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3 keys to help reduce taxes

Key takeaways

  • Incorporating tax-smart strategies into your overall financial plan may help you build wealth faster.
  • Reducing taxable income, maximizing potential deductions, and taking taxes into consideration when making investment decisions can potentially help lower your tax bill and give your money more of a chance to grow over the long term.
  • Mitigating the effect of taxes can be complicated and time-intensive, so consider working with a professional who can help identify the best approaches for your family's situation.

Many of us focus on taxes only around the final few weeks of the calendar year or as we prepare our annual return. But integrating tax-smart strategies into a holistic financial plan demands far more attention. Tax laws change on a regular basis, salaries can fluctuate, markets constantly shift, and life events such as family changes can have a major impact on your tax situation.

"What you pay in taxes affects what you earn, what you keep, and how much you can spend. It's all interconnected," says Lou Gentile, regional vice president for Fidelity Investments.

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Lowering the amount of taxes you pay on your investments, for example, can help you keep more of what you earn and help keep your money growing. And keeping tax efficiency in mind as you tap retirement accounts can help you maximize your savings—and perhaps ultimately allow for greater gifts to your heirs.

Below are 3 tax-smart strategies that may help reduce your tax bill and allow you to build wealth faster.

1. Reduce taxable income

Lowering the amount of your income subject to taxes is one of the most effective ways to reduce your tax bill—and may also help keep your income at a lower marginal tax rate.

Consider maxing out tax-advantaged accounts. Contribution limits on workplace plans such as 401(k)s and 403(b)s are generally bumped up each year. In addition, anyone who has a high-deductible health plan should check if they are eligible to contribute to a health savings account (HSA). Since HSAs are triple tax-advantaged1—contributions aren't subject to federal income tax, invested contributions have the potential to grow tax-free, and withdrawals are tax-free when used for qualified expenses2—you may want to consider covering your current health care expenses with cash and using the HSA as a vehicle for retirement savings.

Manage your bracket. Tax-bracket creep—when you are pushed into a higher bracket—can result from the sale of a house, a bonus, severance package, or many other one-time income bumps. Higher-income taxpayers may also find themselves subject to the net investment income tax (NIIT), a 3.8% surtax on capital gains, dividends, interest income, and other forms of investment income. If you're close to the top of a bracket, you may want to see if it makes sense to defer some income (perhaps from self-employment or the sale of stocks) to the following calendar year.

Alternatively, if your taxable income is unusually low in a certain year, you may want to consider accelerating discretionary income, if possible. A lower-bracket year can also be a good time to consider converting a traditional IRA to a Roth IRA.

Be mindful of retirement account withdrawals. At age 73, the IRS requires you to take minimum withdrawals from traditional IRAs, and 401(k) accounts if you are no longer working for the company. Those withdrawals are generally taxed at your ordinary income rate. Depending on the types of accounts you own and your account balances, among other factors, it may or may not make sense to draw down these accounts sooner or at a faster rate. If you are charitably inclined and have the means, you may want to consider donating funds from your IRA with a qualified charitable distribution, or QCD. A financial professional can help you create an approach that works best for your family.

2. Maximize potential deductions

The 2017 Tax Cuts and Jobs Act roughly doubled the standard deduction, making itemizing deductions a less attractive option than they were prior to the law's passing. By planning ahead of time, however, itemizing deductions can still be a powerful way to lower your tax bill.

Bunch charitable contributions. If you don't normally itemize, "bunching" several years' worth of donations into a single year may push you over the threshold for itemizing one year, allowing for larger tax savings than spreading out the donations across several years. This strategy may also be effective in potentially mitigating tax consequences from a higher-income year where you might bump into a higher bracket. One option that may help with both tax and legacy planning is a donor-advised fund (DAF), which allows you to take an immediate tax deduction, and then recommend grants to various charities over time.

Keep tabs on medical expenses. You can deduct medical expenses that exceed 7.5% of your adjusted gross income. If you might be on the threshold in a given year, consider accelerating any qualified expenses and paying medical bills before year-end. Qualified expenses include everything from out-of-pocket hospital fees to prescription drugs, insurance premiums, and much more.

3. Layer on tax-smart investing strategies

Taxes generally shouldn't be the driver of investing decisions, but once you have an asset mix that makes sense for your time horizon and risk tolerance, adding tax-smart techniques3 can help you keep more of your return—adding as much as 2% per year on average, according to one study.4 Fidelity has found that the average client with a Fidelity Portfolio Advisory Services account using tax-smart strategies could save $3,900 per year in taxes.5

Know the rules around capital gains. If you're selling assets to rebalance or raise cash, keep in mind that securities held for 12 months or less are generally taxed as short-term gains, at a rate as high as 40.8% (37%, plus 3.8% net investment income tax, or NIIT). State and local taxes may also apply. The federal rate on those held for more than 12 months, on the other hand, tops out at 20%, plus the 3.8% NIIT. In professionally managed accounts that use tax-smart investing techniques the managed solutions team looks to sell older lots in client portfolios, allowing them to take advantage of those lower long-term rates.

Harvest losses. If you have realized a net capital loss in a tax year, you can use up to $3,000 of losses to offset ordinary income ($1,500 if married filing separately). You can carry forward any remaining unused losses to future years. When markets fluctuate, this can increase the number of opportunities to benefit from this technique.

Consider tax-efficient investments. Different investments tend to generate different levels of tax impact. In general, passive (index) funds or ETFs tend to be more tax efficient than actively managed funds, as do mutual funds that explicitly call out tax efficiency as an objective. While many bonds and bond funds generate income that is taxed at the investor's ordinary rate, municipal bonds and muni bond funds are typically exempt from federal taxes. State-specific municipal bonds and muni bond funds may also be exempt from state taxes.

Look at location. A diversified portfolio can't be limited to tax-efficient investments. An asset location strategy seeks to, when possible, match assets that are less tax-efficient to tax-advantaged accounts, and vice versa.

Be mindful of mutual fund distributions. Mutual funds generally distribute earnings from interest, dividends, and capital gains every year. This can even cause you to pay taxes in down-market years. Regardless of how long you have held a fund, you're likely to incur a tax liability if you own it on the date of that distribution, so you may want to consider taking that date into account when making buying or selling decisions.

The bottom line

Mitigating the impact of taxes can be an important part of helping you stay on track to meet your long-term financial goals. It also demands an ongoing vigilance to stay abreast of new laws and developments. If you aren't already, you may want to consider working with a tax advisor or financial professional, who can help you figure out the best ways to incorporate tax-smart strategies into your holistic financial plan.

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1. With respect to federal taxation only. Contributions, investment earnings, and distributions may or may not be subject to state taxation. 2. Contributions, earnings, and distributions are tax-free for federal tax purposes when used to pay for qualified medical expenses. Each state may decide to follow the federal tax guidelines for HSAs or establish its own. As of the publication date of this article, only California and New Jersey tax eligible contributions to HSAs. These states regard HSAs as regular taxable brokerage accounts, so residents have to declare any capital gains, interest, and dividends they receive to the state. New Hampshire and Tennessee tax earnings but not contributions. The triple tax advantage applies to state taxes as well, in most states. 3. Tax-smart investing techniques, including tax-loss harvesting, are applied in managing certain taxable accounts on a limited basis, at the discretion of the portfolio manager, Strategic Advisers LLC (Strategic Advisers), primarily with respect to determining when assets in a client's account should be bought or sold. Assets contributed may be sold for a taxable gain or loss at any time. There are no guarantees as to the effectiveness of the tax-smart investing techniques applied in serving to reduce or minimize a client's overall tax liabilities, or as to the tax results that may be generated by a given transaction. 4. "Taxes Can Significantly Reduce Returns data,” Morningstar, Inc., 2022. This example reflects a 96-year period from 1926 to 2021 and is based on the following data: stocks at 10.5%, stocks after taxes at 8.5%; bonds at 5.5%, and bonds after taxes at 3.5%. Past performance is no guarantee of future results. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $120,000 in 2015 dollars every year. For additional details on the study, please see Endnote 3 in Tax-Smart Investing: Could Ben Franklin have been Wrong? (PDF). 5. Tax-loss harvesting is one of several tax-smart investing techniques we apply in managed portfolios. Tax savings will vary from client to client. In any given year it may offer significant benefits during volatile markets. Past performance is no guarantee of future results. Factors that could impact the value of our tax-smart investing techniques include market conditions, the tax characteristics of securities used to fund an account, client-imposed investment restrictions, client tax rate, asset allocation, investment approach, investment universe, the prevalence of SMA sleeves and any tax law changes. This analysis is based on the performance of all accounts in good order within investment strategies (offered through Fidelity® Wealth Services) within taxable account registrations from 1/1/2013 for the Total Return Blended strategy, and from1/28/2019 for Total Return Fidelity-Focused and Index-Focused strategies and the Defensive approach (when tax-smart investment management capabilities were introduced) through 12/31/2022. Accounts managed with household tax-smart strategies are not included in this analysis. The analysis includes calculating the average of each year’s average account’s capital gains tax savings over the past ten years. We estimate potential capital gains tax savings by multiplying each harvested tax loss by the applicable short-or long-term capital gains tax rate for each client account at the end of each year. The average account balance is $715,367, which is the average of each year’s average account balance over the past ten years. Our after-tax performance calculation methodology uses the full value of harvested tax losses without regard to any future taxes that would be owed on a subsequent sale of any new investment purchased following the harvesting of a tax loss. That assumption may not be appropriate in all client situations but is appropriate where(1) the new investment is donated (and not sold) by the client as part of a charitable gift, (2) the client passes away and leaves the investment to heirs, (3)the client’s long-term capital gains rate is0% when they start withdrawing assets and realizing gains, (4) harvested losses exceed the amount of gains for the life of the account, or (5) where the proceeds from the sale of the original investment sold to harvest the loss are not reinvested. Our analysis assumes that any losses realized are able to be offset against gains realized inside or outside of the client account during the year realized; however, all capital losses harvested in a single tax year may not result in a tax benefit for that year. Remaining unused capital losses may be carried forward to offset up to $3,000 of ordinary income per year. It is important to understand that the value of tax-loss harvesting for any particular client can only be determined by fully examining a client’s investment and tax decisions for the life the account and the client, which our methodology does not attempt to do. Clients and potential clients should speak with their tax advisors for more information about how our tax-loss harvesting approach could provide value under their specific circumstances.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

The information provided herein is general in nature. It is not intended, nor should it be construed, as legal or tax advice. Because the administration of an HSA is a taxpayer responsibility, you are strongly encouraged to consult your tax advisor before opening an HSA. You are also encouraged to review information available from the Internal Revenue Service (IRS) for taxpayers, which can be found on the IRS website at You can find IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans, and IRS Publication 502, Medical and Dental Expenses, online, or you can call the IRS to request a copy of each at 800-829-3676.

Portfolio Advisory Services accounts are discretionary investment management accounts offered through Fidelity® Wealth Services for a fee.

Fidelity® Wealth Services provides non-discretionary financial planning and discretionary investment management through one or more Portfolio Advisory Services accounts for a fee. Advisory services offered by Fidelity Personal and Workplace Advisors LLC (FPWA), a registered investment adviser. Discretionary portfolio management services provided by Strategic Advisers LLC (Strategic Advisers), a registered investment adviser. Brokerage services provided by Fidelity Brokerage Services LLC (FBS), and custodial and related services provided by National Financial Services LLC (NFS), each a member NYSE and SIPC. FPWA, Strategic Advisers, FBS, and NFS are Fidelity Investments companies.

The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities.

Investing involves risk, including risk of loss.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917