If you're an investor, you should pay special attention to the taxes that apply to your investments. There are often ways to legally reduce, postpone, or eliminate taxes on your investment gains, helping you keep more of your profits. So it pays to know the smartest ways to minimize your taxes and put more of your money to work for you.
Here are some of the best ways to keep taxes low on your investment income.
How investments are taxed
The Internal Revenue Service (IRS) taxes investment income differently than it taxes earned wage income. Differences include not only the tax rate you pay, but also when and how you tax your investment income. Broadly speaking, investments generate income in two ways, each with different tax treatment:
- Capital gain: A capital gain is an increase in the price of an asset, for example when stocks or real estate increase in value. Generally, governments only tax capital gains when the gain is realized (i.e. when the asset is sold for cash).
- Dividends or cash income: Dividends or cash income is money received during the year and is generally taxable in the year it is received.
Therefore, investors who want to minimize investment taxes must avoid these broad rules.
7 Ways to Minimize Investment Taxes
There are many ways to minimize taxes on investment gains, from Behavioral Tax-Advantaged Accounts to taking advantage of the tax code. Here are the seven most popular ways.
1. Practice buy-and-hold investing
An important note about IRS tax law is that you are only taxed if you sell your investments for cash – i.e. on any capital gains you realize. This exploits a major legal loophole – you don't owe significant capital gains taxes unless you sell.
In fact, you can hold your investment indefinitely and defer taxes on any gains forever.
But that's just one side of the benefits of a buy-and-hold approach. Your investments will likely perform better if you buy and hold. Research consistently shows that passive investing tends to outperform active investing over the long term. That means buy-and-hold investing works to your advantage in two ways: you'll make more money and you'll pay less tax to the IRS.
This approach is at the top of Bankrate's list because it's the most important strategy you can use to reduce your taxes — and it'll likely yield bigger benefits, too.
2. Open an IRA
IRAs are a great way for workers to invest their income for retirement and receive tax-advantaged benefits: Traditional IRAs allow you to save pre-tax amounts, which can reduce your tax bill this year. You can defer taxes on capital gains or dividend earnings. When you take distributions from the account after age 59 1/2, you pay taxes on the money you withdraw from the account. So, with an IRA, you can legally defer taxes for decades.
But if you don't want the IRS to take your money forever, you can opt for a Roth IRA. A Roth IRA lets you save money on an after-tax basis, so you won't get a tax break this year. But it lets your contributions grow tax-free and allows you to withdraw them tax-free when you start taking distributions after age 59 1/2. It's widely considered the retirement account that experts recommend the most.
You should carefully consider whether a traditional IRA or Roth plan is best for your needs. Whichever plan you choose, it's important to follow the rules closely, because mistakes can mean penalties. Don't avoid taxes and fall into another tax trap.
3. Contribute to a 401(k) plan
Employer-sponsored 401(k) plans offer many of the same tax benefits as IRAs, plus a few more: Traditional 401(k) plans allow you to defer taxes up front from your paycheck, reducing your tax bill this year You can defer taxes on any earnings, whether capital gains or dividends If you take distributions from the account after age 59 1/2, you'll pay taxes on the amount you withdraw You can essentially defer investment gains for decades while you work.
A Roth 401(k) offers many of the same benefits as a traditional 401(k), including salary deferrals and employer contributions, but it's offered on an after-tax basis, meaning you pay tax on the contributions you make. However, your account balance can grow tax-free, you can withdraw it tax-free when you take distributions, and you can later roll it over to a Roth IRA.
Both types of 401(k) plans are popular with workers, and you should carefully consider which plan is right for you. Again, it's important to follow the plan's rules carefully, especially when it comes to withdrawals, to avoid unnecessary bonus penalties imposed by the IRS.
4. Recover tax losses
To reduce or eliminate your taxable capital gains, it's wise to recapture tax losses. When you recapture tax losses, the IRS allows you to deduct an investment's realized losses from your gains. Therefore, taxes are only levied on your net capital gains. For example, if you make a $10,000 profit on one investment but lose $8,000 on another, you can offset them. Your taxable gain will be only $2,000, and your tax bill will be significantly smaller.
The IRS allows you to offset more than your gains; that is, you can have a net loss of up to $3,000 in any tax year. If your net loss is larger than that, you must carry it forward to a future tax year. For example, if you make a gain of $10,000 on one investment and a loss of $15,000 on another, your net loss is $5,000. However, you can only claim the $3,000 loss on your tax return this year; you can claim the remaining $2,000 loss in a future tax year.
Some investors make a habit of minimizing taxable gains in this way. If you want to invest for the long term, you may want to buy back your investment after 30 days to avoid a wash sale.
5. Consider asset placement
Dividends and other cash distributions are generally taxed in the year they are received, so if you're using a taxable account, there's no great way to avoid taxes here like there is with capital gains. To keep your dividend taxes low, consider where you hold your assets.
For example, say you have a tax-advantaged account, such as an IRA, and a brokerage account that's taxed normally: If you hold dividend-paying stocks, it makes sense to keep those stocks (or most of your stocks) in the less taxed portion of the IRA to avoid tax on the dividends now.
On the other hand, stocks with (presumably) capital gains can be held in a regular taxable account, where you can still enjoy one of the main benefits of an IRA — tax deferral — until you sell your investments, which could be decades from now. However, you should carefully consider whether putting all your dividend-paying stocks in an IRA makes the most financial sense for you.
6. Utilize a 1031 Exchange
If you're a real estate investor looking to sell a property (that isn't your primary residence) and reinvest in another property, it makes sense to use a 1031 exchange. Essentially, a 1031 is a like-kind exchange that allows you to sell one investment property and defer the capital gains, but you must invest the proceeds (relatively quickly) in another investment property.
The rules for 1031 exchanges are complex and if you don't follow them closely, you lose your right to tax deferral. As with other types of assets, you can hold your investments and defer capital gains for decades. Plus, you can avoid expensive real estate fees.
7. Take advantage of low long-term capital gains tax rates
Investment income is taxed differently than employment income, especially in how capital gains are treated. The IRS taxes long-term capital gains at 15%, 20%, and 0%. Yes, 0%. But you have to follow the rules very carefully.
These tax rates are generally lower than the rates you pay on short-term capital gains, which are taxed at ordinary income rates, but if you hold your investment for more than a year (another advantage of being a buy-and-hold investor), you'll be able to take advantage of long-term tax rates that are likely to be significantly lower.
If you're an individual filer and your ordinary taxable income in 2023 is less than $44,625 (or less than $89,250 if married), you can avoid taxes on capital gains. and Qualified dividends aren't taxed, at least up to a certain threshold, but if you earn too much ordinary income, you won't qualify for the 0% tax rate and you'll end up paying investment taxes at a higher rate.
For example, if you're married and have no ordinary taxable income, you can claim a 0 percent tax rate on long-term capital gains and qualified dividends up to $89,250. Any growth in your investment income above that amount is taxed at a higher rate of 15 percent up to $553,850. Any growth in your income above that amount is taxed at a 20 percent rate.
In contrast, if your ordinary taxable income is $20,000, you'll pay zero percent tax on the next $69,250 of long-term investment income (that is, up to the $89,250 threshold), and from there you'll pay tax at the same 15 percent level as before, until your total income exceeds $553,850.
So even if you have a year where your income is lower than normal, you can still realize a 0 percent tax rate on your investments and even increase the cost price of your investments without incurring any tax consequences.
Conclusion
Using tax-advantaged accounts is a great way to minimize your tax burden, but one of the easiest ways to reduce your tax burden is to take the simplest “buy and hold” investing approach. You'll enjoy similar benefits to an IRA (like deferred capital gains taxes) but with more flexibility to access your funds when needed.
Bankrate Brian Baker contributed to an updated version of this story.
Editorial Disclaimer: All investors are advised to conduct their own independent research into any investment strategy before making any investment decision, and please note that past performance of any investment product is no guarantee of future price appreciation.
