Investing in the stock market is one the key ways to build wealth. Did you know it also offers many other benefits, including ways to reduce tax burden?
We want to make one thing clear: taxes are not inherently a problem. When you think about it, taxes are what fund our public programs. Maybe some of the same ones many of us have been raised through—think: Headstart, food stamps/EBT, WIC, public schools! We can still feel like the IRS is taxing us at too high of a rate. These feelings get stronger each time the news reminds us that those who hold the most wealth tend to pay the bare minimum in taxes. Thinking through ways to reduce our tax burden is okay. It allows us to have more control over our money, decide where it goes, and what causes we want it to support. Read on to learn how you can leverage investing to reduce your tax burden.
1. Utilize Tax-Advantaged Accounts
Remember, within both of these accounts, you have the option of opening a traditional account (pre-tax) or a Roth account (post-tax). Through either option, you are reducing your tax burden. For a 401(k), for example, you could reduce your taxable income by up to $19,500, which is the contribution limit in 2021. For an IRA, you could reduce your taxable income by $6,000, which is the contribution limit in 2021.
The difference between a traditional or a roth is when you will be reaping the benefits. Do you expect to be in a higher tax bracket now? Consider a traditional account. If you’re expecting to be in a higher tax bracket later, perhaps it makes sense to elect a Roth version.
To hear more on how these type of accounts can leverage your path towards financial independence, listen to Episode 92 with Winenance.
2. Choose Your Portfolio Holdings Carefully
Individual stocks and day-trading are all the buzz. But if you are not familiar with the intricacies of this, you can easily set yourself up for a huge tax bill.
Investing vehicles like index funds or ETFs are more tax efficient than something like a mutual fund or individual stocks because they minimize movement. The less movement there is within your portfolio, the easier it is to alleviate your tax burden through investing. Market indexes, for example, dictate index funds, whereas portfolio managers manage mutual funds.
3. Prioritize Long-Term Capital Gains
We want you to think: “Buy and hold.”
One reason for this is that the market historically goes up. Even when it experiences harsh dips like what we saw in March of 2020, the market will swing up, as we are seeing now. Your chances of successfuly timing the market (to “buy low, sell high”) are slim.
The second reason is that selling off your investment vehicles within a year classifies your profit as a short-term capital gain, which is taxed at a much higher rate than long term capital gains.
Each time you sell an asset under one year of purchasing it, the profit made will be added to your total income and taxed at standard rates, sometimes as high as 40%. By simply waiting one year, you can reduce the rate at which your gains are taxed by as much as 20%.
Note: if you have a Roth IRA account, this 1-year “rule” does not apply to you! You can buy and sell whenever you desire. Since it is a Roth account, you’ve already paid your taxes on the money that goes in, hence no need in the eyes of the IRS for you to also pay on the money that goes out (when you hit 59.5). If you do not yet have a Roth IRA and qualify for one, we like M1 Finance! This platform makes investing, borrowing, and cash management easy within one single platform.
4. Hold Your Dividend-Paying Stocks Within A Tax-Advantaged Account
Many stocks will pay you a dividend for owning a share. Think of it as a “thank you” for investing in their company and letting them “borrow” your money. But these earned dividends that are reinvested into your account can impact what’s considered your total annual income.
Depending on the class of dividend, the IRS will tax you at ordinary income rates, or lower rates. However, when you hold dividend-paying stocks within tax-advantaged accounts like an IRA, your accounts grow tax-free. The IRS will not tax your dividends being reinvested each year.
5. Write Off A Loss
This is a strategy we recommend to those who have a bit more experience, or have the support of someone. Through a process known as tax-loss harvesting, you can offset realized investment gains. Note: this is primarily when thinking about minimizing short-term capital gains (so if you follow steps 1 through 4, you shouldn’t have to do much or any of this!).
There are lots of rules to consider in order to adhere to IRS rules and regulations. You should not view this step as a go-to, but rather part of a larger, intentional strategy, in consultation with a professional if you do not yet have the education yourself.
The Bottom Line
The government taxes us at a higher rate when we make more money. Investing offers many wonders, and one of those is the potential to reduce your tax burden.
Check Out Our Podcast Episodes About Investing
- Episode 74. Why You Need To Start Investing Now | Dr. Hans Boateng, The Investing Tutor
- Episode 67: How To Invest Like a Girl | Mabel Nuñez, Girl$ On The Money
- Episode 51: First Gen Immigrants Can Be Investors Too | Nathaly Minda of The Financial Talk
- Episode 48: A Beginner’s Guide to Investing | Delano Saporu of New Street Advisors Group
- Episode 42: Why Investing Is A Revolutionary Act For Marginalized Communities | Georgiy Roykhman of Funancialism
- Episode 2. Let’s Talk About Investing | Host Jannese Torres-Rodriguez