At the time this book is being published, the new administration in Washington is proposing tax changes, including some potential tax increases. For the latest on important changes to federal income tax rates and rules, please visit my website at www.erictyson.com.
Devising tax-reduction strategies
Use these strategies to reduce the taxes you pay on investments that are exposed to taxation:
Make use of retirement accounts and health savings accounts. Most contributions to retirement accounts gain you an immediate tax break, and once they’re inside the account, investment returns are sheltered from taxation, generally until withdrawal. Think of these as tax reduction accounts that can help you work toward achieving financial independence. See Chapter 2 for details on using retirement accounts when investing.Similar to retirement accounts are health savings accounts (HSAs). With HSAs, you get a tax break on your contributions upfront; investment earnings compound without taxation over time; and there’s no tax on withdrawal so long as the money is used to pay for health-related expenses (which enjoy a fairly broad list as delineated by the IRS).
Consider tax-free money market funds and tax-free bond funds. Tax-free investments yield less than comparable investments that produce taxable earnings, but because of the tax differences, the earnings from tax-free investments can end up being greater than what taxable investments leave you with. If you’re in a high-enough tax bracket, you may find that you come out ahead with tax-free investments. For a proper comparison, subtract what you’ll pay in federal and state income taxes from the taxable investment income to see which investment nets you more.
Invest in tax-friendly stock funds. Mutual funds and exchange-traded funds that tend to trade less tend to produce lower capital gains distributions. For funds held outside tax-sheltered retirement accounts, this reduced trading effectively increases an investor’s total rate of return. Index funds invest in a relatively static portfolio of securities, such as stocks and bonds. They don’t attempt to beat the market; rather, they invest in the securities to mirror or match the performance of an underlying index. Although index funds can’t beat the market, the typical actively managed fund usually doesn’t, either, and index funds have several advantages over actively managed funds. See Chapter 10 to find out more about tax-friendly stock mutual funds, including some non-index funds and exchange-traded funds.
Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. Even then, with investment real estate, you often can roll over the gain into another property as long as you comply with tax laws. Increases in value in small businesses can qualify for the more favorable longer-term capital gains tax rate and potentially for other tax breaks. However, the current income that small business and real estate assets produce is taxed as ordinary income.
Reducing Your Taxes When Selling Investments
I advocate doing your homework so you can purchase and hold on to good investments for many years and even decades. That said, each year, folks sell and trade lots of investments.
My experience in helping people get a handle on their investments suggests that too many investors sell for the wrong reasons (while other investors hold on to investments for far too long and should sell them).
In this section, I highlight important tax and other issues to consider when you contemplate selling your investments, but I start with the nontax, bigger-picture considerations.
Weighing nontax issues
Although the focus of this chapter is on tax issues to consider when making, managing, and selling your investments, I’d be remiss not to raise bigger-picture considerations:
Meeting your goals and preferences: If your life has changed (or if you’ve inherited investments) since the last time you took a good look at your investment portfolio, you may discover that your current holdings no longer make sense for you. To avoid wasting time and money on investments that aren’t good for you, be sure to review your investments at least annually. Don’t make quick decisions about selling. Instead, take your time, and be sure you understand tax and other ramifications before you sell.
Keeping the right portfolio mix: A good reason to sell an investment is to allow yourself to better diversify your portfolio. Suppose that through your job, you’ve accumulated such a sizeable chunk of stock in your employer that this stock now overwhelms the rest of your investments. Or perhaps you’ve simply kept your extra money in a bank account or inherited stock from a dear relative. Conservative investors often keep too much of their money in bank accounts, Treasury bills, and the like. If your situation is like these, it’s time for you to diversify. Sell some of the holdings of which you have too much, and invest the proceeds in some of the solid investments that I recommend in this book. If you think your employer’s stock is going to be a superior investment, holding a big chunk is your gamble. At minimum, review Chapter 8 to see how to evaluate a particular stock. Remember to consider the consequences if you’re wrong about your employer’s stock. Develop an overall investment strategy that fits your personal financial situation (see Chapter 5). A problem with holding a large amount of stock in your employer is that both the stock and your job are compromised if the company has a significant downturn.
Deciding which investments are keepers: Often, people are tempted to sell an investment for the wrong reasons. One natural tendency is to want to sell investments that have declined in value. Some people fear a further fall, and they don’t want to be affiliated with a loser, especially when money is involved. Instead, step back, take some deep breaths, and examine the merits of the investment you’re considering selling. If an investment is otherwise still sound per the guidelines I discuss in this book, why bail out when prices are down and a sale is going on? What are you going to do with the money? If anything, you should be contemplating buying more of such an investment.Also, don’t make a decision to sell based on your current emotional response, especially to recent news events. If bad news has hit recently, it’s already old news. Don’t base your investment holdings on such transitory events. Use the criteria in this book for finding good investments to evaluate the worthiness of your current holdings. If an investment is fundamentally sound, don’t sell it.
Tuning in to tax considerations
When you sell investments that you hold outside a tax-sheltered retirement account, such as in an IRA or a 401(k), taxes should be one factor in your decision. If the investments are inside retirement accounts, taxes aren’t an issue because the accounts are sheltered from taxation until you withdraw funds from them.
Just because you pay tax on a profit from selling a nonretirement-account investment doesn’t mean you should avoid selling. With real estate that you buy directly, as opposed to publicly held securities like real estate investment trusts (REITs), you can often avoid paying taxes on the profit you make. (See Chapter 12 for more information.)
With stocks and mutual funds, you can specify which shares you want to sell. This option makes selling decisions more complicated, but you may want to consider specifying what shares you’re selling because you may be able to save taxes. (Read the next section for more