3 Smart Ways for Investors to Cut Their Taxes
High returns aren't the only factor to consider when choosing your investments.
A tax-efficient portfolio can save you enough on your tax bill to nicely compliment your investment returns. Take a look at your own portfolio to see if you've implemented the following tax-shrinking tips.
1. Max out your tax-advantaged accounts
Investors have plenty of options for tucking away their money. If you do your investing in accounts with built-in tax advantages, such as HSAs, IRAs, and 401(k)s, you can save a bundle on your tax bill. Investments in these accounts don't generate taxes when you receive dividends from stocks or interest from bonds, and they also won't incur capital gains taxes if you sell an investment for a profit.
In addition, IRAs and 401(k)s give you a tax break either on the money you put into the account or the money you take out (depending on whether the account is a traditional tax-deferred account or a Roth account). HSAs actually give you a tax break on both contributions and distributions, making them the only triple tax-advantaged account.
These accounts are such a great deal that the IRS has put limits on how much you're allowed to contribute to them each year. So throw your investing dollars into these tax-advantaged accounts until you hit the annual maximum; then and only then should you focus on building up your standard brokerage accounts.
2. Consider tax-advantaged investments
Certain investments have built-in tax savings. For example, treasury securities are exempt from state taxes (although you will still have to pay federal taxes on the interest).
Municipal bonds take the tax advantage a step further: They are exempt from federal taxes and may also be exempt from state taxes, if the bond was issued by the state you live in. Clearly, if you're going to buy municipal bonds, look for ones from your state of residence to max out the tax savings.
A tax-advantaged investment is not always the best choice. The bonds that come with a tax break pay lower returns than bonds that don't, and depending on your situation, the tax break may or may not make up for the lower returns. For example, if you live in a state with high state taxes, tax-free municipal securities are likely to be a good deal -- but if you live in a state with no state taxes, the federal tax savings alone likely won't be enough to turn municipal bonds into a good deal.
3. Don't overlap tax breaks
The big selling point of municipal bonds is their potentially high tax break -- but if you put a municipal bond in an IRA, the tax advantage disappears. Why? Because you don't pay taxes on any bond interest that's deposited into an IRA, whether it's from a municipal bond or not. Thus, putting municipal bonds in a tax-advantaged account is a waste of money.
Similarly, real estate investment trusts (REITs), while a great investment, can expose you to high taxes because of the very high dividends these securities are required to generate. Tucking your REITs into a tax-advantaged account such as an IRA neatly erases this disadvantage, since the copious dividends that REITs produce will not be taxed as they come in.
by Wendy Connick for The Motley Fool