They say two things are certain in life: death and taxes. While you can’t control when you’ll die, you can limit how much you owe Uncle Sam. The April 15 tax deadline might seem far away, but tax experts say now is the time to get your investments in order to limit your tax liability.
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“It’s certainly not too late to use the tax code to help improve your overall investment outcome,” says John Sweeney, executive vice president at Fidelity Investments. “The biggest opportunity for investors of all ages is to contribute the maximum to whatever tax-deferred accounts they have to reduce their taxable income.”
From maximizing your retirement savings to unloading underperforming stocks to offset gains, here’s a look at three end-of-the-year tax strategies investors should be thinking about.
Tax Strategy 1: Contribute the Maximum in Your 401(k)
Employees of all ages should strive to take full advantage of company matching programs when it comes to 401(k) contributions. For instance, if your company will match up to 5% of 401(k) contributions, budget to at least contribute that amount.
“Your employer may not have done the best job communicating details about benefits such as matching 401(k) contributions, or you may not have taken the time to learn them. But now’s the time; this is free money,” says Rao Garuda, president and CEO of financial planning company Associated Concepts Agency. “If your employer is offering a 50% match on your first 6% of contributions to the 401(k), you should be contributing at least 6%. Educate yourself on your company’s plan so you can take full advantage.”
Tax Strategy No. 2: Convert to a Roth IRA
A traditional IRA is a tax-deferred investment tool that lets you grow money tax free. But when the time comes to withdraw funds from the account, you’ll be hit with taxes, possibly at a higher tax rate than today’s rate. One way to avoid taxes from withdrawals is to convert the traditional IRA into a Roth IRA.
With a Roth IRA, you pay the taxes when you deposit the money at the current rate, and won’t face any taxes when you withdraw the money down the road. After all, who knows where tax rates will be in the future.
“Roth IRAs are a tax-diversification strategy that allows you to pay current year taxes and put those assets in a ‘post-tax status,” says Sweeney. He adds that a Roth IRA can often be advantageous for younger investors, who have a longer time before retirement, and could face significantly higher tax rates.
Tax Strategy No. 3: Engage in Tax Loss Harvesting
The stock market has had a strong year, good news for investors’ bank accounts but not so good when it comes time to pay capital gains taxes on that upside. One way to reduce the amount you’ll have to pay the IRS is to engage in tax loss harvesting whereby you offset gains by selling off some of the stocks you lost money on during the year.
“If you pair some of the gains with the losses in your portfolio, you can neutralize your tax bill,” says Sweeney, noting the loss doesn’t have to be a stock but can also be a real estate investment.
Keep in mind that the IRS looks at investments either as short term or long term holdings. Anything held for less than one year is considered a short-term investment and is treated as ordinary income and will be included as income in your tax rate.
Any stocks held for more than one year is considered a long-term investment and taxed at a different rate, says Sweeney. “Make sure the securities are held for a long enough period so that they are considered long term and taxed at that lower rate.”
While there’s still time to do some tax loss harvesting, Sweeney says in an ideal world the investors will be doing it all year long. “It’s not a fourth quarter sport. Dips in the market may come in the first, second and third quarters as well.”