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Tax Planning Basics for Investors

March 26, 2015
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First you worked hard for your money. Then you worked hard to invest it carefully so it would grow. Now you want to make sure your hard-won gains aren’t siphoned off by taxes for Uncle Sam.

Whole books could be written about how to minimize taxes on your investments, but these basic strategies will put you on the right path.

Retirement accounts

For most people, retirement is the single biggest financial challenge they’ll face. Tax-advantaged savings accounts can help you accumulate enough wealth to support yourself after you stop working.

Workplace retirement plans. If you have access to a 401(k), 403(b) or 457 plan through your employer, contributions generally reduce your taxable income. If your employer matches part or all of your contributions, so much the better, as that money isn’t taxed at that point. Money in these accounts will be taxed on withdrawal, however.

Many employers offer Roth 401(k) plans as well. Contributions to these plans don’t reduce your taxable income, but the money and any returns it earns can be withdrawn tax-free and without penalty after age 59½.

Individual retirement accounts (IRAs). Like workplace plans, IRAs come in two basic varieties, both offering tax advantages. With a traditional IRA, contributions can reduce your taxable income, but your withdrawals are taxed. With the alternative, called a Roth IRA, contributions are made from after-tax income, but withdrawals are tax-free. These can be good for those who want to set aside more than the maximum allowed in a workplace plan, or for people whose employers don’t offer retirement plans. Some types are designed for small business owners.

Restrictions may apply to IRAs in terms of how much you can contribute and whether you can take advantage of certain tax benefits, depending on your income and your workplace pension coverage or 401(k) plan participation.

Education accounts

The federal government has also give investors a leg up on saving for education expenses.

529 accounts. Contributions to these savings plans can reduce income subject to state taxes in some states, but at the federal level, contributions aren’t deductible from taxable income. However, investment gains in the account aren’t subject to federal taxes at withdrawal as long as the funds are used to pay for a qualified education expense, like tuition or room and board for your child or grandchild. Contributions can’t exceed the costs of the beneficiary’s education, and may be subject to gift taxes if more than $14,000 a year.

Coverdell Education Savings Accounts (ESAs). Although these have tighter annual contribution limits, ESAs can be used for education expenses starting with kindergarten, making them ideal for parents or grandparents who expect to foot the bill for a child who attends private schools. Income restrictions limit who can contribute to an ESA, however.

Taxable accounts

Sometimes there are good reasons to invest in a brokerage account that doesn’t provide any tax advantages. Perhaps you’ve reached the limit for tax benefits from retirement account contributions, or maybe you’re saving for an early retirement and want funds you can use without penalty before you reach the age when those penalties disappear.

In taxable accounts, emphasize investments that you don’t plan to sell anytime soon. That’s because gains from selling stocks, mutual fund shares and other investments you’ve held for less than a year are taxed at a higher rate than gains on longer-term holdings.

A tax-smart saving and investing strategy can save you tens of thousands of dollars during your lifetime. In fact, evaluating your finances for tax efficiency may be the best investment you ever make.