You may not pay much attention to taxes within your brokerage account, as these costs are often hidden -- rarely does a broker have any line item for accrued tax or projected tax due. This makes it all the more important to know the major tax triggers within your investment accounts to avoid disaster come tax time.
Every investment sold and dividend earned during the year will show up on your year-end tax documents, so it's critical to understand how your actions today will impact your liability next April. Below you'll find four strategies for minimizing taxes due.
1. Lengthen your holding periods
Any time you buy a stock and sell it for a profit within a year or less, you'll have a short-term capital gain (STCG) that's taxed as ordinary income. In other words, the gain from your stock sale will be added to your regular income as if you had earned it working a job.
After a year plus one day, any gains on stock sales are considered long-term capital gains (LTCG), which are eligible for favorable tax rates ranging from 0% to 23.8%. From a tax standpoint, you're almost always far better off buying and holding for at least a year and a day to minimize your liability on investment sales.
2. Tax-loss harvesting
If you've accumulated any investment losses, you have the opportunity to use these losses to offset any gains you've realized. Say you've already bought stock and then sold it after more than a year to realize a long-term gain of $10,000. In the same year and account, you've also held a different stock for over a year and lost $2,000 -- but haven't yet sold out of the position. Under tax-loss harvesting (TLH) principles, you can sell the second stock at a loss and apply it against the $10,000 gain already realized, bringing your total LTCG for the year to $8,000.
This strategy, of course, will only work if you have at least one losing position, and it will also mean that you have to part with the losing investment as well. TLH works best in a down market if you'd like to reduce your tax liability and reposition your portfolio for the future.
3. Check your dividends
You'll want to ensure that the majority of your dividends earned in your taxable account are qualified dividends -- this means the dividend was generated by a U.S. corporation (in addition to some exceptions) and that you have held the underlying stock for a minimum of 61 days, generally speaking. If you've held the stock long enough, your earned dividends will be taxed at favorable capital gains rates and will avoid ordinary income taxation.
If you hold real estate investment trusts (REITs) in your taxable account, you'll likely not be able to take advantage of these beneficial rates, and your dividend income will be seen as ordinary, and thus taxed at higher rates. This speaks to the importance of understanding the character of your dividends and not just the amount received.
4. Put your investments in the most tax-efficient accounts
Another way to ensure you're optimally tax-aware is to double-check that you're holding investments in the right accounts. Growth assets like stock mutual funds should generally be placed in your taxable account. These funds generate low dividends and derive most of their gains from price appreciation, which are only taxed as sales occur.
Higher-dividend stocks, REITs, and corporate bonds should be placed in tax-advantaged accounts. The logic here is that investments deriving most of their benefit from periodic dividends or interest will generate a tax bill immediately when received in a taxable account; if the same investments are held in tax-advantaged accounts, you won't have any tax burden until you withdraw money.
Take the time to minimize tax
While much of the above may seem tedious, it is also quite simple. A solid tax strategy revolves around buying great companies that you're willing to hold for a long period of time, and being especially aware of the rules surrounding the different account types you have. Tax management, put another way, boils down to being extremely patient and having a correct setup; from there, you will minimize stress when the IRS comes knocking on tax day.
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