If you earn a lot of money, you may also pay a lot in taxes – a fact that’s particularly relevant now, as we are well into tax-filing season. At this point, there’s not a lot you can do to affect the outcome for the 2020 tax year, but if you want to change your tax outlook for the years ahead, you can make several moves.
Here are a few “tax-smart” investment strategies to consider:
• Put as much as you can into your 401(k). By contributing pretax dollars to a traditional 401(k), you’ll reduce your taxable income, and your earnings can grow tax deferred. If you have a Roth 401(k) option, you’ll put in after-tax dollars, but your withdrawals – earnings and contributions – will ultimately be tax-free, as long as you’ve had your account at least five years and you’re older than 59 ½ when you start taking money out. In 2021, you can put up to $19,500 into your 401(k), or $26,000 if you’re 50 or older. However, depending on your employer’s plan, you may also be able to contribute additional after-tax dollars, so check with your plan administrator about your options.
• Review Roth IRA strategies. As a high earner, you may face limits on what you can contribute to a Roth IRA, which, like a Roth 401(k), offers the potential for tax-free earnings. You lose eligibility to contribute to a Roth IRA if your adjusted gross income equals or exceeds $140,000 (single filers) or $208,000 (if you’re married and file jointly). Through a “backdoor” Roth IRA conversion, though, you could make after-tax contributions to a traditional IRA and convert it to a Roth. This strategy could be advantageous if you expect your tax rate to be higher when you retire. Consult with your tax advisor to determine if this move is appropriate for your situation.
• Look at municipal bonds. Because interest payments from municipal bonds are typically exempt from federal taxes, and often state and local taxes, too, these bonds can be attractive to investors in the higher tax brackets. Income from some types of municipal bonds may be subject to the alternative minimum tax (AMT), so, if you end up having to pay this tax, you’ll want to be clear about what types of bonds you’re purchasing.
• Consider investing in tax-efficient mutual funds. When most mutual fund managers buy and sell the individual investments within their funds, such as stocks and bonds, they are primarily interested in trying to achieve the goal of the fund itself – growth; growth and income; and so on. However, many of their trades have tax consequences. But managers of funds billed as tax-efficient will consciously try to minimize the moves that can generate taxes.
• Follow a buy-and-hold strategy. If you’re frequently buying and selling investments, you could incur sizable taxes, especially if you sell investments you’ve held for less than a year, in which case your profits would be taxed at your ordinary income tax rate. If you sell investments you’ve held for more than a year, you’ll be assessed the long-term capital gains rate, which will likely be lower than your individual tax rate.
Your financial and tax advisors can help you determine if these moves make sense for your needs. If they do, you may want to start incorporating them into your long-term investment strategy.