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Tax Education for Forward Thinking Investors

Tax Education for Forward Thinking Investors

As investors, it may seem like a daunting task when trying to figure out the best ways to preserve our hard-earned cash and protect our financial freedom. Fortunately, creating an effective strategy that maximizes our additional income, reduces our taxable liability, and safeguards our financial future is possible with a well-designed plan. While death, stress, and taxes may be unavoidable, here are some great ideas to make the most of your cash while reducing your stress, lowering your effective tax rate, and providing you with the retirement lifestyle you’re hoping to achieve. 

How Your Taxes Change as an Investor

At the end of the day, Uncle Sam wants his money and will do whatever he can to collect his fair share. Before choosing an investment vehicle that’s appropriate for your financial situation, it’s important to understand how your taxable liability (the percentage of earnings taxed) will be affected by your chosen investment path. 

Long story short, you will have to pay taxes on your investments at some point; whether it’s before contributing when income is earned, or after cashing out an investment. While there are nearly limitless options when it comes to investments and how they relate to your taxable obligations, let’s cover some of the most common types of investments and how they may impact your tax situation. 

  • 401k: If you make contributions through an employer, it is likely a 401k and you are deferring your income tax on contributions and earnings. You will save money upfront since income tax is not subtracted from the initial contributions but will owe a percentage of the account in taxes upon distribution (once you access the funds). There are penalties for early withdrawal (often a 10% penalty if withdrawn before age 59 ½), and it may be difficult to access the funds if you need the cash in a hurry. 
  • Roth IRA: Roth IRAs and other similar investment vehicles allow a set amount of after-tax contributions to be made each year. Since the money is only taxed before contribution, money earned from interest accumulation is non-taxable. You often have more freedom while selecting a portfolio allocation within these types of investments, and will not have to pay taxes on the investment upon distribution (If you meet the requirements for penalty-free withdrawal such as first-time home buy, age 59 ½, and other qualifications depending on your specific IRA).
  • Individually Traded Stocks & Bonds: If you’re a savvy trader and have been trying to etch out a financial future in the market, your taxable liability depends on the types of trades made. In the world of trading, a short-term capital gains tax will apply to any earnings that you accrue from investments held for less than one year. A long-term capital gains tax will apply to any investments that you hold for a year or longer. The applicable tax rates depend on your overall income for the year, but in general, short-term capital gains taxes are higher than long-term capital gains taxes. 

Since every type of investment comes with its own specific set of tax guidelines, it is essential that you carefully research every investment ahead of time. These are only a few of the most basic investment vehicles available, and you must consider all of the pros and cons before making any important investment decisions. 

Come Up with an Investment Plan That’s Right for You

Even if you don’t have a million dollars to invest, there are nearly limitless investment opportunities that will work to support your financial goals. Since every investment comes with its own set of risks, you must take the time to understand your financial limitations and create a balanced plan that accounts for your financial needs of today and the future. 

An honest evaluation of your current financial situation is a great place to start. Organize current expenses and income, evaluate any areas of financial weakness, and honestly decide how much you can afford to set aside for investments.

In general, a consistent monthly or quarterly contribution to your chosen investment fund or account is better than a large one-time investment. This will protect you from any temporary market fluctuations and prevent buyer’s remorse if you decide on a different investment vehicle down the line. By gradually contributing to your selected investment, you stand to avoid many of the pitfalls that come with large lump sum investments. 

Plan Investments with Tax Efficiency in Mind

You can significantly boost your financial wellbeing by thoughtfully considering investments that will preserve your capital and prevent loss through taxation. Here are some examples of strategies you can use to reduce your taxable liability: 

Individual Property Investment: If you sell your primary residence, you are not liable for capital gains taxes on the first $250,000 in profit if you are single, or $500,000 if married. You can only take advantage of this tax incentive every two years, assuming you have occupied the property for 2 out of the 5 years. You can even use this tax-reduction strategy for a rental property that you charged rent in 3 out of 5 years. The income earned from a primary residence can be used any way you see fit, although managing a rental property on your own comes with its fair share of risks. 

Invest with a Trust: Thanks to the joint efforts of multiple investing partners, you are shielded from a variety of the pitfalls that come with individual investments. Through a trust (think a team of investors with a shared goal), you can effectively reduce income liability, avoid estate taxation, and defer capital gains taxes with the bullet-proof frameworks defined in a trust.  Unlike an individual property investment that is at risk (even under an LLC, you may still be responsible to pay legal damages), a trust protects your investment with diversified assets that are more resilient to broader market influences. 

When discussing the pros and cons of using a trust in comparison to managing properties independently, Barry Bruce in Rent Magazine explains that, 

“For many informed property owners, highly specialized trusts offer real, “bullet-proof” answers to their asset protection concerns. These trusts are interpreted and enforced under commercial codes as contracts and are drafted purposefully.” 

He goes on to explain that unless your investments are shielded by a corporation or trust that includes 35 or more partners, you could be held personally liable in the event of a tenant lawsuit or issue with the property. 

While investing with a real estate trust is generally a safer option since you are protected from the potential liability associated with independent ownership, individual property investments can still be a viable option if you invest with caution. With the 1031 exchange rule, you can defer the capital gains tax on properties sold assuming you meet the IRS requirements. There are many pros and cons to this exchange rule, but as long as you can find a property of equal or greater value within the timeframe, you can feasibly defer capital gains taxes indefinitely by transferring the income from one property to another.

Partner with Professionals for Confident Investing

Whatever investment vehicle you decide on, you must learn the rules of “cashing out.” Whether you’re investing in properties for tax deferral and property depreciation benefits, have a Roth IRA that is tax-free upon distribution, or have partnered with a real-estate trust to protect your assets and prevent estate tax obligations, learning how to time your withdrawals to maximize potential gains is an essential consideration.

Before making any important investment decisions, it’s a smart idea to reach out to seasoned advisors that live and breathe tax-reducing investment strategies. Knowledgeable advisors will teach you everything you need to know about tax-deferred cash-out strategies, the benefits of investing with a trust, and can offer realistic solutions that are designed to preserve your wealth. At Levine Capital, we specialize in making the most of our investor’s capital and work with our clients on a personal level to maximize financial potential and reduce financial risk with a variety of proven investing strategies.