Investing is a fascinating topic, ripe with disagreement about the best way to make money in the stock market. Growth versus dividend stocks is a timeless debate, and niche crowds support every trading and investing strategy under the sun.
But for U.S. investors and those in most countries, taxes are a silent assassin of investment returns, often slipping unnoticed, sapping your returns with a tax bill every spring.
Taxes are a part of life, so while it's hard to avoid tax obligations altogether, you can craft your investment strategy to minimize the impact they have on you. Here's how to do that.
T is for taxes -- and trading
Many investors are happy to sell a position to lock in profit, and as they say: "nobody ever went broke taking a profit." But most overlook the capital gains tax implications of doing so. If you sell a stock held for less than one year, the profits get taxed as ordinary income.
These profits could bump you into a higher income bracket, as high as 37% in the United States. If you hold the stock for longer than a year, they are subject instead to "long-term capital gains tax," which tops out at 20%. In other words, short-term traders often rack up larger tax bills than buy-and-hold investors.
It's also important to remember that it goes back to risk when you profit and reinvest that money, subject to losses. Imagine you sold many stocks for a profit in late 2021 and then reinvested that money a few months later in early 2022. Because of the bear market in growth and technology stocks, there's a good chance you're underwater on those new investments. However, your tax bill on those prior gains will arrive just the same, forcing you to pay it out of pocket or sell at a loss to raise money.
The best way to avoid all these potential headaches? Adopt a long-term investment strategy, and resist constant buying and selling.
Use the proper investment accounts
You have tools available to help you minimize your tax obligations when investing. There are numerous tax-advantaged accounts designed to encourage long-term investing. For example, many employers in America offer 401K plans. You can contribute pre-tax income to these plans, lowering your taxable income for that year, and some employers will even match your contributions to a certain amount -- free money!
Some may also qualify for a Roth IRA, a retirement account that lets you invest funds and withdraw the gains tax-free later on, as long as you meet the requirements. These are simple tools that virtually anyone can access, and some planning around them can make a massive difference in the amount of taxes you pay throughout life.
Cut your tax bill
I don't think anyone enjoys a large tax bill, especially when it catches you off-guard come tax season. Don't let capital gains tax sneak up on you, putting you between a rock and a hard place. A long-term investing strategy and planning around which investment accounts you use can go a long way in making your future as prosperous as possible.