Just as commissions can eat away at your investment returns, so can taxes.
Knowing how to optimize your investments for tax minimization can boost your returns.
In this article, we’ll learn about several techniques to help you save more in investment taxes.
First, make sure you refresh yourself on the Federal income tax brackets so that you know where you stand and what limits to shoot for. Then, the rest of this article will make much more sense.
Day Trading and Short-Term Trades
Day traders have some of the most inefficient accounts when it comes to taxes.
Of course, if you are making big profits, taxes probably aren’t a concern. But most day traders aren’t making big profits.
With frequent trading comes losses and high commissions, which can cause an account to barely break even or go negative when every trade is showing a (small) profit.
If the account has a loss for the year, there won’t be any tax consequences. If the account has any profit, taxes must be paid.
Because day traders are in and out of positions usually within the same day, all of their trades are considered short-term. Meaning, they are held for one year or less.
Short-term trades are taxed at your regular income tax rate. If doesn’t matter when you opened and closed the trade. If the trade was held for a year or less, it is considered a short-term trade.
Long Term Trades
Long-term trades are those held for more than a year. These types of trades or investments can take advantage of tax savings.
Tax rates on long-term trades for 2017 are 0%, 15%, and 20%. If you are already in the 15% income tax bracket, you probably qualify for the 0% rate. High-income earners can expect to pay 19.6%.
Long-term trading is another name for investing. Instead of trading, think more in terms of investing and holding for longer than a year.
Investing requires much less work than short-term trading, cost less, creates fewer transactions and saves more in taxes.
Long-term trading is also more profitable. Taiwan has a very large day-trading community. In 2004, four researchers based in California and Taiwan created a paper that examined the performance of these day traders.
They concluded that “Heavy day traders earn gross profits, but their profits are not sufficient to cover transaction costs. Moreover, in the typical six month period, more than eight out of ten day traders lose money.”
These same authors followed up with a 2009 paper that found the following, “Individual investor trading results in systematic and economically large losses.
Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individuals suffers an annual performance penalty of 3.8 percentage points.”
In summary, while a small group of day-traders may manage to eek out a profit, the majority will not. Of those who do generate a profit, most of it will be gobbled up by transaction fees and taxes. Short-term trading simply isn’t worth hassle.
Mutual funds and index funds are great investments since they are basically set it and forget it. But some funds are more tax efficient than others.
The ones to watch out for are those that distribute short-term dividends and capital gains.
Even if these funds reinvestment their dividends and capital gains, it will still cost you in taxes since these distributions are short-term.
Instead, look for funds that have fewer distributions. Also, funds will list their after-tax net performance, providing you with a better picture of performance to expect from the fund.
Keep in mind that municipal bond interest is exempt from federal taxes and most state taxes.
Taking Advantage Of Capital Gains Losses And Tax Loss Harvesting
If you have gains during a year, you can offset them by selling losers. In fact, for 2017, you can take up to $3,000 in losses.
If you have a $10,000 long-term gain for the year and sell $3,000 worth of losers, your net gain will come down to $7,000. Instead of paying long-term taxes on $10,000, you pay on only $7,000.
What if you have a $5,000 loss? You can still claim $3,000 in losses for the year. Then carry forward $2,000 for next year. In the following year, you’ll start with a $2,000 loss claim.
You can still add another $1,000 of losses to max out your $3,000 capital gains loss. If you still have more than $3,000 in losses for the next year, you can continue carrying forward losses.
Tax loss harvesting is another technique to save on investment taxes. Mike Piper, a St. Louis CPA, says to, “look for opportunities to harvest ‘tax losses’ throughout the year.”
What exactly is tax loss harvesting? Unlike capital gains loss techniques, which usually occur near the end of the year and focus on selling losers, tax loss harvesting looks for opportunities through out the year.
If you purchase a fund for $10,000 and it drops to $9,000, you can sell it take a $1,000 loss. This loss can be counted toward the total year loss or simply offset other gains occurring during the year.
Taxes are a fact of life but everyone has a right to avoid them (as opposed to evading, which is illegal).
By investing long-term, choosing funds that have infrequent distributions and taking advantage of tax loss harvesting, investors can decrease their overall tax burden.
Do you try to minimize taxes paid on investments?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.