Like it or not, taxes can take a bite out of your investments, leaving you with less money than you may have anticipated. But is that tax bite larger than it needs to be?
For many people, it is. They don’t invest their money in the most tax-efficient ways and, as a result, miss out on opportunities to pay a lower tax rate (or no tax at all) on their investment gains.
With better planning, you can keep more money for your own needs and pay less to Uncle Sam. Let’s explore three tax mistakes you may be making with your investments and how to avoid them.
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1. Missing qualified dividends in a taxable account
Stocks, bonds, ETFs and every other investment vehicle play an important role in a well-balanced portfolio. People often don’t know how their taxable account is invested, especially if they have an income need.
On occasion, though, it turns out the investments are all taxable bonds instead of dividend-paying investments.
Why is that a concern? Dividends generated from U.S. companies are typically taxed as long-term capital gains. At most, someone who earns dividends would pay a tax rate of 20%, but some tax filers pay 0% tax on that income.
However, interest from a taxable bond is taxed as ordinary income. The highest tax rate for ordinary income is 37%. Clearly, that’s a significant difference.
If you want to invest in dividend-paying stocks — and there are valid reasons to do so — make sure you benefit from the full advantage of how they are taxed.
2. Failing to make use of tax-loss harvesting
You’ve probably heard of tax-loss harvesting, but many people don’t know how to take advantage of their investments’ growth over time.
Tax-loss harvesting is a strategy in which you take advantage of a loss in one investment by using it to offset the gain in another, reducing your overall tax bill for the year.
The problem? In order to use a loss to offset a gain, an investor must hold an investment that has lost value. True tax efficiency includes taking advantage of gains as much as harvesting gains against losses.
It’s a good idea to review your investments annually for opportunities to take advantage of tax-loss harvesting.
3. Missing windows of opportunity to make IRA withdrawals
If you have saved for retirement in a traditional IRA, you will pay taxes when you make withdrawals from the account.
But if you plan correctly, you can reduce the amount of taxes you will pay over your lifetime by strategically moving the money to a more tax-efficient or even tax-free account.
Unfortunately, too many people fail to take advantage of such opportunities. When an emergency arises, they are forced to make a large withdrawal all at once, possibly pushing them into a higher tax bracket.
Plan well, though, and the tax work is already done if such an emergency comes up.
One of the more popular strategies is to convert money from your traditional IRA or 401(k) into a Roth IRA. With Roth IRAs, your money grows tax-free, and it isn’t taxed when you withdraw it.
You will pay taxes when you move the money from your tax-deferred account, so you may want to do the conversion of smaller amounts over several years.
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But you can also move the money into other taxable accounts as well, such as brokerage accounts, CDs, money market accounts or savings accounts.
I once had a client whose goal was to buy a boat four years after he retired, using money from his IRA. Instead of waiting for four years and making one huge withdrawal, he took out smaller amounts each year for four years, putting the money into a taxable account and taking advantage of the capital gains tax.
When the time arrived to withdraw money to purchase the boat, the taxes he had paid were lower than if he had withdrawn a lump sum from the IRA.
Final thoughts
As you can see from these three examples, there’s a lot to consider with the tax implications of your investments. Finding the right solutions and avoiding the wrong ones can be complicated.
That’s why it’s always a good idea to consult with a financial professional who understands the complexities and can help you make decisions that work best for you.
Then, when tax time arrives, you’ll have a better handle on how to avoid costly mistakes, allowing you to hold on to more of your money when it comes time to pay the federal government its share.
Ronnie Blair contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Way Street Financial, LLC is an Ohio registered investment adviser. Information presented is for educational purposes only and intended for a broad audience. Examples provided are illustrative only, not tailored to any individual’s circumstances, and should not be relied upon as personalized investment advice. For specific recommendations based on your goals, please contact a registered investment adviser. Investments involve risk, including possible loss of principal, and are not guaranteed. Way Street Financial, LLC believes this material does not contain any false or misleading statements or omissions and that the content as a whole does not create a misleading impression of the adviser’s services. Information is presented in a fair and balanced manner. Way Street Financial, LLC does not provide tax, legal, or accounting advice, and you should consult your own qualified professional regarding your specific situation.
