Keep up with the changes
Some years, Congress changes the rules investors face. Other years, the economy necessitates rethinking the best-laid investment plans. In between, investors' personal situations change, from the arrival of children to the loss of a job.
"Investors face a changing environment," says Fred H. Thomas, branch manager of Raymond James Financial Associates in Johnstown, Pennsylvania. "They need to maximize their investment dollars."
Taxpayers trying to build wealth can weather the ups and downs of the tax side of that volatile environment by following a few historically helpful steps.
Put your retirement account to work
Thomas says the number one question clients ask relates to retirement. "People seem to be getting more serious about having enough to sustain themselves for the rest of their life," he says, adding that maximizing contributions to a retirement savings plan makes tax-reducing and wealth-accumulating sense. Traditional IRA and 401(k) contributions grow tax-free until withdrawn, with the added benefit of lowering your taxable income as you contribute.
A tax-deferred retirement account also lets you postpone capital gains taxes. The profit you make when you sell a stock results in a capital gains tax liability. Holding the stock for more than a year lowers the tax rate, but trading based on tax implications can become time-consuming and expensive.
When you trade through a traditional individual retirement account, Keough, 401(k) or SEP—simplified employment pension—plan, you can avoid taxes until you make withdrawals. Withdrawals made during retirement get taxed as ordinary income. This rate can be lower in retirement than the tax rate while you are working.
Funneling an investment in a high-growth mutual fund through your tax-deferred retirement account offers a similar tax advantage.
Review your portfolio mix
Different types of investments present different tax implications. You can lower your tax and risk exposure through tax-friendly asset allocation in your portfolio. Tax-exempt municipal bonds, or munis, provide interest income that the IRS doesn't tax and, depending on the issuer's location, also could save you local and state taxes.
Thomas suggests being aware of investment-return-defeating pitfalls such as rising interest rates when considering bond purchases. Another option is a tax-managed mutual fund, which aims to reduce investors' tax liability by shunning frequent trades and balancing stock holdings with munis.
Play the match game
The United States has taxed capital gains since 1913. Although the tax rate may change, the need for investors to consider the consequences of this tax remains constant. Capital gain or loss takes effect when you sell. If you hold an investment for less than a year, the short-term tax rate on your profit can take a healthy bite out of your gains.
You can reduce or erase your IRS bill by selling a nonperforming stock in the same tax year and using the loss to offset the capital gains tax levied on your profit. Long-term gains must be matched with long-term losses and short-term gains with short-term losses. However, according to the "wash sale rule," individuals who repurchase a stock within 30 days before or after they sold substantially similar investment to realize a tax-saving loss will forfeit their ability to claim the loss until they finally sell the investment.
"Offsetting is a good idea," says Thomas. "You can carry over an extra $3,000 in losses toward ordinary income in future years."
Maximize itemized deductions
For tax years prior to 2018, the expenses you incur while making investments can be itemized deductions that offer tax-reducing benefits. These miscellaneous deductions must total at greater than 2 percent of your adjusted gross income before they begin to count.
Examples include investment-related courses you take, subscriptions to financial publications, special software and safe deposit box fees for holding investments. Legal and accountant fees for investment advice can be deducted, as can travel expenses incurred to get that advice.
You may be able to deduct the cost of a computer and home office used to manage your investments and depending on the percentage of time they are dedicated strictly to investing activity.
Beginning with tax years after 2017, these investment-related expenses are no longer deductible as an itemized deduction.
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