Mutual funds, bonds, and homeownership: all of these are great investment vehicles to ensure security for your future. But before you get ready to collect on any high-earning investments, it’s important to understand how investments are taxed and how you can avoid potential tax pitfalls.
If you make an investment in a mutual fund, the fund is required to make yearly payouts of your capital gains (which are subject to capital gains taxes). It’s recommended that you find a fund that “carries over” its capital losses from previous years, so that even if you have a profitable investment year, you will be able to use the capital losses to offset your taxes.
If you make an investment in bonds and are concerned about taxes, you should consider buying government savings bonds. Government savings bonds are exempt from state and local taxes, and you can defer federal taxes until the bond is redeemed or until it matures.
Municipal bonds, issued by a local city or town, are an even better investment from a tax standpoint because they are not subject to taxes at the federal or state level. However, municipal bonds generally have lower interest rates than other types of bonds, meaning you will earn less interest in the end.
If you are a student and at least 24 years old, you could look at inflation-adjusted savings bonds (also called “I Bonds”) as a possible investment. These bonds allow you to deduct the interest you pay after redeeming the bond from your taxes. To qualify, you must be paying expenses at an institute of higher education during the same tax year that you redeem the bond.
If you run a tax-exempt private charitable foundation, you may still have to pay taxes on your investment income due to a 2% excise tax. This tax is meant to defray the cost that the government incurs in regulating private foundations. Foundations that provide lower amounts of grants may only pay taxes of 1%, and some foundations (such as exempt operating foundations) may pay no investment taxes at all.
For most investors, the tax benefits to starting a private foundation ― which include a tax shelter for the income that was used to start the foundation, as well as benefits on capital gains and estate taxes ― tend to outweigh the drawbacks.
As a general tax planning strategy, if you are able to hang onto an investment that appreciates in value (such as a house) you should try to sell it during a less successful financial year. Since an appreciating investment yields no income to you, strategically holding (and selling) your investment can help keep you in a lower income tax bracket and reduce your capital gains tax.