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1. Capital gains should be long-term

There are various strategies floating around for generating big investment returns through short-term trading. An extreme example is day trading, a practice by which you try to maneuver your money in and out of various investments at hopefully opportune moments.

The problem with all short-term trading strategies is the exposure to maximum income tax liability. Short-term trading means short-term capital gains.

Any time you sell a capital asset in under one year, any profit you earn on the sale is added to your total income and taxed at ordinary rates. If you are taxed at the highest rate (37%), the taxes incurred will take a big chunk out of any profits you earn.

A better strategy -– one earning you bigger profits by default -– is to invest for long-term capital gainsEven if you are at the top tax rate, the tax on long-term capital gains will be no more than 20%.

And if your income falls below the minimum for the 15% bracket, which is $41,675 for single filers and $83,350 for married filing jointly in 2023, your long-term capital gains tax liability will be zero.

Any capital assets you hold outside of a tax-sheltered account should aim specifically for long-term capital gains to minimize your tax liability. You can always find out if your capital gains are in line with your investing priorities by getting your accounts reviewed by a licensed fiduciary advisor.

2. Keep your portfolio in tax sheltered accounts

Tax-sheltered investment accounts, primarily retirement accounts such as 401(k)s, 403(b)s, and various IRA plans, offer the opportunity to allow your investments to grow free from tax considerations.

They aren’t tax-free, but they are tax-deferred and will enable your portfolio to grow much more rapidly than it would in a taxable account. You won't have to deal with tax considerations until you begin making withdrawals when you're retired, and by then you should be in a lower income-tax bracket.

These are the best accounts for interest and dividend-earning investments, as well as the type of investing that produces short-term capital gains. Your money will accumulate without creating the tax liability these types of investments normally produce.

3. Invest in municipal bonds

Municipal bonds are the one definite exception to holding interest-bearing investments in a tax-sheltered account. Interest earned on municipal bonds is free from federal taxation, as well as from taxes within the issuing state.

If your state has a particularly high tax rate, you should favor municipal bonds issued by your own state. Any municipal bonds that originate from other states will be subject to income tax in your home state.

4. Consider real estate investments

Real estate investing offers the potential for both current income (positive rent income), as well as capital appreciation in the form of rising property values. It also offers three major tax advantages:

  • A positive cash flow (rent minus expenses) is typically offset by depreciation for income tax purposes.
  • The value of the property can rise for many years but will not be subject to income tax until the property is sold.
  • Once the property is sold, it will have the benefit of qualifying as a long-term capital gain, subject to lower income taxes.

Real estate isn’t the most liquid asset, but it has been a solid performer over the past half-century. And the combination of tax advantages it offers can be comparable to a tax-sheltered portfolio.

5. Fund your 401(k) beyond your employer match

For most people with a full-time job, a 401(k) account is the first investment they'll come across as an adult. It's a 403(b) account if they work in education or a non-profit organization and a 457 account if they work in a government position. In any case, it is an opportunity to save on your taxes.

Many people choose to take advantage of the employer match but don't increase their contributions beyond that. The contribution limit for this account in 2023 is $22,500. Most people save far less than that. At a minimum, most experts suggest saving at least 10% to 15% of your annual gross pay (before taxes and deductions) in a retirement savings account.

401(k)s, 403(b)s and 457 accounts use pre-tax dollars. That means you don't pay any income tax on the amount you contribute to the account. Instead, you pay tax in retirement, presumably at a lower tax rate when you don't have a full-time job.

6. Max your IRA savings every year

Whether or not you have a 401(k) or other retirement savings, you can save in a traditional or Roth IRA account. IRAs (individual retirement accounts) have a $6,500 annual contribution limit, subject to income limits.

A traditional IRA uses pre-tax dollars, just like a 401(k). A Roth IRA allows you to invest with post-tax dollars, but there is no capital gains tax when you withdraw in the future. This means your investments can grow as a form of tax-free investing where you keep all of the profits. We recommend using Bloom to max out your IRA.

7. Take advantage of an HSA if you can

The only truly tax-free account is a Health Savings Account, or HSA. This account is used to save for and pay for medical expenses like doctor appointments, hospital visits, and prescription medications. You must be on a high-deductible health plan (HDHP) for health insurance to qualify for an HSA.

But if you do qualify, an HSA gives you tax-free contributions and tax-free withdrawals. That means you can contribute and pay for qualified medical expenses completely tax-free. You can also wait to reimburse yourself for a medical cost many years in the future. That turns the HSA into what is effectively the best retirement account available.

Unlike a Flexible Spending Account (FSA), HSA accounts do not impose a “use it or lose it” rule. HSAs allow you to save in a savings account that works like a bank account. Many HSA providers also give you an investment option.

8. Consider a 529 for education expenses

A 529 account is a tax-advantaged account for education. While contributions are not pre-tax or tax-deductible, investments in a 529 account grow tax-free. Assuming you invest well, that means you get a tax-free investment gain.

The downside of a 529 is that you can use the funds only for qualified education expenses. Withdrawing for any other use incurs a tax penalty. On the bright side, however, you can change the name on a 529 to a sibling or other close relative. That means if your oldest child doesn't use all of the funds, you can put it toward a younger child.

You can even move the funds to your own name and take a few classes to grow your skills and feed your interests to help you drain your 529 without penalty.

9. Try index funds

Surprise, index funds are a great way to reduce taxes on investments. Not many investors think of index funds in this way, but it is actually one of best their functions.

They aren’t tax-free or even tax-deferred, but they most certainly qualify as tax-efficient investments. As index funds are established to match the underlying index — say, the S&P 500 — they don't trade individual stocks until and unless the index makes a reallocation. This doesn’t happen all that frequently, so trading is kept to a minimum.

Everything else in the portfolio is kept constant. This means very little selling of stocks and the tax liability it generates. And even when they do sell, it produces tax-favored long-term capital gains.

Contrast these with actively managed funds, which trade stocks frequently in an attempt to beat the market. These types of funds will not only generate capital gains but will often generate short-term capital gains, which do not enjoy the same tax advantages the long-term variety does.

Index funds can grow over many years with little income tax impact at all.

10. Consider a charitable donation of stock

If you made a great stock pick once upon a time and are sitting on a huge capital gain, don't click the sell button just yet. You may be able to give that stock, or a portion of it, to a favorite charity with no tax due, and even take a tax deduction for the full value.

Let's say you bought a stock for $1,000 and it is now worth $2,000. If you sell it, you'll have to pay capital gains tax on the $1,000 profit. If you give it to a charity, you can deduct the $2,000-per-share value, and no one has to pay tax on the $1,000 gain. That's a win-win for you and your favorite nonprofit.

Invest accordingly

Consider the impact of taxes on all of your investments and invest accordingly. There are ways to get around most investment-related tax burdens, or at least to keep them to an absolute minimum.

About the Author

Kevin Mercadante

Kevin Mercadante

Freelance Contributor

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com.

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The content provided on Moneywise is information to help users become financially literate. It is neither tax nor legal advice, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional. We make no representation or warranty of any kind, either express or implied, with respect to the data provided, the timeliness thereof, the results to be obtained by the use thereof or any other matter.