Americans leave a lot of money on the table for the tax man.
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 strategies to consider.
1. Know your tax rates
Investments are not all taxed at the same rate.
Things like real estate investment trusts and bond interest, for example, are taxed as ordinary income, reports Fidelity Investments. For tax year 2018, that means they can have a tax rate as high as 37 percent, while long-term capital gains top out at 20 percent, or even slightly beyond that for folks with very large incomes.
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
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 little 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.