As a business person, you clearly understand how investments can help you build wealth and beat inflation. However, you need to be extra careful while choosing your investment plan to avoid taxes legally.
Luckily, there are many ways you can use to minimize investment taxes. But before we dive into that, let’s touch on how your investments are taxed.
How International Revenue Service (IRS) Taxes Your Investments
Firstly, it would be best to understand that IRS taxes your investments differently from your income. While the IRS uses the Adjusted Gross Income (AGI) calculation to know the total income from your wages subject to tax, it doesn’t have a fixed way to tax your investments. That means you will be subject to different tax rates depending on your investment option.
Before you decide on your favorite option, remember that how your investments generate income affects your tax rates. Let’s have a look.
- Capital gains – This means your capital assets increased in value. i.e., you have sold an asset like a stock or real estate for more than its original cost. Capital gains can be short-term (a year or less) or long-term (beyond one year) and is only liable to tax when they have been “realized” (meaning you have gained more from the original price of your asset).
- Dividends or cash income – this are typically the money received in a given year. You will be subject to taxes at the year the dividends or cash income is received.
5 Best Options to Invest Business profits to Eliminate Taxes
1. Practice buy-and-hold Investing
As the name suggests, you buy assets and hold them to avoid taxes. Remember that the IRS only taxes on realized capital gains, so buying an asset and holding it means no taxes are imposed on the investments until the period you’re selling.
This option is one of the best for investors because it gives you enough time to create wealth without paying taxes. Also, in case the unfortunate happens, and the value of your assets depreciates, you will not be taxed, as the IRS only imposes taxes on realized capital gains.
Here is a real-world example that proves this strategy works if you carefully invest your money.
In 2008, you would have bought 100 shares of Apple stock at $18 per share, spending $1800. If you use the buy-and-hold strategy and keep your shares until September 2022, you will have sold your shares at $157 per share, earning you $15,700. That’s a lot of profit, considering you have evaded taxes for 14 years.
2. Opt for IRA Investments
IRA is an individual retirement account that allows you to save money with tax-free or tax-deferred growth. You can defer all taxes made on your business profits for decades. There are three main types of IRA investments.
- Traditional IRA– in this option, the money you save is subject to tax, but the grow tax-deferred options allow you to invest (without taxes) until the withdrawal period. Therefore, you will earn more from the investment scheme before paying taxes. Another advantage is that it has low tax rates making it a perfect option for investors.
- Roth IRA – you can save money that has already been taxed, meaning your investments will grow tax-free. This is advantageous as you won’t be subjected to any tax despite the period of investments.
- Rollover IRA – this is an investment rollover from other retirement plans. Unlike other saving plans, channeling your investments to Rollover IRA plans allows it to grow more quickly while using the free-tax option.
All the types above will depend on your needs and investment plans. If you want to avoid taxes now, and wait until you withdraw your money, then the Traditional IRA is an ideal option. However, you can grow your investments on a tax-free basis and wait for the complete amount when you withdraw your money.
3. Take Advantage of Tax-loss Harvesting
You can use tax-loss harvesting to reduce your taxes to almost zero. IRS allows investors to write off their investment gains against losses and pay taxes on the net capital gain. Here is an example of how you can evade taxes through tax-loss harvesting.
So, you have gained $10,000 after selling your assets and lost $8,000 in a year. Using this strategy, you can offset them and have an annual realized gain of $2,000. This way, the IRS will tax only the total realized $2,000 gain instead of taxing each of your gains and losses in a single year.
Additionally, tax-loss harvesting allows you to carry forward unrealized gains of more than $3,000. It means the IRS will not tax you for net losses above $3,000. For instance, you have realized $10,000 gains on the first investment and a $15,000 loss on the next investment.
It means you will have a net loss of $5,000. The big Advantage is that you will only be liable to tax for a net loss of up to $3,000—the remaining $2,000 you can carry forward to the future.
The tax-loss harvesting strategy is very effective because it allows you to pay fewer taxes even after realizing net losses. This way, you can strategize your investment plans to get more profits while avoiding taxes.
4. Utilize the 1031 Exchange
This is one of the most effective tax-free strategies for your investment if you approach it carefully. A 1031 exchange (also known as like-kind exchange or starker exchange) is a swap of your real estate investment for another of equal standards without paying capital gains taxes.
There are many rules involved; therefore, you need to take time to understand the rules and regulations to avoid being penalized.
Here are some important rules you should know before using the 1031 exchange.
- You shouldn’t receive any capital gain if you use the 1031 exchange.
- The exchange must be of the like-kind to benefit from the 1031 exchange. The like-kind property will be certified by IRS to determine if you can swap the two properties.
- The 1031 exchange is meant for investment and business properties. That means you cannot use this strategy to swap your principal residence or vacation home. However, some conditions can favor the swapping of residential properties.
- When you exchange a depreciable property, you may be liable to depreciation recapture, which typically means the exchange will be taxed as ordinary income.
- You should consider two timing rules when using the 1031 exchange: the 45-day rule and the 180-day rule. In both rules, you must close the property swap within the stipulated days.
- You need to find an intermediary who will hold the cash after and before you swap your properties. This is because you are not allowed to hold cash made out of the exchange or use it for other personal needs.
- You are also allowed to do reverse exchange. This means you can buy the replacement property before selling the one at hand. However, keep in mind that you will be bound to the 1031 exchange timelines rule.
- If there is cash left over, you can only receive it from your intermediary after 180 days. Remember that this cash will be subject to taxes.
We recommend finding all the necessary information before using the 1031 exchange. Ensure you consider the timeline rules to avoid being penalized. With proper planning, this strategy can help you gain wealth without paying taxes.
5. Take Advantage of Lower Long-term Capital Gains Rates
Long-term rates are very friendly, and if you plan better, you can enjoy up to 0 percent rates on your investments. The IRS rates for long-term capital gains are 0%, 15%, and 20%, which is lower than short-term capital gains taxable at ordinary income rates.
However, this option is ideal if you earn less than $41,675 in ordinary taxable income (keep in mind that the numbers change over the years). Also, you can utilize this strategy if you are married with earnings less than $83,350. Here is how it works.
Let’s say you earn $20,000 (ordinary taxable income) as an individual; you will be liable for 0 percent interest rates in your long-term investment income. However, there is a limit to you enjoying the 0 percent rates up to the $83,350 threshold.
It means you will be subject to a 15% tax rate if your ordinary taxable income if you have exceeded a sum of $83,350 ordinary taxable income.
This option is ideal if your ordinary taxable income is low or you’re married and don’t earn more than $83,350. Nonetheless, the long-term investment tax rates are significantly low and could help you avoid taxes for an extended period.
Investment is the backbone of any business, and you must utilize the legal IRS options available to avoid being subject to unnecessary tax rates.
You can enjoy up to 0 percent tax rates for your capital gains and defer taxes for decades. However, it would help if you took the time to understand all the steps above to land the perfect option.