How to Hold Onto Your Investment Income
Making wise investments is vital to providing for your family and ensuring a comfortable retirement. However, the taxes you pay on those investments can be tremendous. Fortunately, there are several ways to limit your tax liability while still earning a respectable investment income.
Make Investments through a Retirement Account
One of the best ways to keep your investment earnings from falling into the hands of the IRS is to make investments through a retirement account, such as a 401(k) or an IRA. Contributions to these accounts are often fully tax-deductible, though there may be penalties for withdrawing funds before you reach retirement age. Before making an investment in an IRA, keep in mind that if you or your spouse also has a 401(k) account, your IRA contributions may not be fully tax-deductible.
Deduct Your Capital Losses
Another way to hold onto your investment income is to offset your annual capital gains with your capital losses. If you have more capital losses than gains, you can deduct the difference on your tax return to reduce your taxable income. The maximum deductible limit is $3,000 per year for joint filers and $1,500 per year for married couples filing separate returns. You can also “carry forward” your capital losses to the next tax year if they exceed that limit.
NOTE: If you make an investment in a mutual fund, the fund will deduct its losses from its capital gains each year to limit the tax liability for its clients. The mutual fund may also carry forward its capital losses to defray capital gains in a boom year.
Make Non-Taxable Investments
In order to retain your investment income, you may choose to make non-taxable investments, such as municipal bonds. Municipal bonds are issued by local municipalities, including towns and publicly-owned airports. Municipal bonds are not subject to taxes at the federal or state level unless you purchase them across state borders. However, the interest yield for municipal bonds is generally lower than for other types of bonds, such as U.S. government savings bonds. The interest you earn from a U.S. government savings bond is not subject to local or state taxes ― but you will be taxed once you redeem the bond or the bond matures.
Transfer Appreciating Investments
If you have an appreciating investment, such as an estate or piece of art, you may want to transfer that asset to your child. He/she can then sell the investment and incur a lower tax rate that corresponds with their lower income level. To qualify, your child must be older than age 19 (or 24 if they are a full-time student). Gift taxes may still apply to this transfer, so consult a tax professional before making your decision.
You may also want to transfer an appreciating investment to your spouse upon your death ― which will be tax-free, thanks to the estate tax marital deduction. As an added bonus, estate taxes have been repealed for tax year 2010.