If you're in a higher income bracket, taxes can take a big bite out of your investment income. Fortunately, there are several strategies you can use to reduce your federal and state tax burden. Here are seven of the best ways to minimize your tax bill, and possibly even reduce your other taxable income.
1. Max out your retirement savings
Perhaps the most obvious, and most effective, investment strategy to reduce taxable income is to maximize your tax-advantaged retirement savings.
For 2017, you can save $5,500 in a traditional or Roth IRA if you qualify, and if you have a 401(k) or similar retirement plan at work, you can choose to defer up to $18,000 of your compensation into the plan. If you're 50 or older, you're allowed to make an additional catch-up contribution of $1,000 to an IRA and $6,000 to a 401(k).
If you earn self-employment income, there could be even more options available to you. A SIMPLE IRA, SEP-IRA, or individual 401(k) can allow you to set aside a large portion of your income and defer paying taxes on it. For example, if your self-employment income is high enough, a SEP-IRA or individual 401(k) can allow you to save $54,000 (or $60,000 if you're 50 or over) toward retirement.
2. Contribute to a health savings account, if you qualify
A health savings account, or HSA, is designed to help Americans with high-deductible health plans save for medical expenses. To enroll, you must be enrolled in a health plan that meets the 2017 definition of "high deductible," which is $1,300 for an individual plan or $2,600 for a family. You also cannot be enrolled in Medicare and can't be claimed as a dependent on someone else's tax return.
Contributions to an HSA are tax-deductible and are invested on a tax-deferred basis. If you withdraw the funds to pay qualified medical expenses, your withdrawals will be tax-free as well, no matter how much your investments have grown.
If you qualify, you can contribute up to $3,400 in 2017 to an HSA for yourself, or up to $6,750 for a family health plan.
3. Keep the right investments in the right accounts
If you have a combination of tax-advantaged retirement accounts and standard taxable brokerage accounts, it's a smart idea to make sure you're holding the right kind of investments in the right accounts.
Specifically, your highest-dividend investments, such as REITs, should be held in tax-advantaged accounts if possible to maximize their long-term compounding potential and avoid taxes on the dividends you'll receive. On the other hand, there's less of an advantage to holding stocks that don't pay dividends in tax-advantaged accounts, especially if you plan to hold them for the long run. Think carefully about which accounts you invest through and be sure to take full advantage of the tax benefits offered by your IRA or other retirement accounts.
4. Donate stock to charity
Instead of giving cash to your favorite charitable organizations, consider donating appreciated stock investments instead. Not only can you deduct the full market value of the stock on your tax return as a charitable contribution, but you'll also avoid paying capital-gains tax on the stock, no matter how much it has appreciated in value since you bought it.
5. Move to a state with no capital-gains tax
If you get a significant portion of your income from your investments, the state you live in can make a big difference when it comes to capital-gains taxes.
Some states can be rather expensive. California, for example, has a top combined capital-gains tax rate of 37.1%.
At the other end of the spectrum, seven states have no capital gains tax whatsoever. As of the 2017 tax year, these are Alaska, Florida, South Dakota, Tennessee, Texas, Washington, and Wyoming. Paying the top federal long-term capital-gains rate of 23.8% may sound painful, but it's certainly preferable to paying in excess of 30% if you live in a high-tax state.
6. Sell losing investments before the end of the year
You probably know that if you hold an investment in a standard (taxable) brokerage account, you'll have to pay capital-gains tax if you sell it for a profit.
On the other hand, you can sell losing investments and use your losses to offset any capital-gains taxes you owe on your winners. Any excess losses can offset other capital gains, and if you have more overall losses than gains, you can use up to $3,000 to reduce your taxable income. Beyond that, any excess losses can be carried forward to future tax years.
7. Use a 1031 exchange with investment properties
When you sell a primary residence, you can exclude $250,000 in profit (or $500,000 if you're married) from your taxable income. That's not the case when it comes to investment properties.
However, you can avoid paying taxes on the sale of an investment property by taking advantage of a 1031 exchange. Essentially, this says that as long as you use the proceeds from the sale of your investment property to purchase an asset of similar nature within the next 180 days, you can simply roll the proceeds over and delay paying taxes on the sale.