4 Ways to Tax-Proof Your Investment Portfolio

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Americans leave a lot of money on the table for the taxman.

Taxpayers who get big tax refunds have effectively given the federal government an interest-free loan all year, for example. And investors who fail to make sure their portfolios are as tax-efficient as possible could be losing more of their investment returns to taxes than necessary.

Over time, that lack of planning can easily cost an investor thousands of dollars.

While you don’t want to design your portfolio solely around the goal of minimizing taxes, certain tax-minimizing steps may fit naturally into your investment strategy.

Following are several simple ideas for tax-proofing your investments that could have a big impact.

1. Know your tax rates

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Investments are not all taxed at the same rate.

Things like real estate investment trusts (REITs) and bond interest, for example, are taxed as ordinary income, reports Fidelity Investments.

For the 2024 tax year, that currently means they can have a tax rate as high as 37%, while long-term capital gains generally top out at 20%. They can go even slightly beyond that for folks with very large incomes or those selling certain things, including collectibles such as coins or art.

This can affect what kind of investments you select and where you keep them, but it should also have you keeping an eye on your income.

If you’re on the cusp between tax brackets, some financial decisions could push you over the edge. If you know that, you can aim to land on the side that’s better for your situation and what you expect in the future.

2. Choose your tax shelters wisely

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Think of tax-advantaged accounts like 401(k) plans, individual retirement accounts (IRAs) and health savings accounts (HSAs) as boxes you can put investments in. Things inside the box generally have more protection from Uncle Sam’s grabby hands than if they were left sitting on a table in the open.

That’s why they’re often called “tax-advantaged” or “tax-sheltered” accounts.

Different types of tax-advantaged accounts offer different types of tax-minimizing benefits, however. And depending on your situation, one benefit could save you more in taxes than another.

In other words, you can exert a bit of control over how your investments are taxed by carefully picking where you keep your investments.

Take traditional and Roth accounts, for example.

When you contribute to, say, a traditional IRA or 401(k), you’re not taxed on the cash that goes into the account at the time you deposit it. Instead, money in such an account — both your original contribution and the earnings it generates — is taxable later, in the tax year during which you withdraw money from the account.

This fact often makes traditional accounts more attractive to people who expect to have a lower income during the years when they will be withdrawing from the account than the years when they are contributing to the account.

By contrast, money you deposit in a Roth IRA or 401(k) is taxed in the tax year for which you deposit the money. So, if you follow the IRS rules for retirement account withdrawals, you get to withdraw contributions and earnings tax-free.

That fact makes Roth accounts attractive to people seeking to avoid taxation in retirement, for example.

It may be worth your while to consult a financial advisor to review where you keep your investments and explore other options you may not realize are available.

3. Know when to cut your losses

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Nobody wants their investments to lose money, but you may be able to use losses to your advantage.

Capital losses can be used to offset capital gains by lowering your taxable income. The IRS explains:

“If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 of Schedule D (Form 1040), Capital Gains and Losses. Claim the loss on line 7 of your Form 1040 or Form 1040-SR.”

If your net loss is greater than that, you may be able to carry over the excess loss to future tax returns.

This is called “tax loss harvesting.” Ideally, you’ll prune investments that no longer fit in with your investment strategy, seem to have poor long-term prospects or that leave your portfolio improperly balanced.

Don’t prune investments simply because you have seller’s remorse about them. And don’t ditch an investment because you think you can take a loss on paper before buying it back. You can run afoul of the IRS’ “Wash Sales rule” and lose out on the deduction instead.

4. Be charitable

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Charity deductions are getting harder to come by because the standard deduction was doubled in 2018; more taxpayers are choosing that deduction rather than itemizing deductions such as gifts to charity. The IRS only lets you do one or the other.

That change became a bit muddled by the pandemic, however, when a temporary exception was added for 2020 and 2021 to encourage more donations. If you were taking advantage of that exception, it’s gone now.

If you don’t have enough deductions to make itemizing worth it, you might be able to counter this change by making multiple years’ worth of planned donations in a single tax year. So, say you want to donate $1,000 a year to charity — instead, you would donate $2,000 and take the deduction in every even year, then make no donations in the odd year.

Also, instead of selling stock to get cash for a gift to charity, it makes sense to donate the stock itself if you owned it for more than a year. The charity doesn’t have to pay the capital gains tax you would, so you’re not paying one tax to reduce another. The donation also goes further instead of getting siphoned off by Uncle Sam.

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