Invest to Reduce Your Taxes

Just like it’s important to reduce your investment fees and expenses, it’s also important to invest to reduce your taxes. Know the difference between long term and short term gains, understand how dividends are taxed, and by all means, put as much money as you can into tax deferred and tax friendly accounts such as 401Ks and IRAs.

Its a well know investing concept that money you invest in tax deferred accounts is worth more than other money you invest. Roth IRAs and Roth 401Ks are the best, but 401Ks and IRAs are also great ways to build wealth. By putting money in accounts that are tax deferred or tax free (Roths), you are essentially able to compound the investments into multiples of your initial investment, without paying taxes. Here are the advantages of different types of accounts and gains. You should memorize these attributes and adjust your investments accordingly:

Long term gains – These are taxed at much lower rates than short term gains. If possible, hold your investments at least one year to realize a long term gain

Short term gains – Try to avoid these. Tax rates are much higher on these investments. However, if you have losses that you probably won’t recover, use short term losses to reduce your tax bill.

Traditional IRA – Contributions to this type of account are deductible in your current tax year and lower current taxes. They are not taxed until you sell them, so you can compound gains for years without paying taxes. Invest in growth stocks with these accounts when you are younger so that you get full benefit of the tax free compounding.

Roth IRA – Contributions to these accounts are not tax deductible in the year you make them, but you will never have to pay taxes on the value of these accounts. That makes the value of these accounts worth much more than a taxable account. Take more risk in these accounts to maximize the tax free status of the funds over time.

401K – Similar to the Traditional IRA, these accounts reduce your current taxes and compound tax free until you withdraw the money.

Dividends – Keep up with the laws on dividend taxes. Historically, they are treated as short term gains and taxed at your income tax rate, however, recent laws have lowered the dividend tax rate. These laws change so adjust your investments accordingly. Sometimes, it pays to put dividend paying stocks in a tax free account so you don’t have to pay taxes right away and can reinvest all of the dividends without penalty.

Some other ways to invest to reduce your tax bill is to buy securites such as government or municipal bonds that have favorable tax treatment, use prior losses to offset gains, and sell your losers early so that the losses can offset some of your gains.

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