You didn’t see it on your calendar, but Tax Freedom Day fell on April 21 this year. So, why not mark the occasion by beginning to look for ways to become a “tax-smart” investor?
Tax Freedom Day, calculated annually by the Tax Foundation, is the day on which Americans have earned enough money to pay this year’s federal, state and local taxes. Of course, Tax Freedom Day is something of a fiction, because most people pay their taxes throughout the year, via their paychecks. Furthermore, as famed Supreme Court Justice Oliver Wendell Holmes, Jr., said: “Taxes are what we pay for civilized society.” When you pay taxes, you help fund public education, the police, the fire department, food inspection, college scholarships and many other elements of society. Nonetheless, you may want to use the concept of Tax Freedom Day to find ways to reduce the taxes associated with your investments.
Here are some suggestions:
Boost your 401(k) contributions. Your 401(k) contributions are typically made with pre-tax dollars, so the more you put in, the lower your taxable income. (Some employers allow a “Roth” option, under which you can make post-tax contributions.) In 2014, you can put in up to $17,500 to a 401(k) or similar plan, such as a 403(b) or 457(b), and if you are 50 or older, you can contribute an additional $5,500.
Fully fund your IRA. No matter which type of IRA you have — traditional or Roth — you will gain some valuable tax benefits. With a Roth IRA, your contributions are not deductible, but your earnings can grow tax free, provided you don’t start taking withdrawals until you are 59-1/2 and you’ve had your IRA for at least five years. If you own a traditional IRA, your earnings can grow tax-deferred, and your contributions may be deductible, depending on your income level. So, similar to a 401(k), the more you put in to your traditional IRA, the lower your taxable income may be. In 2014, you can contribute up to $5,500 to an IRA, or $6,500 if you are 50 or older.
Contribute to a college savings plan. Many college savings plans offer some type of tax advantage. For example, if you contribute to a 529 plan, your earnings can grow tax free, provided all withdrawals are only used to help pay qualified higher education expenses. (529 plan distributions not used for qualified expenses may be subject to federal and state income tax and a 10% IRS penalty.) Furthermore, your 529 plan contributions may be deductible from your state taxes.
Avoid excessive buying and selling. If you are constantly buying and selling investments, you may find it “taxing,” because short-term gains (gains on assets owned for less than one year) will be taxed at your ordinary income tax rate, which could be as high as 39.6% (and you may also be subject to a 3.8% Medicare surtax). However, if you hold your investments longer than a year before selling them, you’ll pay the more favorable long-term capital gains rate, which will likely be 15% or 20%, depending on your income, though you might still be assessed the Medicare surtax.
Tax Freedom Day is here, and then it’s gone. But by taking the steps described above, you may be able to brighten your tax picture for years to come.