By this time of the year, you probably have already filed your income-tax return or have the finish line in sight. And through it all, you probably have asked yourself: What else can I do to shave the tax bite on my investment portfolio?
Actually, there’s a lot that can be done, as several types of investments offer at least modest tax-shaving potential. And for the most part, these investment tax benefits weren’t undercut by tax reform.
These are some of the more popular choices:
IRAs: Plenty of versatility
Individual Retirement Accounts aren’t a type of investment but rather a type of account, into which you can place all sorts of stuff and receive tax benefits. All IRAs offer tax-deferred growth of your investment dollars. After that, things get more complex but also more beneficial.
With traditional IRAs, you essentially can deduct the money you put into an account. Then, as noted, it builds up tax-deferred until you withdraw it, when your contributions and gains are taxed as ordinary income.
If you withdraw money prematurely, generally before age 59 ½, you face a 10% penalty. You also need to start taking withdrawals by around age 70 ½ or an even bigger 50% penalty could apply.
One nice thing about IRAs: you typically can make a contribution as late as April 15 and apply the deduction to reduce your tax bill for the prior year. Fidelity Investments reports that 33% of all the 2018 IRA contributions made by its customers came in during the three weeks leading up to the April 15 deadline.
With Roth IRAs, the tax benefits are reversed: You don’t get a deduction up front but you also don’t pay taxes on withdrawals (assuming you meet minimum-holding period requirements). With Roths, there are also no required minimum distributions starting around 70 ½.
Which will earn you more over time: a traditional 401(k) or a Roth 401(k) retirement account?
Matches boost 401(k) accounts
As good as IRAs can be, more contributions have been flowing into workplace 401(k)-style retirement accounts.
From a tax standpoint, 401(k) plans work like traditional IRAs, in that you get a deduction on contributions, your gains build up tax-free, then you face regular taxes on withdrawals. Many employers also offer a Roth 401(k) option, meaning you would forsake the deduction but your withdrawals would come out tax free.
Several factors explain why 401(k)s are popular. Matching funds are a big one, as many employers will encourage you to save by pitching in perhaps 50 cents for every dollar you invest, up to certain limits. Also, the accounts are convenient in that the money is diverted automatically from each paycheck, without you having to think about each investment decision.
But while people are putting more new money into 401(k) plans, a lot of that cash will wind up in an IRA eventually. When leaving jobs, workers can choose to retain the tax deferral on their accounts by rolling the money into an IRA. In fact, IRA dollar volumes have been boosted much more by rollovers in recent years than by new contributions.
New life for municipal bonds
For tax minimization in the bond world, municipal bonds reign supreme.
The interest paid by bonds issued by states, cities, counties and other municipalities typically skirts federal taxes (and sometimes taxes in the state where the bonds were issued, too). No wonder they’re popular. In fact, investors pumped a net $11 billion into municipal-bond mutual funds in February, a recent high-water mark, reported the Investment Company Institute.
Municipal bonds typically yield less than Treasuries, corporates and other bonds whose interest is taxed at the federal level, but many people still like them, especially during periods when interest rates are stable, and especially among investors in high tax brackets.
Investment firm Columbia Threadneedle notes that municipal bonds historically have fared well during periods of slowing economic growth. They’re also fairly price-stable, without subjecting investors to often wild rides. These bonds have generated positive returns (including interest income) in 31 of the past 35 years, the company said.
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One caveat to beware: While the interest is generally tax-free, you must report it to calculate whether some of your Social Security benefits might be taxable, assuming you’re collecting Social Security, as many municipal bond investors are.
Regular stocks: Low tax rates possible
There’s much be said for owning stocks outside of an IRA or 401(k) account. In a non-sheltered brokerage account, you would face taxes on any dividends received, but you could delay any capital gains until you sell. Also, losses on money-losing stocks potentially are deductible.
When your net investment losses exceed your gains in a given year, you can apply up to $3,000 of those losses against regular income and carry unused losses to future years.
Even when you do sell stocks at a gain — the goal, of course — you would face reasonably low capital-gain rates on long-term positions held more than one year. While high earners can pay 20%, most Americans will face a 15% capital-gain rate, while for lower-income people, no capital-gain taxes would be due.
The tax implications of stock mutual funds is more tricky, as you could receive a tax bill reflecting trades made by the portfolio manager, even if you didn’t do any buying or selling yourself. You also would face taxes on dividends earned on the fund’s holdings.
That’s why various “tax-advantaged” mutual funds could be a smart choice. The managers of these funds strive to avoid taxable gains by minimizing trades and by avoiding dividend-paying stocks. Index funds feature some of the same tax-shaving benefits, mainly because they don’t engage in a lot of tax-triggering selling.
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Real estate: Lots of breaks
Few mainstream investments feature as many tax breaks as real estate, but there are some caveats.
As a homeowner, you may deduct mortgage interest and property taxes, subject to the new $10,000 household cap on state and local taxes (including property taxes). Tax reform capped the mortgage-interest deduction for high-priced homes with big mortgages, but most middle-class owners won’t notice any difference.
There’s another less-obvious but potentially huge tax break for homeowners who hang onto their properties for a while: If you own and occupy a home for at least two of the five years prior to selling it, you can avoid up to $250,000 in gains (if single) or $500,000 in gains (if married filing a joint return). Conversely, you can’t deduct losses on primary residences.
There’s an expanded set of tax breaks if you own rental real estate. Expenses incurred to maintain the property can be deducted including repairs, management costs, property taxes and mortgage interest.
You also receive and must report depreciation — a non-cash charge that reflects the gradual loss of value on buildings (but not land), even if they don’t actually lose value. Depreciation reduces the tax bite on rental properties while you own them, but eventually this money must be repaid or recaptured after you sell.
Reach Wiles at email@example.com or 602-444-8616. Support local journalism. Subscribe to azcentral.com today.
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