Tax time is hard, especially when you find out that you owe more in taxes than you expected. But good tax planning doesn't just happen. It takes effort to put yourself in position to pay as little tax as you can, and the right time for tax planning is right now. By taking a look at some simple ways to cut your taxes, you'll be more likely to have a favorable experience with the IRS next time around.
1. Look closely at tax-exempt bonds for your fixed-income portfolio
Interest rates have been extremely low for a long time, and to add insult to injury, investors have to pay a portion of their interest income to the tax man on most bonds. With Treasury yields running in the 2% to 3% range, losing 10% to 39.6% of that already scanty income to tax is the last thing that many taxpayers can afford -- especially those who live off the income that their portfolios generate.
One oft-neglected area of the bond market, however, can help you avoid that tax bite. Tax-exempt municipal bonds pay interest that's free from federal income tax, and the tax break is generally available to taxpayers in all brackets.
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Ordinarily, you'd expect municipal bond rates to be far less than yields on taxable bonds, because the market should price in the tax advantages of muni bonds. However, that hasn't been the case lately. For instance, the most recent figures from the bond market put 10-year municipal bond yields at 2.46%, compared to 2.52% for Treasury bonds with the same maturity. With an after-tax yield of 2.27% for low-income taxpayers and just 1.52% for top-bracket taxpayers, Treasuries just don't stand up well against high-quality municipal bonds.
2. Be smart about selling your investments
One of the biggest benefits of long-term investing is that you remain in control of your tax destiny. Many investors don't realize that even in a taxable brokerage account, when you pay tax on the share-price appreciation of the stocks you own is up to you, because capital gains tax is only due on stocks when you sell them.
Most investors know about the benefit you can get by holding onto stocks for longer than a year, with maximum long-term capital gains rates offering reductions of 10 to 20 percentage points in tax compared to short-term capital gains. But fewer think consciously about the benefits from not selling stocks at all until you actually need the money. By choosing to hold off on an unnecessary stock sale on a long-term holding that you're comfortable hanging onto, you can avoid extra capital gains tax liability that can send your tax bill higher.
3. Be smart with retirement plan distributions
Many people make mistakes with their retirement plans, especially 401(k) plans at work. During your career, you can end up paying thousands of dollars of extra tax by cashing out your workplace retirement account when you switch jobs rather than either leaving it in place with your former employer or moving it to a new employer plan or personal IRA. The reason: Distributions you take from your retirement plan are generally subject to income tax, and you'll pay an extra 10% penalty to boot if you aren't old enough to avoid provisions imposing the penalty on early withdrawals.
Even once you retire, thinking about how you take money out of your retirement accounts is essential. If you have a mix of traditional and Roth-style retirement accounts, then balancing which accounts you take money from can give you a tax advantage over simply taking everything from your regular traditional IRA or 401(k) account, because traditional distributions are taxable while Roth distributions typically aren't. Manage your income needs well and you can avoid unpleasant tax surprises at a time in your life when you can least handle them.
Remember the big picture
Finally, keep in mind that smart tax planning is a long-term game. Minimizing tax in one year isn't always a good idea if it leads to higher taxes later on. By contrast, taking a big tax hit currently will sometimes pay off with big dividends well into the future.
If your tax bill is higher than you'd like, look to see what's causing you to pay so much tax. These three tips are a good starting point, and a closer examination can uncover other ideas you can incorporate into your tax planning for this year and beyond.
