Tax Strategies for Investing

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We don't have a way for money to grow on trees, but we have the next best thing: ways to manage taxes. In fact, there are multiple tax-deferral opportunities to address your retirement savings. Let's review strategies.

We all want our nest eggs to grow and compound as much as possible. Ric Sarro, BECU Investment Services Senior Program Manager, gives us his top six methods:

1. Open a retirement account

Of all the tips and tricks that individuals use to manage their investments, one of the simplest things is to contribute to a retirement account that isn't yet taxed, such as a 401(k) or Traditional IRA.

“If you contribute to your 401(k), your contributions are considered pre-tax,” says Ric. “Additionally, tax deferral aims to help your investment grow faster.” The same is true for Traditional IRA accounts (for individuals who don't have access to a 401(k). A Traditional IRA is also tax deferred, up to a certain amount.

2. Look at insurance products

One can also invest using annuities (products guaranteed by insurance companies). Fixed annuities generally offer the additional benefit of tax-deferred growth. Variable annuities offer the opportunity to participate in the markets. Most annuities come with a surrender period, generally 3-7 years. During that period, if you withdraw your funds you would pay a declining penalty, plus a 10% penalty on the gains, if you are under 59 ½.

The tax-deferral benefits and “forced discipline” make it an attractive option for many investors. Plus, in most cases, you may withdraw up to 10% each year without penalty from the issuer. When choosing annuities it is important to understand certain risks. Internal costs may be higher than other investments, reducing comparative returns. Be certain to check with a tax specialist to see if the savings from tax deferral work in your specific scenario. If annuitized for income, making the wrong choice of death option (i.e. single-life vs. joint-life vs. perid certain) may result in income stopping while your survivor still needs it. Choose your insurance company wisely. The annuity is backed by the insurance company. Lower-rated insurance companies may offer higher rates, but those rates come with a risk. For fixed annuities, there is spending power risk. That is, the fixed rate may not keep up with inflation. Consultation with a trusted tax advisor and financial consultant will help you wade through these concerns.

3. Support local projects

Remember war bonds? Bonds are still very much a thing for people seeking fixed income. Municipal bonds are debt issued by a local government entity (a municipality). These bonds are exempt from tax at the federal level. They have the additional benefit of supporting local projects, such as nearby parks, bridges, schools or other building projects.

4. Capital gain for charity

Have a security that has earned large capital gains? “If you sell, you may take a big hit on your taxes. However, you can turn that to your tax advantage. If you donate the security to your favorite charity, you may not have to pay taxes on the capital gains if held for more than one year, while potentially deducting the full, current market value as a charitable donation.” explains Ric. There are potential limitations and reductions that may apply, especially to taxpayers in higher tax brackets.

Say you originally put $5,000 into Company X. Today, the shares are worth $10,000. If you sell the stock, the $5,000 gain will be taxable. Or by donating the shares:

• You have made a $10,000 donation to charity
• You will be able to claim a charitable deduction worth $10,000
• You won't pay a tax on the $5,000 capital gain

Ultimately, you did give away your original $5,000 that you spent, but you also made a difference and helped your own tax situation as well.** NOTE: With the recent tax law changes, it is even more important to consult with a tax specialist to assure your tax deduction is not limited and makes sense in your specific situation. Depending on your tax status, you may not get the same value as in the past.

^**This is a hypothetical example and is not representative of any specific investment. Your results may vary.

5. Tax-loss harvesting

Ric says that investment managers routinely take profits when the price of investments get high, or fundamentals in the underlying companies have changed. They then reinvest those capital gains into the next investment. However, you are on the hook for taxes on the capital gains. A common practice at year-end is to look for securities in the diversified portfolio that have capital losses. By strategic selling of the “losers”, the capital losses can help offset some – or all – of the capital gains.

Best practice when riding the storms of investments? Following Ric's advice: “If you have a comprehensive investment portfolio, it's well diversified to manage risk.” Be sure to consult an expert for additional details on harvesting tax losses.

6. Consider a college 529 plan or prepaid tuition plan

Saving for your child's education is a smart move – education is a valuable asset, and chances are, your child will need help paying for the high cost of tuition. The upside of opening a college plan is that it grows tax-free and receives tax-free treatment upon withdrawal, so long as it's used for qualified education purposes (tuition, books, fees, etc). What if your child doesn't attend college, or receives a full-ride scholarship? You can change the beneficiary to someone else – a niece or nephew or a grandchild, for instance – it's up to you. In fact, you could even use the money for yourself. It's not uncommon for some people to redesign their careers late in life and go back to school. Keep in mind that if you withdraw for purposes other than education, you would be subject to taxes and penalties.

It is important to know some key features and risks of college plans:

1. Prepaid tuition plans: Room and board fees are not covered in these plans, so you should have additional college savings outside of these plans. You are limited to institutions withinin the state of purchase. What if you choose a Washington plan and your child wants to go to UCLA? Also, the number of states offering these is shrinking because of the expense and some are under-funded. You may get hit with extra assessments and new fees to cover funding shortfalls.
2. 529 savings plans: The funds withdrawn must be used for Qualified Higher Education Expenses, per the IRS. So, not all expenses can be paid for via 529s, but they can be used for a broad variety of things besides tuition, such as room and board, books, supplies, equipment—even rent for off-campus housing. However, be aware that any funds not used properly are subject to tax and a 10% penalty.

Whichever approach you take, the hardest part is getting started. Make a commitment to yourself and start now!

Questions? Get answers from a professional. Talk to a trusted financial advisor with BECU Investment Services. Call 206.439.5720 or click here.

Helpful Resources

• Roth IRA and Tradition IRA Accounts

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 may result in a 10% IRS penalty tax in addition to current income tax.

Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.

Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.