Who among us hasn't wanted to avoid taxes? In some European countries, "how to pay less in taxes" has become a national sport. Jokes aside, taxes are important: someone has to pay for schools, hospitals, and roads. The good news is that you don't have to do anything immoral or illegal to optimize your taxes.
As investors, we have many options: which index funds to buy, when to buy or sell them, which brokerage account to choose, and so on. Different decisions lead to different tax consequences. Reducing or deferring taxes is perfectly acceptable. Moreover, many countries have developed tax rules specifically to encourage responsible long-term investing.
Tax Optimization: Where to Start
To legally optimize your taxes, you need to minimize the impact of the most common tax triggers. In particular, it's important to reduce capital gains taxes and dividend taxes. Let's break them down one by one.
Capital Gains Taxes
If you do not live in a country with taxes on deemed capital gains (such as Denmark), the tax is only levied when you sell investments at a profit. Therefore, one of the best ways to minimize tax is to not sell your investments too often. This may seem obvious, but in practice, it is one of the most important strategies for a long-term investor. The less often you sell assets, the fewer capital gains taxes and brokerage fees you will have to pay.
Example: Imagine you invested 10,000 euros in an IT company's shares, and after a couple of years, their value grew to 15,000 euros. If you decide to sell these shares and the capital gains tax rate is 20%, you will pay 1,000 euros in taxes, leaving you with 14,000 euros. You then decide to invest these 14,000 euros in other shares, but unfortunately, they lose half of their value over three years. In the end, you are left with 7,000 euros—your capital has decreased by 3,000 euros in five years, and the taxes you paid are non-refundable. Frequent buying and selling of shares can lead to potential losses due to taxes, which emphasizes the importance of a long-term holding strategy to minimize the tax burden.
Another strategy during portfolio rebalancing could be to avoid realizing gains on successful stocks and instead sell those that have decreased in value. This allows you to use losses to offset gains and reduce your tax burden. It should be noted that selling loss-making assets is a tactical move, unlike long-term holding of profitable stocks. Different strategies are used depending on optimization goals.
Dividend Taxes
To optimize dividend taxes, you can use accumulating funds, where dividends are not paid out but reinvested into the fund. Additionally, if you have the opportunity to invest in funds registered in jurisdictions with more favorable tax conditions, such as Ireland or Luxembourg, this can help minimize dividend tax payments. This is especially useful if your investments are subject to so-called withholding taxes.
Tax Savings Opportunities
In some countries, there are special tax benefits for pension funds or tax-advantaged investment accounts, such as an Individual Savings Account (ISA) in the United Kingdom or tax benefits for individual pension accounts in some EU countries. This is an excellent opportunity for investors to reduce their tax burden, and it is worth carefully studying which options are available in your country. Sometimes, you can also take advantage of holding period benefits: for example, in some countries, such as Germany, if you hold investments for more than ten years, capital gains may not be taxed at all.
General Recommendations
- Do not sell investments too often.
- Use the tactic of loss realization to reduce tax burden when rebalancing is necessary or when funds are needed.
- Build a simple portfolio to minimize the need for frequent rebalancing.
- Use accumulating funds if possible.
- Study tax treaties and opportunities for obtaining tax benefits.
- Always adjust your strategy according to local tax laws.
Please note that only basic principles and core ideas are considered here, which may or may not be applicable in your country and to your specific situation. In general, taxes may seem like a complex topic, but a proper approach to optimization can significantly increase your investment returns. If it is difficult for you to understand all the nuances yourself, do not hesitate to seek professional advice! In most cases, a tax-optimized portfolio will more than cover any consulting costs.
