How to Invest Money & Avoid Taxes

by Rocco Pendola, Demand Media

    You finally have some cash to invest. And you finally have a reason--family, kids, house, retirement--to sock money away. Just when you discover how difficult it is to decide which investments provide the proper amount of risk and potential reward, you realize a whole host of other key considerations. You should put your portfolio's tax impact at or near the top of the list of your primary concerns.

    Step 1

    Max out your 401(k) or other workplace retirement plan. Your employer deducts contributions you make to these plans from your income before it deducts taxes. As a result, you invest money and effectively lower your tax bill in the process.

    Step 2

    Limit how frequently you make profitable trades. Every time you sell an investment such as a stock or mutual fund for a profit, you trigger what the IRS refers to as a capital gain. You must report capital gains annually on your tax return and pay the applicable capital-gains' tax on them.

    Step 3

    Keep investments, particularly ones that are tax-inefficient, in an IRA. Taxable earnings such as interest, capital gains and dividends receive tax-deferred treatment if you hold them in an IRA, meaning the IRS does not require you to claim them every year. When you take withdrawals from a traditional IRA, you must pay regular income tax on the proceeds. If you wait until you are 59-1/2 and have held your Roth IRA account for at least five tax years, the IRS spares taxes on the entire amount of Roth distributions.

    Step 4

    Monitor the tax implications of mutual funds you own. When a mutual fund buys and sells stocks that it owns, it produces a capital gain. If a stock a fund owns pays a dividend, there is a tax consequence. In both cases, the mutual fund pays out a distribution to its shareholders. You must report these distributions to the IRS and pay taxes on them. Beware of funds with high turnover rates, meaning they trade their holdings frequently. You can find this information in the fund's profile or prospectus. Also, realize that funds that specialize in investing in dividend-paying stocks tend to produce larger dividend distributions.

    Tip

    • If you sell an investment such as a stock or mutual fund for a loss, you incur a capital loss. The IRS allows you to offset capital gains with capital losses. If your capital losses are greater than your capital gains, you can deduct up to $3,000 in capital losses every year. You can carry leftover capital losses forward to future years. By deducting a capital loss from your taxable income, you reduce your total tax due.

    About the Author

    As a writer since 2002, Rocco Pendola has published numerous academic and popular articles in addition to working as a freelance grant writer and researcher. His work has appeared on SFGate and Planetizen and in the journals "Environment & Behavior" and "Health and Place." Pendola has a Bachelor of Arts in urban studies from San Francisco State University.