Tax-efficient investing: 7 ways to minimize taxes and keep more of your profits

If you’re an investor, be sure to give special attention to the taxes you’ll have to pay on your investments. In many cases, you have ways to legally reduce, defer or even eliminate taxes on your investment gains and keep more of your profits. So it pays to know the smartest ways to minimize your taxes and keep more of your money working for you.

Here are some of the best ways to keep taxes low on your investment income.

How your investments are taxed

The Internal Revenue Service (IRS) taxes your investment income, but it does so differently from how it taxes income from working wages. Those differences include not only the tax rates you pay but also when and how taxes are assessed on investment income. Broadly speaking, investments generate income in two ways and each is treated differently for tax purposes:

• Capital gains: Capital gains are an increase in the price of an asset, for example, if a stock or real estate property goes up in value. In general, the government taxes capital gains only when they’ve been realized (i.e., an asset has been sold for cash).
• Dividends or cash income: Dividends or cash income is money received during the year, and it’s usually subject to taxes for the tax year in which it was received.

So investors looking to minimize their investment taxes have to work around these broad rules.

7 ways to minimize investment taxes

You have a number of ways to minimize taxes on investment gains, ranging from the behavioral to tax-advantaged accounts to efficient use of the tax code. Here are seven of the most popular:

1. Practice buy-and-hold investing

An important caveat on the IRS tax laws is that you’re taxed only on realized capital gains, that is, when you sell an investment for cash. That’s a huge legal loophole for you to jump through. As long as you don’t sell, you won’t be liable for capital gains taxes, which can be substantial.

In fact, you can hold your investments indefinitely and permanently defer any tax on gains.

But that’s only one side of the benefits of the buy-and-hold approach. Your investments will likely perform better if you buy and hold. Research consistently shows that passive investing tends to outperform active investing over longer periods. So buy-and-hold investing can help you win in two ways: you’ll likely make more money and you’ll pay less of it to the IRS.

This approach is at the top of Bankrate’s list because it’s probably the single most important strategy you can use to reduce your taxes. And you’ll probably get better gains, too.

2. Open an IRA

An IRA is a great way for workers to invest their income for retirement and get some tax advantages. A traditional IRA lets you put away money on a pre-tax basis, reducing your taxes this year. You’ll be able to defer any taxes on your profits — either capital gains or dividends. When it comes time to take distributions from the account after age 59 ½, you’ll pay taxes on any money taken from the account. So you can legally defer taxes in your IRA for decades.

If you want to get the IRS out of your pocket for good, though, you can opt for a Roth IRA. The Roth IRA lets you put away money on an after-tax basis, meaning you won’t get a tax break this year. However, you can grow your contribution tax-free and then withdraw it tax-free when you begin taking distributions after age 59 ½. It’s widely considered to be the experts’ top pick among retirement accounts.

You’ll want to carefully consider which plan — the traditional IRA or the Roth — fits your needs better. Whichever you choose, it’s important to closely follow the rules, since you can get hit with penalty taxes if you make a misstep. Don’t avoid taxes only to fall into another tax trap.

3. Contribute to a 401(k) plan

An employer-sponsored 401(k) plan offers many of the same tax advantages of an IRA, plus a few more. A traditional 401(k) lets you defer money from your paycheck on a pre-tax basis, reducing your taxes this year. You’ll be able to defer taxes on any earnings, either capital gains or dividends. When you take distributions from the account after age 59 ½, you’ll pay taxes on any withdrawals. Effectively, you can defer investment profits for decades while you work.

A Roth 401(k) offers many of the same benefits as a traditional 401(k) — paycheck deferral, an employer match and more — but does so on an after-tax basis, meaning you’ll still pay taxes on any contributions. However, you can grow your account tax-free and then withdraw any money tax-free when it’s time to take distributions. You can even roll it over into a Roth IRA later on.

Both types of 401(k) plans are popular with workers, and you’ll want to carefully consider which plan is better for you. Again, it’s important to carefully follow the plan’s rules, especially on withdrawals, so that you avoid any unnecessary bonus penalties that the IRS levies.

4. Take advantage of tax-loss harvesting

It can be smart to use tax-loss harvesting to reduce or eliminate your taxable capital gains. With tax-loss harvesting, the IRS allows you to write off realized investment losses against your gains, so you’ll owe tax only on your net capital gain. For example, if you realized a $10,000 gain on one investment but have an $8,000 loss on another, you can offset them. You’ll wind up with a taxable gain of just $2,000 and a much smaller tax bill.

The IRS even allows you to offset more than you’ve gained — up to a net $3,000 loss in any tax year. If your net losses are bigger than that, you’ll have to carry them forward to future years. For example, if you realized a gain of $10,000 in one investment and a $15,000 loss in another, you’ll have a net loss of $5,000. But you’ll be able to claim only a $3,000 loss on this year’s tax return, while the remaining $2,000 loss can be claimed in future tax years.

Some investors make a habit of minimizing taxable gains this way. They may end up repurchasing the investment, if they like it longer term, after a 30-day period, to avoid a wash sale.

5. Consider asset location

Dividends and other cash distributions are generally taxable in the year you receive them. So if you’re using a taxable account, you don’t have a great way to wiggle free of taxes here, as you do with capital gains. To keep taxes low on dividends, consider where you hold your assets.

For example, you may have a tax-advantaged account such as an IRA and a regular taxable brokerage account. If you have dividend stocks, it may make sense to keep those (or most of them) within the tax-light confines of your IRA, so you avoid taxes on the distributions today.

Meanwhile, stocks with (probable) capital gains could be held within a regular taxable account. Yet in a taxable account you can still enjoy one of the IRA’s key benefits — tax deferral — until you sell your investment, potentially decades later. But you’ll want to carefully consider whether stuffing all your dividend payers into an IRA makes the most financial sense for you.

6. Use a 1031 exchange

If you’re a real estate investor, it can make a lot of sense to use a 1031 exchange if you’re selling a property (not your primary residence) and looking to reinvest in another. Basically, the 1031 is a like-kind exchange allowing you to sell one investment property and defer your capital gains — so long as you invest the proceeds (relatively quickly) in another investment property.

The rules surrounding a 1031 exchange can be complex and must be followed exactly, or you’ll lose your tax deferral. Like other types of assets, you can hold on to your investment and defer capital gains, potentially for decades. Plus, you’ll avoid those high real estate commissions.

7. Take advantage of lower long-term capital gains rates

Investment income is taxed differently from wage income, and that may be especially evident in the way that capital gains are treated. The IRS taxes long-term capital gains at 15 percent, 20 percent — and 0 percent. Yes, 0 percent. But you have to follow the rules very carefully.

These tax rates are typically lower than what you’ll pay on short-term capital gains, which are taxable at the ordinary income rate. But if you hold your investment for more than a year — again, another benefit of being a buy-and-hold investor — you’ll be able to take advantage of the long-term rates, which are likely to be significantly lower.

If you’re an individual filer and earned less than $44,625 in ordinary taxable income (or married with less than $89,250) in 2023, you can avoid taxes on capital gains and qualified dividends, at least up to a certain threshold. If you realize too much ordinary income, however, you won’t be able to qualify for the 0 percent rate, and you’ll start paying investment tax at a higher rate.

For example, if you filed as married and had no ordinary taxable income, you’d be able to claim a 0 percent rate on long-term capital gains and qualified dividends of up to $89,250. Any incremental investment income above that level would then be taxed at the higher 15 percent rate, up to $553,850. Incremental income above that level would be taxed at a 20 percent rate.

In contrast, if you had ordinary taxable income of $20,000, you’d pay 0 percent on your next $69,250 in long-term investment income (that is, up to the $89,250 threshold). From there, you’d pay at the 15 percent level, until your total income passed $553,850 and so on, as before.

So if you have years where your income is lower than normal, you can realize that 0 percent investment tax rate — and even step up the cost basis on your investment with no tax hit.

Bottom line

While making use of tax-advantaged accounts is a great way to minimize a tax hit, one of the easiest ways to reduce the bite of taxes is the simplest: take a buy-and-hold investing approach. You’ll enjoy some of the same benefits — such as deferred capital gains taxes — as you would in an IRA, but you’ll have greater flexibility to access your money, should the need arise.

— Bankrate’s Brian Baker contributed to an update of this story.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.