No matter the time of year, taxes are an important topic for investors. There are quite a few investment strategies you can use to lower your tax bill, retain as much of your pretax profit as possible, and give your after-tax bottom line a money-in-the-bank boost.
Ways to save, this year and beyond
Tactic: Buy to hold. The IRS provides a strong incentive for doing what Fools do anyway: Invest for the long haul. Your income affects the rate you'll pay on realized capital gains (i.e., investment profits), but consider two identical investments of $10,000 by a pair of tax filers in the 28% tax bracket. Investor A gets an itchy trigger finger, sells after a heady six-month run-up of 40%, and pockets a pretax profit of $4,000. Investor B holds the position for more than a year and endures a bit more volatility but ultimately earns that same 40%.
A wash? Not at all. The IRS will ding impatient Investor A at a marginal rate of 28%, to the tune of $1,120. Investor B, however, gets the current favorable long-term rate of 15% and is liable for just $600 -- saving almost half the amount.
The moral of the story? At least for this portion of the tax code, the IRS has your back. It rewards investors with a long-term ownership orientation and discourages short-term speculation. Of course, if you find a compelling reason to sell a stock, make every effort to sell shares you've held for more than a year. Doing so can boost your bottom line.
Tactic: Profit from your losses. Selling for tax reasons isn't generally a smart move, but if you have some holdings that meet our sell criteria -- fundamental change, opportunity costs, juicy relative valuations -- you can make the most of them by realizing a loss and using it to offset comparable capital gains. This strategy is known as tax-loss harvesting.
Tactic: Use the right bucket. Some investments, such as low-turnover mutual funds and low- or no-yield growth stocks, are inherently more tax-efficient than, say, bonds or high-churn funds, which can cause your tax tab to climb as a result of income payouts and realized capital gains. The solution? Use your taxable accounts for the IRS-averse investments we mentioned before.
Tactic: Make the most of your 401(k). Your 401(k) is a terrific vehicle for retirement savings because, in addition to socking away your hard-earned moola, you'll reduce your taxable income by the amount you kick in. Your employer may cough up a matching contribution, which makes a good deal that much better. But even if your employer offers a lousy plan, you can still whip it into fighting shape.
Tactic: Consider an annuity. Annuities aren't for everyone, but if they're right for you, the amount you plunk down can grow on a tax-deferred basis.
Ways to save before the filing deadline
OK, those are useful tips for next year's tax-filing deadline, but what about taxes from last year? Relax! If the filing deadline hasn't passed yet, you still have a few strategies available to cut down on the tax bill you'll owe.
Action Item: If you're self-employed and need more time to save, consider filing an extension. We're not encouraging you to procrastinate come tax time. We think it's best to get the pain out of the way, particularly since, even if you do file an extension, you'll need to estimate and pay the amount you expect to owe by the regular April filing deadline.
Still, for self-employed folks, filing an extension provides additional time to contribute to a solo 401(k), the best vehicle for serious self-employed savers. Depending on your income, you could be eligible to deduct a big part of your taxable income -- up to $46,000 in 2008. So if you need more to time to scratch up the dough, take it. The more you plunk down, the more miraculous the miracle of compound interest will be.
Action Item: Open a traditional IRA. Want to reduce your taxable income this year? Consider a traditional IRA. If you file solo and don't participate in a company-sponsored retirement plan, such as a 401(k), your contribution, which is due by the regular April filing deadline, is fully deductible, no matter how much you make. Deductibility for joint filers depends on the company plan status for both you and your spouse, but if neither of you participates, you can reduce your taxable income by the combined amount of your contribution.
Action Item: Open a Roth IRA. You won't be able to deduct the amount you kick in to a Roth, but when it comes time to tap the account, you won't pay a penny in taxes on qualified withdrawals. What's more, unlike with a traditional IRA, you can withdraw contributions (but not your earnings) at any time without penalty. The bottom line? If you haven't been contributing to an IRA for fear that you might need the cash in case of emergency, that excuse -- um, that concern -- evaporates on contact with a Roth. Sorry.
Learn more about how to reduce your tax bill at The Motley Fool's tax center.
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This article is adapted from an article included in The Motley Fool's tax center collection. It has been updated by Dan Caplinger. The Fool has a disclosure policy.