Today, millions of Americans will celebrate the end of tax season by finally getting their tax returns finished and filed with the IRS. Many of those taxpayers have discovered in the process of preparing their returns that they pay considerable amounts of tax on their investments, especially given the strong performance the stock market has given them over the past several years.
Obviously, there's nothing you can do after April 15 to affect what you've paid in taxes on your 2014 return, but by considering a few tax-planning strategies sooner rather than later, you can set the stage for a better showing when tax time rolls around in 2016. With that goal in mind, here are three ways to reduce your taxes over the coming year.
1. Boost your retirement contributions
The simplest way to cut your taxable income is to increase the amount you contribute to a 401(k) or a traditional IRA. The money you contribute to a 401(k) simply never shows up on your W-2 form at the end of the year, while IRAs allow many taxpayers to deduct contributions directly on their tax returns. Given the contribution limit of $18,000 for 401(k)s plus another $5,500 for IRAs, most people aren't in any danger of maxing out their tax-advantaged retirement savings -- least of all those aged 50 or older, who can contribute an extra $6,000 to a 401(k) and an extra $1,000 to an IRA.
Not only do retirement contributions cut your current tax bill, but they also defer taxes on your portfolio gains until you retire. Over time, as your retirement account balances get bigger, the tax savings from that deferral really add up, which means these retirement accounts are also long-term investments in a lower tax bill.
2. Be smarter about the tax consequences of your investments
Often, investors simply ignore the tax ramifications of the investments they choose. Yet you can often get better returns by choosing the investment with the better tax considerations.
Source: 401kcalculator.org via Flickr.
For instance, many investors have complained about the low interest rates most bond investments have offered in recent years. Yet right now, you can actually get higher interest rates on state and local municipal bonds than you can on Treasuries of the same maturity, and the added benefit of muni bonds is that they're generally tax-free at the federal level, as well as in the state that issued them. When you consider net after-tax returns, muni bonds can come out way on top right now, but many investors never even consider them.
Similarly, many of those who own mutual funds saw them pay large capital-gains distributions at the end of 2014, leading to a higher tax bill. Yet those who owned similar exchange-traded funds have largely avoided those tax consequences, as the structure of ETFs makes them less likely to have to make big year-end capital-gains payouts. Replacing a mutual fund with an ETF going forward can bring tax savings.
3. Don't wait for year-end to use valuable tax breaks
Because many people never think about taxes until April rolls around, it's easy to forget about the things you have to do by Dec. 31 in order to get valuable tax breaks. Things like charitable deductions and tax-loss investment sales have to happen by year-end, or else you lose the opportunity to do them for the year.
Making those moves early might seem unnecessary, but it helps you ensure they happen. Especially if you've found yourself scurrying at the last moment to get things done for your taxes this year, consider getting a jump on your 2015 tax planning by weeding out losers from your investment portfolio or making charitable gifts now instead of waiting for fall fundraisers.
Tax planning isn't necessarily fun, especially when you've just reached the finish line with your 2014 tax return. Nevertheless, if you want to pay as little in tax as possible, taking steps now could well lead to a less painful return for 2015.
