Taxes are one of those facts of life that everyone must plan for. Like clockwork, tax bills come due every year. Keeping those liabilities as low as possible is the ideal that everyone works toward. Most people want to keep more of what they earn, whether it’s from employment or investments.
Of course, the tax rules are always changing with each filing season – and usually not in our favor. One of the more recent changes from the IRS is a bump in the standard deduction. Singles and married couples can deduct more from their 2023 incomes on their tax returns if they choose this route. Singles and those filing separately from their spousescan deduct $13,850compared to last year’s $12,950.
The revised amounts are higher for couples who file jointly and taxpayers who qualify as heads of households. It sounds great, but it doesn’t do much if your income rises in proportion to the deduction increase. The real key to lowering your tax liabilities is knowing how to leverage all the rules, particularly regarding investments. Investments are how you build wealth, and planning a tax-savvy investment strategy helps you retain more funds.
Retirement savings accounts represent the bulk of many people’s investments. Building wealth to cover life’s expenses once full-time employment is no longer feasible might seem like a no-brainer. However, the tax implications for savings in a Roth IRA can differ from money stashed in a traditional IRA.
Lifestyle Investingexpert Justin Donald emphasizes the importance of opening the proper accounts. Factors like income and tax brackets impact an investment’s tax efficiency. Tax-efficient investments and accounts result in lower liabilities, whereas less efficient options tend to do the opposite.
Whether it’s more tax-efficient to contribute to a Roth or traditional IRA depends on your projected income and tax brackets. A Roth account makes sense if you are in a lower tax bracket today than you anticipate being in the future. With a Roth IRA, you make contributions after income taxes. You’ve already paid taxes on that money, so you don’t have to do it again. The savings can multiply without incurring taxes when it’s time for you to withdraw them.
A traditional IRA account works differently. It makes more sense if you’re in a higher tax bracket now. As an investor, you won’t pay taxes on your contributions when you make them. You’ll pay the IRS later when you take the money out. Projecting likely tax brackets and income levels will help you determine which account type will best lower your tax liabilities.
Say someone buys a property for $100,000. Two years later, the property’s value has gone down. It’s no longer worth $100,000, according to market comps. Instead, it’s likely to fetch $80,000 at best. If the owner sells the property today for $80,000, they take a loss.
Sales of investments that have decreased in value since the original purchase date can offset your current year’s tax bill. Even if you have experienced gains with other holdings, sell-offs of losing investments will reduce your liabilities. This strategy is called tax-loss harvesting. But as with anything regarding the IRS, there are limits to how far investors can take this move, and you will want a competent tax accountant to help you with your decisions.
The IRS caps tax-loss harvesting deductions to$3,000 a year. The limit goes down to $1,500 if you are married but file separately. However, you can carry a balance into the next tax year if your capital losses exceed the limits.
Monitoring value fluctuations helps you determine whether it’s best to hold or sell. The more an asset increases in value, the higher your tax liability will be if sold. Capital gains increase the amount you owe the IRS, whereas capital losses reduce the liability. Say the same $100,000 property has a current market value of $300,000. It can make more sense to hold if there aren’t other investments to sell to offset the property’s potential capital gains.
The benefits of diversified portfolios extend beyond minimizing losses from market value fluctuations. Diversification also lets you be more strategic about your tax obligations. Whether an account type is taxable or carries tax advantages can impact your liabilities. With a 401(k), the advantage is delaying the government’s share of the returns. However, a brokerage account doesn’t come with those same benefits.
A second factor to consider is the type of investment you hold. The potential for capital gains and tax exemptions also influences liabilities. A stock with a high return rate is better off in a 401(k) if the holding timeline is short. The capital gains potential increases with return rates and shorter holding periods. Investing in these types of securities in an account where taxes are delayed can reduce your liabilities.
However, certain types of federal, state, and municipal bonds may be tax-exempt. These exemptions may likewise be granted at the federal, state, and local levels. It’s probably okay to park these types of investments in brokerage accounts. Gains in these accounts are taxable in the current year, so putting tax-efficient investments in them is a wiser move. It’s also usually okay to put stocks you’ll hang on to for a year or more in taxable accounts.
Withdrawing from retirement accounts too early comes with a higher tax bill. Not taking out the required minimum amounts once you reach a certain age does as well. The IRS considers withdrawals beforethe age of 59.5to be early. The government adds an extra 10% to the taxes as a penalty.
There are exceptions, of course. Examples include the account holder becoming permanently disabled or needing to pay health insurance premiums while unemployed. Being mindful of early withdrawal penalties and exceptions can help you keep more of your returns.
The same applies once retirement account holders reach a certain age. Current IRS rules say minimum annual withdrawals muststart at age 72. If you turn 72 after December 31, 2022, you have until age 73. You can then get slapped with a 50% tax penalty if you don’t withdraw the minimum amounts. That’s a big chunk of change and can significantly reduce your earnings.
Taxes are one of life’s inevitabilities, but that doesn’t mean you should lose your returns to the IRS when you don’t have to. Reducing tax liabilities should be part of your game plan to maximize earnings. Paying a higher tax bill can quickly derail your retirement and wealth-building goals. Learning what rules apply to which account and investment types will help ensure you don’t give up more than you should.