Reducing your taxes boils down to three basic principles: reduce taxable income, increase deductions and take advantage of tax credits. You can use several methods to achieve each of these tax-reduction principles.
Consult with your financial advisor, and consider using these tax-reduction strategies for the upcoming tax year:
- Contribute to your retirement plan. By putting money towards retirement, you benefit in both the short and long-term. As of 2016, you can put $18,000 towards a 401(k) or other retirement plans. If you are over 50-years-old, the IRS allows you to make additional “catch-up contributions” of up to $6,000. Money contributed to your retirement accounts are not considered taxable income.
- Put the right assets in the right accounts. Use an asset location strategy to manage your tax liability. Place high-income generating assets such as real estate investment trusts (REITs) and taxable bonds into accounts with tax advantages. Consider putting assets that generate smaller tax bills such as municipal bonds and stock index ETFs in taxable accounts.
- Use a health savings account. A health savings account (HSA) gives you three major tax benefits. A HSA allows you to make tax-deductible contributions, generate interest tax-free and make tax-free withdrawals for qualified medical expenses. HSAs differ from flexible spending accounts, which limit the amount you can carry over from year-to-year. HSAs have no carry-over limit and do not dictate a timeframe in which you must use the funds.
- Buy and hold. Buy and hold is a passive investment strategy where investors buy stocks and hold onto them for an extended period of time, regardless of market fluctuations. The taxation rate for long-term investments tends to be lower than short-term investments.
- Check your investment timing. Mutual funds must distribute a certain percentage of their net income each year and the investors are typically liable for the income distribution. How long you have owned the account is not taken into consideration. Before purchasing mutual fund shares, check the distribution date to make sure you do not make the purchase right before distribution date.
- Donate and repurchase. Charitable giving has intrinsic rewards, and immediate (and future) tax benefits. You can maximize your charitable giving deduction by donating appreciated securities instead of cash. Charities do not pay taxes on the sale of the stock, so they receive the maximum donation value of the shares. After donating the securities, you can buy back the shares at a higher value than when you originally purchased them. If you sell the same shares in the future, your basis for capital gains tax is now much higher, making the capital gains tax liability much smaller.
- Choose tax-friendly college saving options. You can save money for higher education for a beneficiary including your children, grandchildren, friends or even yourself using a 529 college savings account. You can put after-tax money into a 529 savings account, receive tax-deferred growth and make tax-free withdrawals for qualifying education expenses. Keep in mind that contributions exceeding the yearly $14,000 gift exclusion may be subject to gift taxes.
As an investor, there are several strategies you can use to reduce your tax liability. Before putting these strategies to use, consult with your financial planner. Contact a Fifth Third Bank financial advisor to create a tax-reduction strategy that is right for you.