By Dr. James M. Dahle, WCI Founder
There are a number of ways to reduce your investment-related taxes. In fact, it is possible to completely eliminate taxes on your investments. However, prior to doing so, consider what your real goal is. Is it to reduce your tax bill or to maximize your after-tax returns? As you give it more thought, you’ll realize that your goal is to maximize the after-tax returns, and sometimes that involves paying more in taxes than you would pay using other investing techniques.
This article will discuss six ways savvy investors can reduce their tax bill while boosting their after-tax investment returns.
#1 Investing in Retirement Accounts
There is no doubt that the single best way to decrease your investment-related taxes is to invest in tax-protected accounts, such as 401(k)s and Roth IRAs. Too few physicians have gone to the trouble of actually reading the plan documents for their employer-provided retirement plans or, if self-employed, opening an appropriate retirement plan. They also may not be aware that despite their high income, they can still contribute to a personal and spousal Roth IRA—they simply have to do it “through the backdoor.” [As of early January 2022, it's still unclear if the Backdoor Roth IRA will survive a congressional bill that would wipe it out, but you should continue to utilize it for as long as the law allows.]
Health savings accounts (HSA) may be the best investment account you have since it's potentially a triple tax-advantaged account. If you have more than one unrelated employer—for example, if you’re an emergency physician doing locums on the side—you may also have more than one 401(k).
Investing in retirement accounts has multiple tax-related benefits. With a tax-deferred account, you get an upfront tax break and often an “arbitrage” between your current high tax bracket and a future lower tax bracket. Very few physicians are saving enough money to be in the same tax bracket in retirement as in their peak earning years. With a tax-free (or Roth) account, all future gains are tax-free. Dividends and capital gains distributions also benefit from tax-deferred or even tax-free treatment, depending on the type of account.
#2 Using Municipal Bonds and Bond Funds
A typical physician who wishes to invest in bonds in a taxable account should choose municipal bonds, typically using a bond mutual fund to minimize hassle and maximize diversification. Municipal bond yields are federal, and sometimes state, income tax-free. Although municipal bond yields are typically lower than treasury or corporate bond yields, on an after-tax basis, municipal bond yields are often higher for those in the upper tax brackets.
#3 Buying and Holding Tax-Efficient Investments
Another important way to reduce the taxman’s take on your investment returns in a nonqualified (i.e., taxable) account is to invest in a tax-efficient manner. That means choosing investments such as low-cost, low-turnover stock index mutual funds, where taxable distributions are minimized and those that you do get receive favored tax treatment at the lower-dividend and long-term capital gains tax rates. For example, if you wanted to invest in two mutual funds with similar expected returns but had to put one in your taxable account, look up their tax efficiency on a website such as Morningstar.com and put the most tax-efficient one in the taxable account. Holding on to your investments for decades rather than frenetically churning them also reduces the tax bill. That might be a little more of a mental struggle, though, if the beating that the stock market has taken in early 2022 continues for too long. But as usual, stay the course.
#4 Tax-Loss Harvesting
The natural inclination of many investors who own a losing investment is to hold the investment until they get back to even before selling it. However, this is completely wrong. There is rarely any reason to hold on to a losing investment in a taxable account, even if you believe it will come back in value in the near future. It is best to exchange that investment for one that is very similar but, in the words of the IRS, “not substantially identical.” This locks in that tax loss while still allowing you to enjoy the future gains of the investment. Professionals call this “tax-loss harvesting.” You can use those losses to offset future investment gains, and you can deduct up to $3,000 per year against your earned income. If you have more than $3,000 in losses in any given year, they can be carried forward to the next year. These losses can be so useful that investment advisors, tax preparers, and financial gurus around the world recommend that you book them any time you can.
#5 Taking Advantage of Depreciation
Savvy real estate investors know they can lower their tax bill thanks to depreciation, one of my favorite tax breaks that has gotten even better. The IRS allows a typical residential investment property to be depreciated over 27.5 years, which means that an amount equal to 3.6% of a property’s initial value can be taken as a depreciation deduction each year, directly reducing the amount of rental income on which taxes must be paid in that year. Although depreciation must be recaptured when you sell, it is recaptured at 25%, which is a rate that is typically lower than a physician’s marginal income tax rate. Even better, if you exchange that property for another (instead of simply selling it) through a 1031 exchange, that depreciation does not have to be recaptured.
#6 Donating Appreciated Shares and the Step-Up in Basis at Death
If you do have investments—whether mutual funds, individual securities, or investment property—that you have owned for many years and that have appreciated a great deal, you can avoid paying the capital gains taxes on the investments in two ways. The first is to use them instead of cash to make charitable donations. When you give them to charity, you get to deduct the full value of the donation on your taxes but do not have to pay the capital gains taxes due. The charity also does not have to pay capital gains taxes. So it is a win-win for everyone but the IRS.
The second way is to die. When you die, your heirs receive a “step-up in basis,” meaning that the IRS considers the value at which your heirs purchased the investments to be the value on the date of your death rather than the value when you purchased them decades earlier. This can save them so much in taxes that it is generally far better to sell investments with a higher basis (or even borrow against them) and hold on to low-basis investments until death.
Ben Franklin said, “In this world, nothing can be said to be certain except death and taxes.” Physicians might not be able to prevent their own deaths, but they can certainly minimize the effects of taxes on their investments through wise investment planning and management—either on their own or in conjunction with a competent, fairly priced advisor (speaking of which, you can find some of those right here).
What have you done to reduce taxes on your investments? Have you used the above mentions, or have you tried other strategies? Comment below!
[A version of this article was originally published at ACEPNow.com.]