Investing your money is key to building wealth over time. But with rising inflation and an uncertain economic outlook, it’s no wonder that many investors are looking for ways to improve the tax efficiency of their holdings.
“It’s not likely you’ll be able to avoid taxes altogether, but certain kinds of investments are much more tax advantageous than others,” says Josh Zimmelman, founder of Westwood Tax & Consulting in Long Island, New York.
Whether you opt for tax-advantaged investment accounts, such as Roth IRAs or health savings accounts, or invest in tax-exempt funds, there are a number of investment vehicles you can use to save on taxes.
How Investments Are Taxed
When you invest your money, your profits are subject to taxes. The tax rate you’ll pay on your investment income depends on the type of investment and your tax bracket. Here are some of the different types of taxes you may owe on your investments:
— Taxes on dividends: Dividends are payments made by a company to its shareholders. If you own stock in a company that pays dividends, you’ll be responsible for paying taxes on those dividends. There is a maximum tax rate of 20% on qualified dividends if the company is based in the U.S. Non-qualified dividends are taxed at regular income tax rates.
— Taxes on interest: If your investment earns interest, you’ll owe money on that growth at ordinary tax rates. The tax rate you’ll pay is dependent on your tax bracket.
— Taxes on capital gains: Capital gains tax applies if you sell an investment for more than you paid for it. Short-term capital gains are taxed at your regular income tax rate, while assets held for longer than one year, or long-term capital gains, are taxed at a lower rate of 15% to 28%, depending on your income and the investment type.
High earners may also have to pay the 3.8% net investment income tax on dividends, taxable interest and capital gains.
While taxes can be burdensome, investments with the lowest taxes aren’t always the best approach, cautions Zimmelman. Sometimes an investment with a higher yield may make more financial sense than focusing on those with more tax advantages.
That said, depending on your investing goals, one or more of the following investment options can help minimize your taxes:
— Municipal bonds.
— Tax-exempt mutual funds and ETFs.
— Roth IRAs.
— Health savings accounts.
— 529 education savings plans.
— Donor-advised funds.
— Qualified opportunity funds.
— Community development financial institutions.
Municipal bonds are debt securities issued by state and local governments to finance public projects like roads, schools and hospitals. These fixed-income investments pay a specified amount of interest and return the principal to the holder on a specific maturity date. The interest you earn from municipal bonds is usually exempt from federal income tax, and it may also be exempt from state and local taxes if you live in the state where the bond was issued.
Tax-Exempt Mutual Funds and ETFs
For those who want to diversify their investments, some mutual funds and exchange-traded funds, or ETFs, can also offer tax advantages. These types of investments pool money from many different investors and invest it in a variety of securities.
Tax-exempt mutual funds and ETFs invest in municipal bonds and other securities that are exempt from federal income taxes. These are most appropriate for higher-income earners who are investing outside of an individual retirement account (IRA) or traditional retirement plan. Otherwise, you probably won’t save enough in taxes to compensate for the lower yields from a tax-exempt fund.
There are two main forms of IRAs: traditional and Roth. A Roth IRA can be a tax-efficient way to save and invest for retirement.
You contribute money to a Roth IRA with post-tax dollars. Your contributions aren’t tax-deductible, but there are other advantages that can make a Roth IRA worthwhile:
— Tax-free withdrawals: If you withdraw money from a Roth IRA at 59½ or older and you have owned the account for five years, your withdrawals from your contributions and earnings are penalty- and tax-free. Exceptions apply: For example, funds can be withdrawn without penalty before age 59½ for a first home purchase.
— Tap into contributions without penalty: With most retirement accounts, you have to pay taxes and penalties on any withdrawals you make before reaching retirement age. But with a Roth IRA, you can withdraw your contributions, but not the earnings, tax-free with no penalty.
You can contribute up to $6,000 per year to a Roth IRA ($7,000 if you’re 50 or older). However, income restrictions exist on who can take advantage of a Roth IRA. If you’re single, to contribute the annual maximum amount to a Roth IRA your modified adjusted gross income must be less than $144,000. If you’re married, you must make less than $214,000 in combined income to contribute the maximum. Contributions begin to phase out at $129,000 for single taxpayers and $204,000 for those who are married and filing jointly.
Health Savings Accounts
If your employer offers a health savings account, or HSA, it can be a powerful investment tool. Drew Feutz, a certified financial planner and co-founder of Migration Wealth Management in Avon, Indiana, says HSAs are one of the only truly tax-free investment accounts.
HSAs are known as “triple-advantaged” plans because they offer the following benefits:
— Pretax contributions: Like an employer-sponsored retirement plan, you make contributions to an HSA with pretax dollars.
— Earnings grow tax-free: If you invest the money in your HSA into stocks, bonds or funds, the earnings can grow tax-free.
— Withdrawals are tax-free: If you use your HSA dollars for eligible health care expenses, such as medications, mobility devices, insurance copayments or deductibles, your withdrawals are tax-free.
If you are 65 or older and still have unused HSA dollars, you can use the money in the account for non-medical expenses without penalty. However, your withdrawals for non-eligible expenses will be taxed at ordinary income tax rates. If you’re younger than 65, you’ll pay a 20% penalty on withdrawals for non-eligible expenses in addition to taxes.
The HSA contribution limits for 2022 are $3,650 for individual coverage and $7,300 for families. The limit for 2023 will increase to $3,850 for individuals and $7,750 for families. Those 55 or older can contribute an additional $1,000 per year.
Some investors choose to max out their HSA and pay for health care expenses from other accounts to take full advantage of its compounding and tax-saving potential. HSA owners can make a one-time rollover from a traditional IRA into an HSA, up to the annual contribution limit.
529 Education Savings Plans
A 529 education savings plan can be used to save and invest for a child’s education. In a 529, earnings grow tax-deferred, so you don’t have to pay taxes on the earnings until you make a withdrawal. And if the withdrawals are used for eligible education expenses, such as college tuition, textbooks or supplies, the withdrawals are tax-free.
While your 529 contributions aren’t tax-deductible at the federal level, some states offer special tax incentives or credits to encourage families to save for college. For example, Pennsylvania residents participating in a PA 529 account can deduct up to $16,000 in contributions per beneficiary, or $32,000 if married and filing jointly, from their state taxable income.
BlackRock has an online resource that breaks down the tax benefits by state. Or you can contact your state education agency to see what options are available.
For those that want the peace of mind that comes with knowing their loved ones will be taken care of financially if they die, life insurance can be a tax-advantaged way to provide for them.
With life insurance, the policy beneficiaries can receive a tax-free death benefit. However, some policies, such as indexed universal life insurance policies, can accumulate a cash value tied to the performance of an index such as the S&P 500, and that cash value can earn interest over time, tax-deferred within the policy. The benefit may be tax-free to the beneficiaries when paid out at maturity, but there are circumstances when it is taxable, so it’s important to know the details of your particular policy.
How withdrawals are handled tax-wise can vary based on the type of policy you have and how the money is used, so talk to a tax professional to ensure you understand the tax implications before taking any action.
When the standard deduction was raised several years ago, a lot of people lost out on the benefit of deducting charitable contributions, says Sarah Catherine Gutierrez, a certified financial planner and the CEO and founder of Aptus Financial in Little Rock, Arkansas. A donor-advised fund brings back some of that benefit.
A donor-advised fund is a tax-advantaged investment account that you can use to make charitable donations. When you contribute cash, securities or other assets to a donor-advised fund, you are usually eligible for a tax deduction on those contributions. Those assets can be invested for tax-free growth, and you can choose most IRS-qualified public charities as the recipients.
Qualified Opportunity Funds
A qualified opportunity fund is an investment vehicle that helps you invest in certain types of businesses and real estate located in designated “opportunity zones”: economically distressed communities that have been given that distinction by a state and certified by the U.S. Treasury.
Qualified opportunity funds are a relatively new option; the first designations were made in 2018 and are designed to stimulate economic development and job creation.
The tax benefits of investing in a qualified opportunity fund can be significant. Investors can defer their capital gains taxes by reinvesting their capital gains into qualified opportunity funds, reducing their tax bill later on. The longer you hold onto your investment, the greater the benefit, maximizing your returns.
Community Development Financial Institutions
Under the New Markets Tax Credit Program, you can help economically distressed communities and earn a federal tax credit. Individuals and corporate investors can make equity investments in community development financial institutions, or corporations and partnerships that offer loans, investments or financial counseling in designated low-income communities.
The tax credit for investors totals 39% of the original investment amount and is claimed over the span of seven years.
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