Understanding tax planning is very important for the investor. By setting up accounts correctly and thinking about the tax consequences when making trades one can save a lot on taxes. Conversely, do things wrong and it can cost you a lot in taxes.
Before we continue, understand that I am an investor, NOT A CPA OR FINANCIAL PLANNER, and therefore you should check and verify what I am saying. Every situation is different and I’ve found that an hour or so every few years with a CPA is well worth the expense since they can help you out with planning for your individual situation. Take these as general tips to reduce or limit your taxes.
1. Take a long-term perspective to limit your taxes in your taxable accounts and maximize the compounding of your investments. If you are frequently trading in a taxable account, the short-term capital gains you rack up can have a big effect on your taxes. Because you are paying out taxes each year you lose the ability to compound and make money on the cash you are paying in taxes each year. If you buy a stock and hold it for ten or twenty years, you have a huge taxable capital gain in the end but you will make money for years on the money that would have gone to taxes. This can easily increase your total return by 2% or more each year. For this reason, your taxable accounts should be full of growth stocks that pay little or no dividends, index funds, and the like.
2. Place income stocks and assets in tax deferred and tax-free accounts. Assets like bonds and REITs that pay large dividends should be placed in IRAs, 401K’s, and other accounts that are tax deferred or tax-free. That way these assets can compound without a tax bite being taken each year.
3. When you take a loss, look for a gain. When you take a gain, look for a loss. If a stock purchase doesn’t work out, think about selling some shares of a big winner. Likewise, if you sell a stock with a big capital gain, think about selling one of the losers in your account. This way you can write the loss off against the gain and reduce your taxes. You can also write some ordinary income off against a loss from investments (but the amount is limited) and carry losses into future years if you don’t have enough income to write the whole loss off against. See your accountant for the details here. Note that you can’t buy the shares of the loser back within 30 days (or buy shares of the loser 30 days before you sell it) or it is considered a wash sale and you can’t deduct the loss.
4. Think about delaying gains into future years. Think about taking losses in the current year. The general rule is to delay income into future years and bring losses into current years. This means selling loser before the end of the year and waiting until after the new year to sell winners. This is not always the best choice, however. For example, if you know you are going to have a big gain or a raise next year, you may want to delay taking a loss into the following year.
5. Pay deductible expenses in the current year. Just as it is good to take losses in the current year, it is good to take deductions in the current year. Pay your property taxes before December 31st even though you may have until March. Likewise, pay deductible investment expenses like account fees before year-end if you can.
6. Think about tax-free investments, but do the math. People sometimes seem overly eager to save money on taxes. They continue to pay a home mortgage they could pay off because they can deduct the interest even though they are paying $10,000 in interest each year but only saving $2500 in taxes. They rush out to shop on a sales tax holiday even though they are only saving 8% that way. Many tax-free investments just don’t provide the return that taxable investments do. Be sure to do the math and make sure the tax-free status is worth the low returns. Also remember that capital gains from stocks are tax deferred until you sell, so a portfolio of stocks that you only tap gently for a little extra income is very tax efficient by itself.
7. Never do things just for taxes. While it may seem nice to save on taxes, I’ve seen many investments drop quickly, wiping out any gain that would have been made by avoiding taxes when people try to get too cute. If you have a stock with a big gain and it’s time to sell, you might very well lose 30% on the whole position waiting to save 25% on half of it. Perhaps the worst example I’ve seen was from an article I read in the Wall Street Journal after the dot-com bubble burst in 2000. A woman who was one of the early employees in a dot-com company became a millionaire when her shares of company stock went public and jumped several hundred percent. Rather than sell some shares to make improvements on a house she wanted to do, her broker convinced her to take a loan against the shares to avoid the capital gains taxes. When the shares fell through the floor, not only had she lost the millions she made, she ended up owing about $400,000 on the loans! Consider taxes, but don’t let them drive your investment decisions.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.