Taxes are an inevitable burden that everyone must deal with at some point, but they can be minimized through strategic planning.
To maximize these advantages, it is important to comprehend how deductions and credits can reduce your taxable income. After that, you can take the appropriate steps to maximize them.
1. Keep Track of Your Itemized Expenses
Tracking your expenses is an integral component of tax planning. It helps keep personal and business finances separate, preventing you from spending money on unnecessary items.
Tracking your expenses has never been simpler! Consider investing in accounting software that automatically categorizes spendings for you. Doing this gives you a comprehensive view of your expenditures and helps break bad spending habits.
Itemized deductions are specific expenses you can deduct from your taxable income, reducing the size of your tax bill. Examples include medical costs, interest on a home mortgage, and charitable contributions.
2. Look for Tax-Advantaged Holdings
One way to minimize your tax bill is by investing in tax-favored holdings. Many investments are by their very nature tax-efficient, such as equity index mutual funds and exchange-traded funds (ETFs).
At times, however, investing in less tax-efficient assets may make sense. For instance, when saving for a down payment on a home or paying off debts, it may be more advantageous to hold short-term bond funds in a taxable account rather than an ISA.
Additionally, tax loss harvesting–selling stocks that you haven’t held for a year or more at a profit and reinvesting the proceeds–can be an efficient strategy to maximize your return. It may also help keep your portfolio allocation balanced.
3. Look for Tax-Advantaged Investments
Tax-advantaged investments and accounts allow you to shield part or all of your income from taxes, helping reduce your overall tax liability. This could mean more money in your pocket at the end of the year.
When investing, investors may be tempted to place more of their portfolios in tax-advantaged accounts such as traditional IRAs and 401(k) plans. However, these tax-favored accounts may not always be the best place for certain kinds of investments.
For instance, some taxable bond funds can be highly tax-inefficient due to their frequent income payments. Furthermore, certain funds like real estate investment trusts (REITs) frequently reinvest their holdings and may experience large capital gains.
4. Look for Tax-Advantaged Retirement Accounts
Depending on how you invest your money, you may be able to postpone paying taxes on some portion of your investment earnings. Doing so could save you money in the future and enable you to grow your wealth more rapidly.
Tax-advantaged retirement accounts, such as 401(k)s, 403(b)s and IRAs, offer investors several advantages. One of these is delaying taxes on contributions and withdrawals until a later date.
Many other investments offer tax benefits, such as 529 college savings plans and health savings accounts (HSAs). These can be part of a comprehensive tax strategy designed to maximize your after-tax returns.
5. Look for Tax-Advantaged Investments
Tax-advantaged investments are an excellent way to minimize your tax bill and maximize deductions and credits. Examples include 401(k)s, Roth IRAs, 529 plans and other tax-exempt retirement accounts.
Stocks are a popular option for tax-advantaged investors as they generate more income than bonds do. Unfortunately, the IRS imposes ordinary income taxes on stocks and dividends at rates up to 37% plus an additional 3.8% if the net investment income tax applies.
Investors seeking a tax-deferred alternative may wish to consider investing in municipal bonds, partnerships or exchange-traded funds (ETFs). These products tend to produce less income than taxable bonds and have lower asset turnover rates, leading to fewer capital gains tax events.