How to Reduce Your Tax Liability

Tax day might be less than a week away, but there’s still time to reduce your tax liability.

Being proactive to reduce your tax liability not only means paying less money to Uncle Sam every April, but it can also improve your retirement planning.

Here are three steps to lower your tax bill and help secure your financial future.

Step No.1: Step Up Your Retirement Contributions

Do you know how much you can deduct from your taxable income through retirement plan contributions? The answer may be more than you think.

Your maximum annual individual 401(k) plan contribution for tax year 2013 is $17,500, and you can also put $5,500 into an IRA for a total tax deductible contribution of $23,000. If you’re age 50 or older, you can contribute an additional $5,500 into your 401(k) and another $1,000 into your IRA this year.

If you’d like to see that sum disappear from this year’s Form 1040, you can still make contributions now, and label them retroactively as prior-year contributions.

Even if that’s too big a sum to come up with before April 15, you can contribute some portion of it and still lower your tax bill. You can also set a monthly schedule to get you closer to that maximum for next year.

Many of us are slow to start making the most of our tax-advantaged retirement plan options. Early on in our careers, there are always other things that seem to take more immediate priority: paying the monthly bills, saving for a first home … the list can go on. But the earlier you start saving for retirement, the more you can take advantage of compound interest--the tax savings you enjoy along the way are icing on the cake.

Step No.2: Organize Your Accounts for Tax Optimization

Locating the right assets in the right tax-advantaged vehicle help keeps more of your money working for your retirement and less going to the tax man.

Here’s how it works: Every investor has an “allocation” – a split between different equities, bonds and other asset classes like REITs and commodities. There are different tax implications for each asset class.

Let’s imagine you have an asset allocation of 60% equities and 40% fixed income. Does this mean that you should invest all your accounts – your 401(k) and your taxable brokerage account alike – along the exact same 60/40 proportions?

If you want to maximize your after tax returns, the answer is no. You don’t want the same 60/40 split for both accounts. Figure out which assets tend to generate higher taxes, such as bond funds, individual bonds or high-dividend common and preferred stock. Concentrate these exposures in your tax-advantaged accounts, while keeping a higher proportion of the high-growth and low-dividend assets (such as small-cap growth stocks) in your taxable brokerage accounts.

To be clear, we’re not saying that tax optimization should drive your asset allocation decisions. You should allocate based on your age, goals, and other important factors. But once you have figured out your ideal allocation, tax-optimizing your accounts is a critical source of additional savings.

Step No.3: Tax-Smart Investing

Here’s another tax-smart investment tip: Watch out for activity that could generate short-term gains. One common way this happens is from “churn”-the term applied when brokers trade in and out of positions over short time periods. In other words, if the investments inside your mutual fund are frequently traded, your returns may be hampered by “churn” and the tax cost associated with them.

Short-term capital gains (less than one year) are taxed at your individual income tax rate, while long-term capital gains are taxed at 20%. If you’re in the top income tax bracket, that amounts to a difference of 19.6% (the difference between 39.6%, the top income bracket, and 20%). Furthermore, churning your account -- processing trades -- results in additional commissions, which means it’s a double negative for you.

Churn is likely to be less of a problem if you are invested in ETFs or passive index funds, since there tends to be less turnover in strategies tied to an index benchmark.

Active funds, which often feature high turnover, need to generate returns in excess of their benchmark after additional taxes, commissions and the typically higher fund fees. Very few active funds can accomplish this successfully on a sustained basis. You might be able to reduce your tax liability by investing in passively-managed funds, like index mutual funds or ETFs.

A smart approach to taxes should be an integral part of your overall investment strategy. Remember, every dollar you can keep out of Uncle Sam’s pockets is one more dollar you can grow toward your long-term investment goals.

Jemstep is the leading online investment advisor that provides expert advice on how to invest your 401k and other retirement savings accounts. Based on Nobel Prize-winning economic research and patented portfolio optimization technology that reviews more than 38K mutual funds and ETFs daily, Jemstep delivers step-by-step guidance that is accessible, personalized and always unbiased. Jemstep works with employers and plan providers to give millions of Americans the investment advice they need to have a more secure retirement. A Registered Investment Advisor with the SEC, Jemstep is led by a team of experts with over 100 years’ combined experience in financial management and technology innovation and development. Learn more at Jemstep.com.