Taxes and inflation erode the return you make on your investment portfolio. If you are in a 30% tax bracket and inflation is 4%, you need to earn 5.7% to earn nothing.
Any effective plan to minimize your income taxes requires an ongoing effort on your part. That means you have to plan and make adjustments year-round, not just when you fill out your tax forms. Most tax preparers are just scorekeepers. They are reactive rather than proactive. You should work with a firm available throughout the year, not just one time a year.
There are three broad categories of tax-favored investments that reduce your income taxes. These are: “Tax-Exempt”, which offers income that is not taxed by the federal government; “Tax Deferred”, which defers taxes on accumulation until it is withdrawn; and “Tax Advantaged” instruments, which provide a tax credit against taxes.
Municipal bonds and Tax Free Money Market funds are two types of tax exempt vehicles.
The most popular tax-deferred investments are 401k plans, and IRA’s – both Traditional IRA’s and Roth IRA’s. Other tax-deferred alternatives are annuities, life insurance, and individual stocks and mutual funds.
Tax advantaged alternatives legally shelter income from taxes by creating a tax credit versus a tax deduction. The 3 primary Tax advantaged vehicles are: Rental Real Estate, Low Income Housing and Historic Rehabilitation Properties.
Older annuity and life insurance contracts can be exchanged for newer, higher paying interest contracts by using a 1035 exchange. This IRS section allows you to re-position these investments without incurring any tax liability.
The tax law allows married couples to exclude up to $500,000 of capital gains on the sale of their personal residence. This benefit can be used every two years.
There are numerous options available for all of these strategies and a tax and financial professional should assist you in selecting one that properly fits your specific needs.