Tax season is upon us again, and we know that nobody is looking forward to filing their tax return. What you can look forward to is saving on your federal taxes by strategically managing your investments to reduce your tax burden.
There are a variety of steps that individuals can take to help lower their federal income taxes and save money come tax season. Here are some of our top tips for tax-efficient investing.
Pay Into Your 401(k)
Save for retirement and save money on your taxes all at the same time! Utilizing your retirement account is one of the simplest tax efficiencies available. Money that you put into tax-deferred accounts such as an IRA or 401(k) is not taxed upfront. These tax benefits mean you can deduct money you contribute to these accounts from your yearly tax return.
You’ll still need to pay tax when you withdraw from the account, but this strategy is still a great way to get an immediate tax break and save for your future. It’s an especially beneficial play if you are in a high tax bracket now and expect to be in a lower tax bracket by the time you retire – instead of paying high tax on the income now, you will pay a lower tax rate once you retire and want to withdraw your cash. That's a desirable advantage when you're retired and on a fixed income.
This strategy does have its limits when it comes to total contributions – in 2023, you can contribute a maximum of $6,500 to your IRA and $22,500 to your 401(k). If you are in a lower income bracket, that might be all you need to cut down on taxable income. For high earners, maximizing the tax benefits associated with your retirement accounts is a good first step, but there are additional strategies you can adopt to boost your tax efficiency.
Account Diversification
Depending on your income bracket, expanding beyond an IRA or 401(k) could improve your tax efficiency. You can reduce your yearly taxes by paying into your 401(k) and benefit in the short term, but the downside is that you will have to pay tax on the money once you withdraw it.
If you expect to be in a higher income bracket by the time you retire, you might benefit from using a Roth IRA. While contributions to a Roth IRA are made after tax, withdrawals are tax-free. So, while you might not see any immediate tax breaks, you will reap the reward in the future. It might even be best to have a combination of all three types of accounts – IRA, 401(k), and Roth IRA – to cover all your bases and maximize your tax efficiency.
Health Savings Account (HSA)
This type of tax-advantaged account gives you a couple of different benefits while lowering your taxes. An HSA kills two birds with one stone – you’re setting aside money for future healthcare expenses, and you can avoid paying taxes on the money you contribute to this account.
Tax season is upon us again, and we know that nobody is looking forward to filing their tax return. What you can look forward to is saving on your federal taxes by strategically managing your investments to reduce your tax burden.
There are a variety of steps that individuals can take to help lower their federal income taxes and save money come tax season. Here are some of our top tips for tax-efficient investing.
Pay Into Your 401(k)
Save for retirement and save money on your taxes all at the same time! Utilizing your retirement account is one of the simplest tax efficiencies available. Money that you put into tax-deferred accounts such as an IRA or 401(k) is not taxed upfront. These tax benefits mean you can deduct money you contribute to these accounts from your yearly tax return.
You’ll still need to pay tax when you withdraw from the account, but this strategy is still a great way to get an immediate tax break as well as save for your future. It’s an especially beneficial play if you are in a high tax bracket now and expect to be in a lower tax bracket by the time you retire – instead of paying high tax on the income now, you will pay a lower tax rate once you retire and want to withdraw your cash. That's a desirable advantage when you're retired and on a fixed income.
This strategy does have its limits when it comes to total contributions – in 2023, you can contribute a maximum of $6,500 to your IRA and $22,500 to your 401(k). If you are in a lower income bracket, that might be all you need to cut down on taxable income. For high earners, maximizing the tax benefits associated with your retirement accounts is a good first step, but there are additional strategies you can adopt to boost your tax efficiency.
Account Diversification
Depending on your income bracket, expanding beyond an IRA or 401(k) could improve your tax efficiency. You can reduce your yearly taxes by paying into your 401(k) and benefit in the short term, but the downside is that you will have to pay tax on the money once you withdraw it.
If you expect to be in a higher income bracket by the time you retire, you might benefit from using a Roth IRA. While contributions to a Roth IRA are made after tax, withdrawals are tax-free. So, while you might not see any immediate tax breaks, you will reap the reward in the future. It might even be best to have a combination of all three types of accounts – IRA, 401(k), and Roth IRA – to cover all your bases and maximize your tax efficiency.
Health Savings Account (HSA)
This type of tax-advantaged account gives you a couple of different benefits while lowering your taxes. An HSA kills two birds with one stone – you’re setting aside money for future healthcare expenses, and you can avoid paying taxes on the money you contribute to this account.
As with retirement accounts, there are contribution limits in place for an HSA. In 2023, you can contribute up to $3,850 to your HSA, or if you have family health coverage, you can put in up to $7,750. The best part is that you don’t have to pay any tax to withdraw money from your HSA, provided you use it to pay for qualifying medical expenses.
Buy-and-Hold Investing
Now we’ve covered savings accounts, let’s talk about how to make your investments more tax efficient. Capital gains taxes on investment profits can really add up and leave you with a staggering tax bill. Buy-and-hold investing is a great way to practice tax-efficient investing.
Since you only have to pay capital gains when you cash out an investment, holding investments long-term means you can defer capital gains. Basically, you can grow your wealth by maintaining your investments for a long period. As long as you don’t sell, you don’t have to pay capital gains. This strategy is not only one of the biggest and best ways to reduce your tax burden but also a great investment strategy, as investments generally perform better when held for longer rather than selling whenever the market has a temporary dip.
Long-Term Capital Gains
If you plan to sell off certain investments, it’s still advantageous to hold off on selling for at least a little while. In addition, holding your investments for longer is a more tax-efficient investment method than constantly buying and selling.
The reason longer investments are more tax efficient is simple – capital gains tax rates. If you hold your investments for longer than a year, you will pay a long-term capital gains tax rate. This is lower than the income tax rate applied to investments you have held for less than a year. For example, taxes for short-term capital gains for 2022-2023 coincided with the tax brackets for ordinary income taxes – 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Long-term capital gains taxes operate differently than short-term investments. Individuals making less than $44,625 in taxable income won’t pay any long-term capital gains tax. However, that rate jumps for the following groups:
• 15% for people making $44,626 to $492,300 in taxable income
• 20% for people making more than $492,300 in taxable income
The rates differ depending on whether you are planning to file individually, married filing jointly, or married filing separately. Regardless, the numbers are clear – long-term capital gains taxes are much better than short-term rates.
Tax-Loss Harvesting
Getting healthy returns on your investments is great, but it also means more taxes. To make your investing more tax efficient, consider tax-loss harvesting.
In a diversified portfolio, not all your stocks will make money. Luckily, you can turn your losses into a win by offsetting your investment losses on your taxes. If you made an overall profit on your investments this tax year, you can deduct your losses from your profit total in order to pay fewer capital gains tax overall. If you made an overall loss (let’s hope that’s not the case), you can still deduct a portion of your losses from your ordinary income.
If you combine this strategy with buy-and-hold investing and paying long-term capital gains, you can truly maximize your investment tax efficiency.
Donating to Charity
If you’re confident that your investment strategy is suitably tax efficient, you’ve maxed out your contributions to your retirement and health savings accounts, and you’re still looking for more ways to reduce your taxable income, take a look at the charitable donations you’ve made in the past year. Donating to charity is not only a meaningful way to give back and help others, but also benefits you by giving you a tax break.
You can write off up to 60% of your adjusted gross income in donations to charities – just make sure to keep good records of your donations and check that you’re making donations to qualifying tax-exempt charities.
Work with a Financial Advisor for Tax-Efficient Investing
Preparing for tax season doesn’t have to be a solo adventure. JL Smith’s team of financial planners are ready to help you take advantage of tax efficiencies and plan for your financial future.
Whether you want to create a realistic budget, explore your investment options, or start planning for retirement, we will create a comprehensive financial plan tailored to your needs. Contact the JL Smith team today to schedule a free consultation and learn all about the benefits of having a financial expert on your side.