3 Smart Ways for Investors to Cut Their Taxes

Markets Motley Fool

High returns aren't the only factor to consider when choosing your investments. A tax-efficient portfolio can save enough on your tax bill to nicely compliment your investment returns. Take a look at your own portfolio to see if you've implemented the following tax-shrinking tips.

Continue Reading Below

1. Max out your tax-advantaged accounts

Investors have plenty of options for tucking away their money. If you do your investing in accounts with built-in tax advantages, such as HSAs, IRAs, and 401(k)s, you can save a bundle on your tax bill. Investments in these accounts don't generate taxes when you receive dividends from stocks or interest from bonds, and they also won't incur capital gains taxes if you sell an investment for a profit.

In addition, IRAs and 401(k)s give you a tax break either on the money you put into the account or the money you take out (depending on whether the account is a traditional tax-deferred account or a Roth account). HSAs actually give you a tax break on both contributions and distributions, making them the only triple tax-advantaged account.

These accounts are such a great deal that the IRS has put limits on how much you're allowed to contribute to them each year. So throw your investing dollars into these tax-advantaged accounts until you hit the annual maximum; then and only then should you focus on building up your standard brokerage accounts.

2. Consider tax-advantaged investments

Continue Reading Below

Certain investments have built-in tax savings. For example, treasury securities are exempt from state taxes (although you will still have to pay federal taxes on the interest). Municipal bonds take the tax advantage a step further: They are exempt from federal taxes and may also be exempt from state taxes, if the bond was issued by the state you live in. Clearly, if you're going to buy municipal bonds, look for ones from your state of residence to max out the tax savings.

A tax-advantaged investment is not always the best choice. The bonds that come with a tax break pay lower returns than bonds that don't, and depending on your situation, the tax break may or may not make up for the lower returns. For example, if you live in a state with high state taxes, tax-free municipal securities are likely to be a good deal – but if you live in a state with no state taxes, the federal tax savings alone likely won't be enough to turn municipal bonds into a good deal.

3. Don't overlap tax breaks

The big selling point of municipal bonds is their potentially high tax break – but if you put a municipal bond in an IRA, the tax advantage disappears. Why? Because you don't pay taxes on any bond interest that's deposited into an IRA, whether it's from a municipal bond or not. Thus, putting municipal bonds in a tax-advantaged account is a waste of money.

Similarly, real estate investment trusts (REITs), while a great investment, can expose you to high taxes because of the very high dividends these securities are required to generate. Tucking your REITs into a tax-advantaged account such as an IRA neatly erases this disadvantage, since the copious dividends that REITs produce will not be taxed as they come in.

Matching up investments and accounts correctly can protect you from the drawbacks of heavily taxed investments while allowing you to take full advantage of the tax breaks that other investments enjoy. And that can lead to a considerably more pleasant experience on April 15 every year.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.