Unless you filed an extension, all of us just wrapped up our annual tax filings. In this process, you may have been reminded that taxes can take a significant bite out of your investment returns if you're not careful. But not to worry…. there are plenty of strategies you can employ to minimize your tax bill and keep more of your hard-earned money working for you.
1. Utilize Tax-Advantaged Accounts
Tax-advantaged accounts like IRAs and 401(k)s are excellent ways to help limit the tax bill while retaining hard-earned dollars. There are two primary advantages to these types of accounts. First off, these are tax-deferred, meaning what you put in now isn’t taxed until you take money out of the accounts, ideally in retirement… What does that mean exactly?
Say for example you put $7000 into two separate accounts… one is an IRA and the other is an individual/taxable account. You invest in the same stock or mutual fund in both accounts and it doubles in value after three years at which time you decide to sell it. In the individual account, you are taxed at the long-term capital gains rate of 15%, owing a little over $1000 in taxes, bringing your account balance to just under $13K. In the IRA your investment gain remains tax-deferred and can be put to use in another investment of your choosing. So that $7000 is now $14,000 and you’re able to reinvest it elsewhere, again tax-deferred.
Another advantage in the short term… whatever you contribute to the IRA or 401K lowers your taxable income by that amount. So retuning to our example, an individual making $100,000 that contributes $7K to an IRA know has taxable income of only $93,000. Less taxable income is likely to equal a lower tax bill, yet you still retain what you earned… you just can’t spend it until later in life. It’s not that you’re avoiding tax on these dollars altogether. You will eventually get taxed when you take money out of the account. But the theory is that when you actually need the money in retirement you’re more likely to be at a lower tax bracket than you are today.
So what are the max contributions you can make to an Traditional IRA in 2024? $7K if you’re under 50 and $8K if you’re over 50. A 401K allows for $23K to be deferred annually by an employee under 50 and $30,500 for those over 50. What about those of you who are self-employed and fund your own SEP IRA? Contributions an employer can make to an employee's SEP-IRA cannot exceed the lesser of: 25% of the employee's compensation, or $69,000 for 2024. Take advantage of this if you’re not already doing so!
2. Harvest Your Losses
Next, let's discuss tax-loss harvesting. This strategy involves selling investments that have experienced losses to offset capital gains and reduce your tax liability. This is only relevant for taxable accounts of course… not IRAs like we just discussed. When capital losses are greater than capital gains, investors can deduct up to $3,000 from their taxable income. Tax-loss harvesting can help you save on taxes, but it also allows you to rebalance your portfolio and potentially improve your overall returns.
3. Choose Tax-Efficient Investments
Now, let's talk about the importance of choosing tax-efficient investments. Certain assets, like index funds and municipal bonds, are often more tax-friendly than other investment holdings. By focusing on
investments with lower turnover and qualified dividends, you can minimize the taxes you owe and keep more money in your pocket.
4. Consider Roth Conversions
Last but not least, let's touch on Roth conversions. This strategy involves converting traditional retirement account funds into a Roth IRA, potentially allowing you to enjoy tax-free withdrawals in retirement. A Roth IRA differs from a Traditional IRA in that you are funding it with “after-tax” dollars. But there is an enormous advantage in that once dollars are invested in a Roth IRA they won’t be taxed upon distribution from the account. If you have time on your side, then shifting assets from a Traditional IRA to a Roth IRA can be really beneficial. Say you have $20,000 in a Traditional IRA. You decide to convert it to a Roth. Doing so triggers a tax bill as this is taxed at your current income tax rate… for our purposes of easy math we’ll say 20%. So your $20K has become $16K. But in time that $16K grows and results in a portfolio that is say $100K. When you take money out in the future it distributed tax free. That can be a huge benefit long term.
We find the best approach is to populate several buckets, some tax-deferred, some tax-free, and perhaps others taxable and more liquid than retirement dollars. Being a tax-efficient investor ultimately has the potential to allow you to keep more of your money in your pocket. Working alongside a team of advisors and tax professionals collectively can help you become a more tax-efficient investor. Don’t hesitate to talk to us about ways we can work with you and your tax team to plan more effectively in the future.
Any opinions are those of Kent Oliver and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.
Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. These are hypothetical examples for illustration purposes only. Actual investor results will vary.
Unless certain criteria are met, Roth IRA owners must be 59 ½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.