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.
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.