(BPT) – American taxpayers file roughly 140 million tax returns annually, according to the IRS. Of those, just 14 percent are the simplest type of form, the 1040EZ. In fact, all the 1040EZs, 1040s and 1040As filed — the least complex types of returns that you should, in theory, be able to do for yourself — account for just 22 percent of all tax returns, IRS data show.
“It’s not what you make that counts. It’s what you keep,” says Bill Harris, CEO of Personal Capital and author of a new book “Investment Tax Guide.” “Tax time is a great time to review your strategy for saving taxes on your investments — all year long. You need more than basic tips and last-minute tricks to efficiently benefit from all the complexities of the tax code.”
Several key strategies can help investors manage their tax liability.
Focus on tax-efficient investments
Of course the goal of any investment is to generate returns. Tax-efficiency refers to how much of those returns you have left after Uncle Sam has taken his share. The more you have left, the more tax-efficient your investments are.
Investment accounts can be taxable, tax-deferred or tax-exempt. For taxable investment accounts, such as money market mutual funds and individual or joint investment accounts, you pay taxes on income from those accounts in the year you earn it. Tax-deferred accounts like IRAs, Roth IRAs and 401(k)s allow you to put off paying taxes on returns as long as the returns remain in the account. When you finally withdraw returns in retirement, you will — in theory — be paying a lower tax rate because your income will be less.
Of course, tax-exempt accounts mean you never pay taxes on returns. Municipal bonds, REITs and 529 college savings accounts are examples of tax-exempt investment accounts.
Invest in tax-advantaged accounts
“You have numerous options for investing and each has different tax implications,” Harris says. “To maximize your portfolio’s tax efficiency, it’s important to invest in accounts that offer tax advantages.”
Harris offers these tips for choosing tax-advantaged accounts:
* Instead of investing in mutual funds, which have notoriously high tax impact, put your money in exchange-traded funds (ETFs). ETFs are generally more tax-efficient than mutual funds; their passive management means lower turnover and lower tax bills. ETFs are also traded like stocks, so you don’t need to sell the securities in your ETF in order to raise cash for redemptions.
* Municipal bonds can be a good option for people in very high tax brackets. You’ll pay no federal income tax on the returns, and if you live in the state where the bonds were issued, you won’t pay state tax either.
* Properly managed individual stocks are the most tax-efficient way to invest. Certain stocks do pay taxable dividends, but it’s up to you whether to invest in them or not. Mutual funds and ETFs both take that decision out of the investor’s hands.
Individual stocks, when properly managed, are the most tax-efficient way to gain exposure to equities. They leave control over realizing gains entirely in the hands of the investor. Of course, certain stocks pay taxable dividends; but the choice to own dividend-paying stocks is up to the investor. This is not the case with mutual funds or ETFs, where investors lack control over underlying securities.
Make losses work for you
Of course, not every investment produces returns. Sometimes you lose money, and that can be a good thing from a tax perspective. Tax-loss harvesting is a strategy that helps you benefit from investment losses.
By selling losing investments such as individual stocks, ETFs or mutual funds, you can offset the amount of return you gather from taxable accounts. For example, if you sell individual stocks for a loss of $3,000, you may be able to reduce your taxable income by that amount.
Consider a conversion to a Roth IRA
Roth IRA gains are tax-exempt, you can contribute at any age, you can withdraw without penalty whenever you want, and you can use the Roth to leave a legacy for your heirs if you choose. However, high earners don’t qualify to open Roth accounts.
You can tap the tax advantages of a Roth IRA by converting a traditional IRA to a Roth at a later date. There are no income restrictions on Roth IRA conversions. However, because Roth IRAs are funded with taxed income, and your traditional IRA was funded with pre-tax income, when you convert to a Roth IRA, you’ll pay a conversion tax based on your ordinary income tax rates.
To get more information, you can download Harris’ book at www.personalcapital.com/tax.
