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How a Financial Advisor Can Help You Understand the Tax Implications of Your Investments

When it comes to choosing investments, it is important to keep in mind your investment horizon, risk appetite, and the asset class you wish to invest in. A financial advisor can help create an investment plan for you that takes into account your current financial situation and your future goals. Doing so would not only lower your level of risk, but also help you identify the tax implications of your investments. Taxes can be quite complicated, and you might need professional help to understand the tax structure of your investments. If you wish to understand how you can lower your taxability, you may consult with a professional financial advisor who can help guide you on the same.

This article covers the tax implications of different investments, and how you can use different tax strategies such as tax loss harvesting and offsetting capital gains tax to lower your tax bill.

Should you hire a financial advisor for tax planning?

There are two primary ways of investing. You can either invest money yourself or can seek a financial advisor’s help. Either way, you will have to pay a tax on your income. Thus, you need to understand the tax implications of your investments and how they can impact your financial planning. Most financial advisors can help you with your taxes and some of them are trained experts in tax planning and management. Try to understand the tax rates charged on each instrument and ask your advisor if you have any doubts regarding your tax bill.

Let’s look at some basic asset classes and their tax implications.

What are the tax implications of different investments?

You can earn good returns with efficient asset allocation, but to lower your tax liability, you need to know the tax implications of different financial instruments.

1. Stocks:

Stock or equity represents ownership in a company. If you hold a stock for less than a year, you will incur short-term capital gains tax as per the applicable tax rate based on your income bracket. The different tax brackets for short-term capital gains tax are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. On the other hand, if you hold a security for more than a year, you will have to pay long-term capital gains tax on the investment income. Depending on your taxable income and filing status, the long-term capital gains tax rate is either 0%, 15%, or 20%.

2. IRAs:

IRAs or Individual Retirement Accounts are tax-advantaged retirement savings accounts where you contribute your pre- or after-tax money that grows on a tax-deferred or tax-free basis. The IRA is primarily used by self-employed individuals who do not have access to a 401(k). IRA withdrawals may be subject to a 10% early withdrawal penalty with some exceptions such as if you are a first-time homebuyer, you are using the money to pay for higher education, and more.

3. 401(k):

401(k)s are company-sponsored retirement savings accounts that offer tax advantages to employees. These plans are provided by the employer who may match the employee’s contributions in part or in full known as the employer’s match. There are two major types of 401(k)s - Traditional 401ks and Roth 401ks and both have different tax implications. For instance, if you invest in a traditional 401(k), you make contributions from your pre-tax income that lowers your taxable income for the year. That said, you will have to pay tax at the time of making a withdrawal in retirement. On the other hand, in a Roth 401k, you contribute from your after-tax income. This means you receive no tax deduction in the year of the contribution. However, you can make tax-free withdrawals in retirement. Additionally, you do not have to take our required minimum distributions (RMDs) in a Roth 401k but have to do so in a traditional 401k once you turn 72. You can consult with a professional advisor who can advise you on which 401k to pick based on whether you expect to be in a higher tax bracket post-retirement or not.

4. Mutual funds:

Mutual funds are an investment vehicle wherein money from shareholders is pooled in various securities such as stocks, bonds, money market instruments and other assets. These funds have a common investment objective and are managed by financial experts and fund managers. If your primary objective is to save taxes, not all mutual funds will help you in this regard. This means that you will have to look out for a particular mutual fund or a set of mutual funds that are tax efficient. In the case of some mutual funds, like active mutual funds, you also need to pay taxes on capital gains along with regular taxes.

You can calculate your tax obligations based on the buying and holding pattern and the duration for which you hold the funds.

5. Municipal bonds:

Municipal bonds are debt securities issued by the Federal or State Government where the interest paid on the security is often tax free. This feature makes municipal bonds an attractive investment for individuals in high tax brackets. The proceeds from these bonds are used for construction of highways, bridges, or schools.

6. Annuities:

Annuities are a financial instrument that provides a guaranteed income stream to its investors. This financial product is offered by financial institutions. Annuities are considered to be ideal investments for individuals who want stable, guaranteed retirement income. Annuities offer several tax benefits such as tax-free growth, which includes interest, dividends, and capital gains. You can reach out to your financial advisor to understand how to make the best of these investments.

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How can tax loss harvesting help reduce your tax liability

Harvesting tax gains and losses is a powerful way to reduce taxes, especially when concerning equity investments. There are two ways of tax harvesting:

  • Reinvesting to avoid taxes
  • Offsetting profits with losses

For instance, by employing tax-loss harvesting, you can offset losses from one investment against profits from another. Losses of up to $3,000 can be reported and offset against gains. Married individuals filing separately are limited to a $1,500 loss deduction in the form of tax harvesting.

You can reach out to your financial advisor who might help you understand how to sell a stock to offset a gain. You must also try and avoid wash sale transactions. A wash sale transaction is one wherein you purchase a similar security within 30 days of selling a security at a loss for tax purposes. Though you cannot regain your lost funds, you can reduce the severity of your loss through tax loss harvesting.

Can a financial advisor help with taxes?

The answer may vary depending on the kind of advisor you engage. While some advisors provide services limited to only making investments and placing trades, several others can help file a return. In fact, most financial advisors can help you review your tax returns to get a fair picture of your financial position. Furthermore, an advisor can guide you on your investment strategies to lower your tax liabilities. For instance, if an advisor observes that you have tax-loss carryovers as a part of your returns, they could help you offset your loss effectively against your profits. Also, if you are nearing retirement, you need to come up with ways that can help you reduce your tax bill. An advisor may suggest making a donation to benefit from charitable tax deductions. Lastly, you can ask your financial advisor to review your taxes to ensure you have not missed any deductions. For instance, they might suggest taking advantage of the ensuing tax benefits if your healthcare expenses exceed 7.5% of your gross income. Most professionals need to keep themselves up to date with the changing tax laws to offer up to date and relevant tax advice to their clients.

To conclude

Investments carry different tax implications that can cause you to run a hefty tax bill if you are not careful. If you are new to the world of investing and do not know how to manage the ensuing taxes, you need to reach out to a financial advisor who can help you understand the tax implications of every investment in your portfolio. Financial advisors need to stay up to date with different tax laws and can also help you file your tax returns. They can also assist you with tax planning to reduce your tax liability to allow you to pay the lowest taxes possible.

Use the free advisor match service to match with vetted financial advisors that can help lower your taxability by employing different tax saving strategies. Answer a few questions about yourself and get matched with 1-3 financial advisors that can help you with your unique financial needs and goals.

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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice.
A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.