One of the most important considerations that investors should make is what will their net rate of return be. Net rate of return is basically your gross rate of return minus your income tax, state tax, alternative minimum tax and, of course, your net invest income tax on gains. Some investors can pay more than 50% in tax on their short-term investment’s gains.
Obviously, no one likes to give away more than 50% of their hard-earned profits in unnecessary tax payments. So, what are some smart and efficient tax strategies you can use to reduce or eliminate your tax liability?
Invest in Tax Deferred Accounts
Using retirement plans such as traditional IRAs, 401K plans, employer sponsored pensions, annuities and life insurance plans will allow your account to grow faster. All gains in such plans are tax deferred until you withdraw funds from these accounts. Your tax differed investment could be three or even four times larger than your taxable accounts. Deferred accounts allow you to basically increase your net rate of return by your marginal tax bracket and provide you an automatic boost to your net investment rate of return of up to 50% annually.
Furthermore, contributions to your IRA or 401K reduce your taxable income by the amount contributed, providing you additional savings that can be further invested.
Lastly, when you take distributions after retirement your tax bracket is typically lower than the one you are currently in, which produces more savings and helps to build your wealth bucket faster.
Invest in Tax Free Accounts
When investing in municipal bonds, Roth Accounts, 529 plans and death benefit portion of life insurance, your gains and principal are tax free. Municipal bond income is generally exempt from federal taxes, and municipal bonds issued in-state may be free of state and local taxes as well.
An investor in the 33% federal income-tax bracket would have to earn 7.46% on a taxable bond, before state taxes, to equal the tax-exempt return of 5% offered by a municipal bond. In other words, by investing in a municipal bond you can “settle” for a lower gross rate of return to achieve the same net rate of return on a taxable investment.
529 plans may be a great way to save for your children’s college tuition while catching a tax break and growing the education fund faster. Consult with your tax advisor and financial advisor for more info.
Look for Tax Efficient Investments
Tax-managed or tax-efficient investment accounts and mutual funds are managed in ways that may help reduce their taxable distributions. Investment managers may employ a combination of tactics, such as minimizing portfolio turnover, investing in stocks that do not pay dividends and selectively selling stocks that have become less attractive at a loss to counterbalance taxable gains elsewhere in the portfolio. In years when returns on the broader market are flat or negative, investors tend to become more aware of capital gains generated by portfolio turnover since the resulting tax liability can offset any gain or exacerbate a negative return on the investment.
Taxes are an important consideration in selecting investments but should not be the primary concern. Some mutual funds that have low turnover also inherently carry an above-average level of undistributed capital gains. When you buy these shares, you effectively buy this undistributed tax liability.
If you plan to trade yourself, consider trading futures and commodities. Under the IRS code section 1256, 60% of the gains from trading regulated futures contracts are taxed under the favorable long term capital gain rate which can be as low as 0% or as high as 23.8%. This is a tremendous benefit as you can trade for short term profits yet pay long term capital gain rates on 60% of your gains.