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Tax Wise Investing

Most investment income is taxable, but if you take advantage of a number of tax-saving strategies, you may be able to build your portfolio value while owing less to the IRS and your state tax authority. Two particular strategies that you might want to consider are tax-deferred retirement accounts and accounts that permit tax-free withdrawals.

Tax-deferred investing

A tax-smart way to invest for retirement is by participating in all the tax-deferred plans for which you're eligible. For example, if your employer offers a 401(k), 403(b), or 457 plan, you can defer part of your salary to the plan. And if your employer matches part of what you defer, it's smart to defer at least enough to qualify for the full match. Everything you and your employer add to the plan and any earnings those contributions produce are tax-deferred.

The deferred amount reduces the tax you owe right now. That's because it's subtracted before your income is reported to the government. What your employer contributes is not reported, either. Withdrawals will be taxed at the same rate that you'll be paying on your ordinary income when you withdraw. It's possible this rate will be lower than the rate you pay now, though there's no guarantee that will be the case. But either way, you'll have had the benefit of years of untaxed compounding. Keep in mind that investing carries risks, even in a retirement account, and you could lose all of what you invest.

In addition, you can contribute to an individual retirement account (IRA) any year you have earned income. You set up an IRA yourself with the institution of your choice. And you can invest using any of the investment products that are available through your institution. IRA withdrawals from a tax-deferred account, like those from a 401(k) or similar plan, are taxed at the same rate as your ordinary income.

You may be able to deduct the amount of your IRA contribution when you file your tax return for the year, though caps apply if you're also eligible for an employer's plan.

  • You can deduct if you're not eligible for an employer's retirement plan, whatever you earn. The only provision is that, if you're married and your spouse is eligible for an employer's plan, your combined adjusted gross income (AGI) determines whether or not you can deduct.
  • If your spouse isn't eligible for a plan either, or if your AGI is less than the annual cap, you can deduct your contribution.

Tax-free accounts

Another tax-saving strategy is to open a Roth IRA or Coverdell education savings account (ESA). In both cases, you choose an institution for the account, just as you do with a tax-deferred IRA, and you invest in any products available through the institution. However, both types of accounts have AGI caps that may limit your ability to participate.

With these accounts, you invest after-tax income, so there are no immediate tax savings as there are with tax-deferred accounts. But withdrawals are tax free, provided you follow the rules that apply to the type of account you have. With a Roth IRA, you must be at least 59 1/2 when you take the money out and your account must have been open and funded at least five years. With an ESA, the money must be used to pay qualified education expenses for the account's beneficiary. He or she must be younger than 30.

Some employers offer a Roth 401(k), 403(b), or 457 plan alternatives to their tax-deferred retirement plans. If your employer offers this option, you contribute after-tax income, but withdrawals are tax free provided that you're at least 59 1/2 and your account has been open at least five years. There are no AGI caps with a Roth 401(k) or similar plan.

Tax efficiency

When your investment accounts are neither tax deferred nor tax free, you can still limit the amount of income tax you owe.

  • Any gain you realize on an investment you've owned for more than a year is taxed at your long-term capital gains rate. That's lower than the rate you pay on ordinary income.
  • Most dividends on domestic stocks and exchange-traded funds (ETFs) and income distributions from stock funds are taxed at your long-term capital gains rate.
  • Capital losses you realize on investments you've owned more than a year can be used to offset long-term capital gains. Short-term losses can offset short-term gains.
  • Capital losses can be used to offset up to $3,000 of ordinary income each year.
  • Some mutual funds, including money market funds that invest in municipal bonds and stock or bond funds with limited portfolio turnover, may limit your taxable income.

Paper profits

Another way to reduce your current taxes is to make investments that pay little or nothing in dividends now, such as certain stocks, stock mutual funds, ETFs, and some managed accounts. There are also ways to pass these growth investments along to your heirs without owing tax on the full increase in value.

Just remember that with most of these strategies there is always the risk that your investment will not grow as much as you anticipate or will lose value. And always consult a tax professional when incorporating tax strategy into your investments.