket or less ($36,250 for single filers and $72,500 for married filing jointly). To minimize your tax liability, any capital assets you hold outside of a tax-sheltered account should aim specifically for long-term capital gains. 

Keeping your portfolio in Tax Sheltered Accounts 

An opportunity to allow your investments to grow free from tax considerations is what tax-sheltered investment accounts primarily retirement accounts such as 401(k)s, 403(b)s, and various IRA plans offer. 

Compared to a taxable account, they are tax-deferred and not tax-free and will enable your portfolio to grow much more rapidly. Until you begin making withdrawals when you are retired, you won’t have to deal with tax considerations and by then you should be in a lower income-tax bracket. 

For interest and dividend earning investments, these are the best accounts as well as the type of investing that produces short-term capital gains. The money that you invested will accumulate without creating a tax liability these types of investments normally produce. 

Invest in Municipal Bonds

Holding interest-bearing investments in a tax-sheltered account is a definite exception for municipal bonds. Taxes within the issuing states and federal taxes are free on the interest earned on municipal bonds. 

You should favour municipal bonds issued by your own state if your state has a particularly high tax rate. In your home state, any municipal bonds that originate from other states will be subject to income tax. 

Considering Real Estate Investments 

The potential for both capital appreciation in the form of rising property values and potential for current income (positive rent income) is what the real estate offers. Below are three major tax advantages it also offers:

• By depreciation for income tax purposes, a positive cash flow (rent minus expenses) is typically offset.
• The property will not be subject to income tax until the property is sold even if the value of the property will rise for many years. 
• It will have the benefit of qualifying as a long-term capital gain and subject to lower income taxes once the property is sold. 

Real estate has been a solid performer over the past century even if it is not the most liquid asset. It can also be compared to a tax-sheltered portfolio with the real estates' combination of the tax advantages it offers. 

Index Funds

To reduce taxes on investments, an index fund is a great way! It is actually one of their best functions even if not many investors think of index funds this way. They most certainly qualify as tax-efficient investments even if they are not tax-free or tax-deferred. 

Until and unless the index makes a reallocation, they don’t trade individual stocks as index funds are established to match the underlying index-- say, the S&P 500. Trading is kept to a minimum since this doesn’t happen all that frequently. 

In the portfolio, everything else is kept constant. This means the tax liability generates in every little selling of stocks. It produces tax-favored long-term capital gains when they do sell. 

Compare it with an actively managed funds that trade stocks frequently in an attempt to beat the market. It will often generate short-term capital gains that do not enjoy the same tax advantages the long-term variety do since these types of funds will not generate capital gains only. 

With little income tax impact, index funds can grow over many years. 

Invest accordingly after considering the impact of taxes on all of your investments. There are ways to keep them to an absolute minimum or get around most investment-related tax burdens.