The main goal of investing is to build wealth. Tax conscious investors know that in order to build wealth overtime, they have to be mindful about taxes and put their money in the right place. Taxes can take out a significant chunk out of your investment returns, thereby derailing your efforts of growing your overall investment income.
So, how do you invest to avoid paying taxes? What type of investments attract the least tax? If you are investing in the stock market; does reinvesting stocks avoid tax and how much in dividends is tax free?
The main purpose of tax efficient investing is to maximise returns on investment after taxes have been done. There are several tax efficient strategies that can be followed by investors to minimise their tax bills and get more returns from their investments. In this article, we are going to look at what these strategies are and also give you some tips and tricks on how you can reduce taxes on stock market investing.
In this article
How Do You Invest To Avoid Paying Taxes?
For starters, putting your investments in the right account is the first step towards avoiding paying taxes on investments. There are two types of investment accounts you need to know about: taxable accounts and tax advantaged accounts.
A taxable account is an investment account that has no tax benefits e.g a brokerage account. It is more flexible, with fewer restrictions and you can withdraw money with no tax penalty. The returns however are taxed, depending on how long you have held an asset when you choose to sell it. Taxable accounts are good for stocks you plan to hold for more than a year.
A taxed advantage account is a tax deferred or tax exempt account e.g traditional IRAs, where you withdraw money in retirement. With tax advantaged accounts, there are restrictions and you may pay taxes or penalties if you withdraw money before its stipulated time. Taxed advantaged accounts are good for stocks you plan to hold for less than a year.
If you want to invest to avoid paying taxes, you must look closely at these investment accounts, determine your investment needs and figure out the pros and cons of investing in either investment option.
What is the Best Investment For a Taxable Account?
When you are considering the best investment to put in a taxable account, you have to consider factors such as your risk tolerance, your investment goals and the current tax situation. Investments whichlose less of returns to taxes should be put here. Some of these investment options include:
- Stocks: Individual stocks which are held for more than a year can provide long-term growth potential. You are not taxed for gains in a taxable account until you sell the stock. If you sell it after a year, you are taxed at a long-term capital gains rate.
- ETFs or Index funds. ETFs are good for diversification and if you want to access a list of assets from a single purchase, with low fees. They can generate capital gains tax when sold.
- REITs. Real Estate Investment Trusts ( REITs) can provide regular income and diversification and may generate taxable income.
- Bonds. Bonds offer a fixed income and diversify your portfolio, but they also have interest rate risk and may generate taxable income.\
- Municipal bonds. These bonds are issued by local governments and are exempt from federal income tax. They can provide tax-free income, but may have lower yield than taxable bonds.
How to Avoid Taxes on a Brokerage Account
Is a brokerage account tax efficient? A brokerage account can be tax efficient depending on several factors such as the investments made, holding period and tax laws on the account held. Brokerage accounts are often not tax-deferred, thus any capital gains, dividends, or interest income earned by the account is taxed to the investor.
Municipal bonds and some kinds of exchange-traded funds (ETFs) are examples of investments that may be held in a brokerage account that are subject to lower tax rates or qualify for tax advantages. It is crucial to remember that it is neither wise nor lawful to try to totally dodge taxes on a stock brokerage account. However, there are several tactics that can help lessen a brokerage account’s tax burden. Let’s look at the 6 best ways to reduce stock investing below:
6 Best Ways To Reduce Taxes on Stock Investing
Here are some of the finest strategies for lowering stock investment taxes:
- Put money into a tax-advantaged account: Investing in a tax-advantaged account, such as an Individual Retirement Account (IRA) or a 401(k), is the best strategy to decrease taxes on your stock investments. You can lower your taxable income for the year by contributing to these accounts with pre-tax or tax-deductible funds. These accounts also allow you to avoid paying taxes on gains until you receive the money in retirement.
- Invest in tax efficient ETFs or mutual funds that minimise taxes: Some exchange-traded funds (ETFs) and mutual funds are built with tax efficiency in mind. These funds reduce the number of capital gains distributions, which lowers turnover and lessens the tax burden on investors. These funds may also invest in stocks with modest dividend yields, which lessens the tax burden on investors who hold them in taxable accounts.
- Hold stocks for the long term. The long-term capital gains tax rate, which is lower than the short-term capital gains tax rate, will apply if you keep a stock for more than a year before selling it. The tax rate on short-term capital gains might be significantly greater than your ordinary income tax rate.\
- Use a qualified dividend strategy: Use a qualified dividend strategy because they are taxed at a lower rate than regular income: qualified dividends are taxed at the long-term capital gains rate. The stock must be held for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date in order to be eligible for this tax treatment.
- Tax loss harvesting: Tax-loss harvesting is a strategy that involves selling losing investments to offset gains on other investments. This can reduce your tax bill by lowering your taxable income. Be mindful of the wash sale rule, which prohibits you from claiming a loss on a security if you purchase a substantially identical security within 30 days before or after the sale.
- Donate appreciated stock to charity: If you’ve owned an appreciated stock for more than a year, you can donate it to a good cause and get a tax deduction for the full market value of the stock. You won’t be required to pay capital gains taxes on the appreciation, either.
Final Thoughts
In conclusion, lowering your stock investment taxes takes careful preparation and taking your investment objectives into account. You can reduce the tax burden on your investment returns by employing qualifying dividend strategies, tax-advantaged accounts, long-term stock holdings, tax-efficient funds, tax-loss harvesting, and donated appreciated stock. To decide the best course of action for your unique circumstances, speak with a financial counsellor or tax expert.
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