Tax Bite Prevention
Unlike death, taxes can be minimized.
Personal Finance
We've all had a chuckle at Ben Franklin's famous quote that nothing in life is certain but death and taxes. Still, seeing taxes eat into your investment returns can cause fresh pain each year. So, how should you think about taxes as an investor?
Your goal as an investor should be to achieve the highest aftertax rate of return, not to avoid paying taxes. Taxes are an important consideration, but they should not control your investment decisions.
Below are a few basic planning strategies to think about (because, unlike death, taxes can be minimized).
Consider Your Tax-Advantaged Options
Tax-advantaged accounts offer one of the most effective ways to minimize the tax blow. Conventional tax-planning wisdom says it's better to pay taxes later than sooner, but recently tax planners have become more divided on the best strategy amid speculation that tax rates may be higher in the future.
No one can say with certainty whether taxes will be higher later, but you can still benefit from various types of tax-advantaged accounts such as traditional and Roth IRAs and 401(k)s and college-savings options such as 529 plans.
For example, traditional IRAs and 401(k)s provide an immediate tax advantage because you do not have to pay taxes on your contributions until you withdraw funds in retirement. Roth IRAs and Roth 401(k)s provide a tax advantage later--but you have to pay taxes on your contributions now. However, your assets will increase tax-free and you won't have to worry about taxes when you withdraw money in retirement. See this article for help deciding between a traditional or Roth IRA. Click here to read about various college-savings options.
Hold Securities for at Least a Year
Capital gains--the difference between what you sell a stock for versus what you paid for it--are "tax preferred," or taxed at lower rates than ordinary income, but you are only entitled to the capital gains tax rate if you have owned the security for more than one year. If you hold a security for less than a year, your gains will be taxed at ordinary income rates. Capital gains are taxed at the much lower rate of 15%, and taxpayers in the 10% and 15% tax brackets will not owe capital gains tax on the sale of assets they've owned for a year or more.
Consider Taking a Loss
Although it's never fun to lose money, you can reduce your tax bill by using capital losses to offset capital gains. If you happen to have both short-term and long-term capital gains, you may want to consider realizing short-term capital losses on stocks you have held for less than one year. These short-term losses will offset your short-term gains, which are taxed at higher ordinary income rates. This will give you the most tax mileage for your capital loss.
Time Capital Gains and Losses Strategically
When faced with large capital gains and losses, it may be advantageous for you to realize both in the same year. Suppose you have $30,000 of capital gains and $30,000 of capital losses. If you realize only the gain in 2010, you will have to pay tax on the entire $30,000. If you decide to realize only your loss in 2010, you'd have no capital gains to offset it, and you could only deduct $3,000 against your other income. The remaining $27,000 loss must be carried over into future years. Instead of delaying the tax benefits of your loss, you could choose to realize both the capital gain and loss in the same year. Because they completely offset each other, you would not owe any taxes.
On the other hand, if you do not have a large capital loss to offset, you should generally time the realization of long-term capital gains--which will be taxed at favorable rates--for years when you do not realize any capital losses. Then you can realize your future capital losses in years when you can immediately deduct them against other income that may be taxed at higher ordinary income rates.
Taxes should not be the primary driver of your investment decisions, which should be based on the fundamentals of your holdings or your income needs. But you should always be aware of the bite that taxes will take, and time your decisions strategically whenever possible to minimize the tax hit.
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