Don’t ignore the impact of taxes on your investments. While taxes should not drive your investment strategy, understanding how taxes affect your earnings will help you minimize taxes and maximize your return. Some things to consider:
1. Capital gains carry a special favored tax status. The tax rates on long-term capital gains are lower than the rates on ordinary income (such as wages and business income). Consider putting more of your investment dollars into investments that produce capital gain income, such as stocks and real estate that will appreciate in value. Hold investments at least long enough to qualify as long-term.
2. Balance your stock winners and losers. You can deduct annually up to $3,000 of capital losses in excess of gains. Consider selling enough losers each year to arrive at an overall $3,000 loss for the year. Your gains for the year will be sheltered, and then some.
Watch out! If you make a “wash sale” by buying the same security within 30 days before or after the sale, your loss will be disallowed.
If earlier sales generated losses over $3,000, consider selling enough winners before year-end to get back to that level. Taking these gains will not increase your current taxes.
3. Tax-free investments escape federal, state, or local taxes. Many investments can be found that escape taxes at all of these levels. For example, municipal bonds issued by your state of residence are generally exempt from all taxes. Conversely, U.S. Treasury securities are only exempt from state and local taxes.
A sage once said, “It’s not how much you make that matters, it’s how much you keep.” When considering tax-advantaged investments, make sure you compare the after-tax yield of a comparable taxable investment with the yield of the tax-advantaged investment.
4. Consider savings bonds. The U.S. savings bond can be a sound long-term investment. In addition, you don’t have to pay state or local tax on the bonds.
5. Invest to build a college fund. Investigate the options available to you that would allow tax-advantaged investing to build college funds for your children.
You should also consider Series EE and I savings bonds for college savings. The bond interest may be exempt from income tax if the bond proceeds are used for certain higher education expenses.
To get tax-free status, the bonds must meet the following requirements:
- They must have been purchased after 1989.
- They must be purchased by someone aged 24 or older. (Don’t put the bonds in your child’s name.)
- The bonds must be used to pay educational expenses incurred by the bonds’ owner, a spouse, or a dependent.
- They must be used to pay higher education tuition and fees. (Bonds redeemed to pay room and board costs don’t qualify.) This interest exclusion is phased out for higher-income families. The income test is based on the parents’ income at the time the bonds are redeemed.
6. Investing in real estate offers significant tax breaks. Real estate investments provide tax deferral through growth in the value of the investment due to inflation and other economic forces. Also, investors can engage in tax-deferred exchanges of their property for property of a like kind.
Real estate investors who “actively participate” in managing their property can deduct up to $25,000 a year in losses against other income (although this break disappears once your adjusted gross income exceeds $150,000).
7. Tax-credit investments can be found in certain real estate opportunities. Currently, tax credits are available for real estate investments in low-income housing, rehabilitation of commercial buildings originally placed in service before 1936, and rehabilitation of certified historic structures.
8. Choose the method that minimizes your taxes when you sell mutual fund shares. You can choose among three methods to determine capital gains and losses on mutual fund shares that you’ve purchased in lots over a period of time: the first-in, first-out method, the specific identification method, or the average-cost method.
Please do not hesitate to ask for assistance in identifying investment strategies that are suited to your tax situation. Contact any member of the Baker Holtz staff at (616)458-1835.