3 Ways You Can Beat Higher Taxes

When you're trying to save enough to retire rich, taxes are your enemy. Yet as the saying goes, sometimes it makes sense to keep your enemies close to you.

Given unprecedented budget deficits and the possibility of new, costly government programs on the horizon, pretty much everyone now expects income tax rates to go up in the future. In order to beat higher taxes before they get you, you may actually need to consider something you would normally never even think about: paying taxes sooner rather than later.

When deferral doesn't work
Ordinarily, it's smart to put off paying taxes as long as possible. After all, every dollar you pay in taxes is a dollar that you can't invest. Paying taxes earlier than you have to costs you not only that dollar, but also all the income and capital gains that it would have generated for you. Conversely, by deferring tax, you're the one who earns a return on that money, not the IRS.

The situation changes, though, when you know that tax rates are going to increase in the near future. Obviously, there's a powerful incentive to pay $1 in tax today if by doing so, you avoid having to pay $2 in tax tomorrow.

That's why you should take a close look at three different strategies designed to make the most of today's lower tax rates while they last.

1. Take your gains.
One of the best things about investing in stocks is that you don't have to pay tax on your capital gains until you sell. If you're a buy-and-hold investor, therefore, you have complete control over your tax liability. With today's 15% maximum capital gains rate in danger of rising to 20% or more, it might be better for you to sell now and pay tax at a lower rate than to hold on and have to pay more in taxes later.

For instance, say you have a big gain on a stock you've held for a long time. You anticipate you'll need to sell 1,000 shares within the next few years to cover your living expenses. Take a look at how much you might save by selling now versus waiting until a higher tax takes effect:

Source: Yahoo! Finance. Assumes dividends held in non-taxable account.

If you're concerned that you don't want to miss out on potential gains between now and when you need the money, you can buy back your shares immediately after you sell them. Although that strategy doesn't work with tax losses, there's no wash-sale rule on gains.

2. Use Roth IRAs rather than traditional ones.
Many people prefer traditional IRAs over Roth IRAs because traditional IRAs give you a current tax deduction. The tradeoff, though, is that with a traditional IRA, you have to pay taxes when you withdraw money from your account in retirement.

Higher taxes in the future may be enough to shift the balance in favor of a Roth. By giving up your deduction, you'll pay more tax now -- but in exchange, you'll avoid getting taxed at a higher rate later. That's especially useful if you plan to retire in the near future.

3. Shift dividend stocks to tax-favored accounts.
Until 2003, dividend income was taxed at the same higher rate as most other income, including your salary. But a tax law change gave dividends the same 15% tax rate that applies to capital gains. That made it cheaper to hold high-dividend stocks like BP (NYSE:BP) and AT&T (NYSE:T) in a taxable account.

A prospective tax increase could well remove or at least increase that preferential rate on dividends. In that case, adjusting your portfolio to put your dividend-paying stocks into an IRA rather than your taxable account could save you from immediately having to fork over up to 35% or more of those payouts to the IRS.

You'll have time
You don't have to worry about making these moves right now. In the past, most tax law changes have been applied prospectively, meaning that you'll have fair warning to plan accordingly for whatever changes occur. Yet by preparing for the future now, you can avoid having to rush when the time comes. The thousands you could save on your taxes makes it well worth the trouble.