Q. I like seeing the money my investments are making, but every time tax season rolls around, it seems like a big chunk is going to the IRS. How can I reduce my investment-related tax bill?
A. There are a number of ways to reduce your investment-related taxes. In fact, it is possible to completely eliminate taxes on your investments. However, prior to doing so, consider what your real goal is. Is it to reduce your tax bill or to maximize your after-tax returns? Of course, as you give it more thought, you’ll realize that your goal is to maximize the after-tax returns, and sometimes that involves paying more in taxes than you would pay using other investing techniques. This article will discuss six ways savvy investors reduce their tax bill while boosting their after-tax investment returns.
#1 Investing in Retirement Accounts
Hands down, there is no doubt that the single best way to decrease your investment-related taxes is to invest in tax-protected accounts such as 401(k)s and Roth IRAs. Too few physicians have gone to the trouble of actually reading the plan documents for their employer-provided retirement plans or, if self-employed, opening an appropriate retirement plan. They also may not be aware that despite their high income, they can still contribute to a personal and spousal Roth IRA—they simply have to do it “through the backdoor” as discussed in a previous ACEP Now column. Health savings accounts may be the best investment account you have, a topic also discussed in a previous column. If you have more than one unrelated employer, for example, if you’re an emergency physician doing locums on the side, you may also have more than one 401(k).
Investing in retirement accounts has multiple tax-related benefits. With a tax-deferred account, you get an upfront tax break and often an “arbitrage” between your current high tax bracket and a future lower tax bracket. Very few emergency physicians are saving enough money to be in the same tax bracket in retirement as in their peak earnings years. With a tax-free (or Roth) account, all future gains are tax-free. Dividends and capital gains distributions also benefit from tax-deferred or even tax-free treatment, depending on the type of account.
#2 Buying and Holding Tax-Efficient Investments
Another important way to reduce the taxman’s take on your investment returns in a nonqualified (ie, taxable) account is to invest in a tax-efficient manner. That means choosing investments such as low-cost, low-turnover stock index mutual funds, where taxable distributions are minimized and those that you do get receive favored tax treatment at the lower-dividend and long-term capital gains tax rates. For example, if you wanted to invest in two mutual funds with similar expected returns but had to put one in your taxable account, look up their tax efficiency on a Website such as Morningstar.com and put the most tax-efficient one in the taxable account. Holding on to your investments for decades rather than frenetically churning them also reduces the tax bill.