Investing is full of uncertainty and unknowables, especially in the short-term. Because of this, it's critically important that investors take the time to understand the things they can control and affect, and make the best decisions possible around those things. Unfortunately, too many investors don't consider taxes when they make their investing decisions, giving back part of their profits to the government unnecessarily.
And while it may not seem like much, a few percent here and there can quickly turn into thousands and thousands of dollars over an investing career -- money that you don't have to give the government, and you'll never, ever get back.
With that in mind, here's a closer look at 3 top tax breaks every investor should remember. If you're not using these tax breaks, you're probably paying more in tax than you have to.
Investing for retirement? The right account can mean a big tax break
The most common thing people invest for is retirement, and there are multiple kinds of retirement accounts that are specifically designed to help investors keep more of the money they set aside for retirement.
The most common is the 401(k), a retirement plan that's sponsored by your employer, and lets you contribute as much as $18,000 ($24,000 if you're 50 or over) of your salary each year toward your retirement. The tax benefits of a 401(k) are two-fold: First, you are allowed to deduct contributions you make each year from your taxable income, lowering your taxes this year. Second, that money grows completely tax-free, until you take distributions in retirement, where any gains you take in distribution are treated as regular income.
If your employer doesn't offer a 401(k) or other retirement plan, you can contribute to a traditional IRA instead, and get the same tax benefits. The difference is that you can only contribute $5,500 ($6,500 if you're 50 or over) each year.
In addition to the 401(k) and traditional IRA, there's also the Roth IRA. The contribution limits are the same as a traditional IRA, and your contributions grow tax-free inside the account, but there's a difference in how contributions and distributions are taxed from the other two kinds of retirement accounts. With a Roth, you cannot deduct yearly contributions from your income. However, your distributions in retirement are completely tax-free. In other words, you're trading the tax break today, for a tax break in retirement.
Acting long-term will cut your taxes, too
Sometimes investing in a taxable account makes sense, such as when you're saving for something other than retirement. However, just because you're investing in a taxable account doesn't mean you can't take steps to reduce how much tax you have to pay. It starts with understanding about long-term and short-term realized gains.
Long-term capital gains are taxed at 15% for most Americans (20% for the highest-earners), while short-term gains are taxed at your marginal income tax rate. For most people the long-term rate would be far lower than their marginal income tax rate, behooving most investors to think long-term.
So what's a long-term gain? If you sell stock that you've held for more than one year at a profit, that would qualify as a long-term gain. Anything shorter than one year would be considered a short-term gain. In other words, by focusing on companies that you can buy and hold for the long-term, you should be able to reduce how much tax you pay, if and when you sell for a profit.
Getting a benefit from those painful losses
Every investor makes the occasional mistake and picks a loser sometimes.
If you're forced to sell a stock at a loss in your taxable account, you can get a tax benefit from those losses. The first thing you can do with them is use them to offset any taxable gains from that year, applying long-term losses against long-term gains and short-term losses against short-term gains, then using any remaining losses to offset any remaining gains. If you have losses remaining above and beyond any gains, you can apply as much as $3,000 in capital losses against your regular income tax owed.
However, don't start selling stocks that are down just to get the tax benefit. Remember your long-term goals, and consider why you made the investment to begin with. If the thesis is sound, selling just because the stock price has fallen is like selling your house just because home prices are down.
Tax-loss harvesting can be a helpful tool, but it shouldn't drive your investing strategy.