Nothing in life is certain except death and taxes, right? Nobody is immortal, but we might have some good news when it comes to taxes. If you have earned money from investments, you can’t legally avoid paying taxes altogether, but you can make smart investment decisions that let you keep a lot more of your money than you would otherwise.
How Investment Income is Taxed
The money you make from investments is treated differently by the IRS than the money you earn from working wages. Investment income is taxed in two different ways.
Capital gains are the proceeds made from selling an appreciated asset, such as stocks, real estate, cryptocurrency, or a business. Capital gains are not taxed until you actually sell an asset and realize the profits. They are taxed at a special capital gains tax rate.
Dividends are paid out regularly, and they are taxed in the year that you receive them. Any investment income you receive from dividends, royalties, or interest are added to your ordinary income and the IRS taxes them at the applicable income tax rate.
Minimizing Taxes and Maximizing Returns
When it comes to investments, the less you pay in taxes, or the longer you are able to defer your taxes, the more money you can continue to make. For example, if you have $1 million invested in stocks that are averaging an 8% return, those stocks will appreciate $80,000 a year. If you were to sell your stock and realize your gains, you would owe around $200,000 in federal capital gains taxes. Additionally, depending on the state, you could face state capital gains taxes ranging from 0% to 13.3%, potentially adding up to another $133,300 to your tax liability. Once you pay those taxes, you can reinvest the $666,700, but at 8%, you’ll only be making $53,336 a year in returns.
In contrast, if you can delay paying capital gains taxes, either by waiting to realize your investment gains or by using another tax deferral strategy. This approach would allow you to continue to make money off the full $1 million, maximizing your investment returns.
Here are seven strategies to help you minimize or delay your taxes, so you can get the most from your investments.
1. Hold Onto Your Investments
Since capital gains are not taxed until realized, the most effective way to avoid paying capital gains taxes in the short term is to hold onto your investments. This is called buy-and-hold investing and it has multiple benefits.
First, as long as you hang onto your assets, you won’t owe capital gains taxes, and they can continue to make money as they appreciate.
Second, assets held for more than a year are taxed at a significantly lower rate than short-term investments–those held for less than a year. Long-term capital gains are taxed at 0%, 15%, or 20% depending on your income bracket. Short-term capital gains (the profits made on assets held for less than a year) are taxed at normal income tax rates, which can be as high as 37% for those in the top tax bracket.
Third, your investments will most likely perform better if you hang onto them. Research has shown that passively managed funds consistently outperform actively managed funds where assets are regularly bought, sold, and traded.
2. Utilize an IRA or a 401K
IRAs and 401Ks are tax-advantaged ways for you to invest for retirement. A traditional IRA and a traditional 401K allow you to save money in the current year, by investing your money or a portion of your wages pre-tax. When you reach retirement age and take distributions from the account, you’ll have to pay taxes, but the IRA or 401K allows you to delay taxes on your investment for decades.
With a Roth IRA or a Roth 401K, you invest money after taxes, which doesn’t give you any tax advantages in the current year. However, you can then grow your investment tax-free, and you won’t have to pay any taxes when you retire and begin taking distributions. In this way, you avoid paying taxes on the appreciation of your assets.
Both IRAs and 401Ks have contribution limits. In 2024, the combined contribution limit for traditional and Roth IRAs is $7,000. The contribution limit for 401Ks is $23,000. So, while these are both excellent ways to minimize taxes on your investments, there are significant limitations.
3. Use Tax-Efficient Accounts
Along with IRAs and 401Ks, putting more of your investments into dedicated, tax-efficient accounts can reduce your overall tax burden. While contributions are not deductible, the money you put into a 529 educational savings account can grow tax-free and you don’t have to pay taxes on the distributions as long as they are used for qualified educational purposes.
A HSA or Health Savings Account has triple benefits. If you have a high-deductible health insurance plan, the contributions you make to an HSA are tax-deductible, your assets can grow tax-free, and you don’t have to pay taxes on any withdrawals as long as they are used for medical expenses.
4. Harvest Your Losses
The IRS allows you to write off up to $3,000 of capital losses each year to offset any capital gains. In any given year you might have some stocks or assets that are doing well and others that are underperforming. If you sell an asset for less than you bought it for, that is called a capital loss.
If you are realizing a significant capital gain, you can sell an underperforming asset in the same year and use that capital loss to offset some of your capital gain and reduce your tax liability. This is called tax-loss harvesting and it is frequently used by investors to minimize their tax burden.
5. Donate to Charity
Philanthropic contributions have a double benefit. Not only do you get to feel good about helping others, but you can deduct a portion of your charitable giving from your taxable income. Even better, when you donate highly appreciated assets you avoid the capital gains taxes you would have had to pay if you sold them, and you get the income tax deduction from your charitable contribution.
6. Use a 1031 Exchange
A 1031 exchange is a way to sell and reinvest real estate profits while deferring capital gains taxes. If the property you are selling is not your primary residence or a vacation home, and you are wanting to reinvest in another investment property, a 1031 exchange can be a great tax deferral option.
The rules for a 1031 exchange are complex and must be followed exactly or you will lose the tax benefits, so it is best to work with a tax professional. When using a 1031 exchange you must identify a like-kind replacement property within 45 days and purchase within 180 days.
7. Set up a Deferred Sales Trust
Deferred Sales Trusts are another type of tax-deferred trust and work slightly differently by utilizing what the IRS refers to as an installment sale in the tax code.
With a Deferred Sales Trust, instead of selling your appreciated asset directly to a buyer, you transfer your asset to the independent, third-party trust in exchange for a promissory note. The trust then sells the asset to a buyer and takes receipt of the proceeds. Because you haven’t received any profits, you don’t owe any capital gains taxes. The trust can then reinvest the proceeds on your behalf and will distribute payments to you in regular installments. You only owe taxes on the proceeds you receive each year. Installments can be structured as interest-only payments, keeping the capital gains tax 100% deferred. In this case, only ordinary income tax would be owed on the payments received.
Using a Deferred Sales Trust gives you more flexibility than a 1031 exchange, as you can reinvest in a variety of investment vehicles, not just real estate. It allows you to delay capital gains taxes and spread payments out over time. By hanging onto your profits longer, you can maximize the return on your investments. Like a 1031 exchange, a Deferred Sales Trust requires the assistance of qualified capital gains tax consultant and tax attorney to ensure that the trust is set up and executed according to IRS regulations.
Bonus information: Irrevocable trusts, if properly structured, can be an excellent way to remove assets from your personal estate and thus avoid estate or gift taxes. There are two types of Deferred Sales trusts. One is irrevocable and one is a business trust. The irrevocable deferred sales trust (AKA DST Plus/DST2.0) removes assets from your taxable estate. The Deferred Sales Trust 1.0 is inside of your taxable estate.
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If you’ve earned money from investments, you can’t completely avoid taxes, but smart choices can help you keep more of your earnings. This infographic highlights seven strategies to minimize or delay taxes and maximize investment returns.
