As a savvy investor, you work hard to make sure your investments are strategically positioned, are in alignment with your goals, and generate the returns you are targeting. However, it’s possible that taxes could be slowing the growth of your investments and diminishing your returns. While your investment strategy should not be formed solely around taxes, with some awareness and planning, you may seize opportunities to minimize the tax impact to your investments and boost your after-tax returns. Here are five best practices for more tax-efficient investing.
1. Make tax-conscious investment selection and asset location decisions
Understanding how different investments are taxed, as well as the taxation of the accounts that hold them, allows you to make tax-aware decisions for the types of securities in which you invest and where to locate them.
Some securities are more tax-efficient than others. Taxes are typically assessed upon the capital gains and income you receive from an investment. Thus, investments which generate fewer capital gains and income also have fewer immediate tax implications. Compare the tax profiles of different investment options:
- Actively managed funds, such mutual funds, tend to buy and sell securities more often, which generates more capital gains distributions and taxes. In comparison, passive funds, such as exchange-traded funds (ETFs) typically trigger fewer capital gains taxes.
- Municipal bonds are typically exempt from federal taxes, and often receive preferential state tax treatment as well. Meanwhile, real estate investment trusts (REITs) and traditional bonds are taxed as ordinary income, which is generally taxed at a higher rate.
Taxation also varies depending on the type of account in which the securities are held. Investment accounts can be classified into three broad categories of tax treatment:
- Taxable accounts are those that do not have any tax benefits, but typically offer fewer restrictions and more flexibility than tax-advantaged accounts. With a taxable account, you can withdraw your money any time, for any reason, without penalties. An ordinary brokerage account (that is not a retirement account) is an example of a taxable account.
- Tax-deferred accounts are a type of tax-advantaged account. If an account is tax-deferred, you get a tax break upfront and wait to pay taxes until you withdraw your money in retirement. Examples of tax-deferred accounts include individual retirement accounts (IRAs) and 401(k)s.
- Tax-free accounts are another type of tax-advantaged account. With a tax-free account, your contributions are made with after-tax dollars, and your investments grow tax-free; qualified withdrawals in retirement are tax-free as well. A Roth IRA is an example of a tax-free account.
If they could, most investors would opt to hold all their securities in tax-advantaged accounts. However, contribution limits and penalties that reduce flexibility make this an impractical asset location option for most investors.
Once you understand the taxation of different securities and accounts, you can form a tax-aware asset location strategy to help reduce the tax drag on your investments. It’s best for more active investments that distribute higher levels of short-term capital gains to be placed in tax-advantaged accounts, so capital gains taxes can be deferred or minimized. In other words, investments that are less tax-efficient (lose more of their returns to taxes) should be placed in tax-advantaged accounts, while tax-efficient investments may be placed in taxable accounts. Here is an example of a possible tax-aware asset location strategy:
Hold in tax-advantaged accounts:
- Individual stocks you intend to hold for one year or less
- Actively managed funds that generate significant short-term capital gains
- Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
- REITs
Hold in taxable accounts:
- Individual stocks you intend to hold for longer than one year
- Tax-managed stock funds, index funds, ETFs, low-turnover stock funds
- Stocks or mutual funds that pay qualified dividends
- Municipal bonds
2. Reconsider Your Holding Periods
The amount of time you hold an investment results in different levels of capital gains taxes. Thus, being mindful of holding periods when making the decision to sell can make a difference in your tax bill.
Securities held for less than 12 months before being sold are considered short-term capital gains and are taxed as “ordinary” income, with a rate between 10% and 37% (depending on your income level). Meanwhile, securities sold after being held for at least one year are taxed as long-term capital gains (called “qualified” income) at tax rates of 0%, 15% or 20%, depending on your income. While risk and return expectations should be factored into your buy and sell decisions, the difference in capital gains tax rates may make a long-term hold strategy worthwhile.
Not only are long-term capital gains rates lower than short-term rates, but because taxes are assessed upon realization, the longer you hold an investment, the longer you defer your capital gains taxes. Simply put, as long as you don’t sell, you won’t be liable for capital gains taxes.
3. Utilize Tax-Efficient Gain and Loss Harvesting
When it comes to investing, both gains and losses are inevitable, but can be proactively managed. It is important to identify which Federal tax bracket your capital gains will be taxed (i.e., 0%, 15% or 20%) and identify an efficient tax rate to target.
Gains are easy to harvest, as there are no special rules regarding how long you have to wait to repurchase the investment that was sold.
You may also consider using investment losses to your advantage through tax-loss harvesting, which allows you to write off realized losses against your realized gains—reducing your net capital gain (upon which you are taxed). The IRS allows you to claim up to $3,000 against taxable income in any tax year. If your net losses are greater than that, you can carry them forward to offset realized gains and income in future years.
If you anticipate realized gains, it may make sense to look for opportunities to realize losses so you can take advantage of tax-loss harvesting and reduce your tax bill. However, keep in mind the wash-sale rule—if you sell a security at a loss, you may not repurchase the same or substantially identical security within 30 days of the sale.
4. Maximize the Benefit of Charitable Gifting
The tax code provides incentives for charitable gifting—if certain requirements are met, you may deduct the value of your gift from your taxable income. Investors can take advantage of the charitable gifting provisions by donating highly appreciated securities from taxable accounts instead of cash. If you donate certain long-term appreciated assets, like stocks, mutual funds and cryptocurrency to a public charity, you may be entitled to a fair market value deduction for the gift. In addition, you avoid the significant capital gains taxes you would have incurred had you sold the highly appreciated assets instead. In this way, giving to others allows you to give back to yourself by reducing your tax burden.
5. Diversify Your Investments by Tax Treatment
Throughout your investing journey, you’ve likely heard that diversified investments are essential to your success. However, have you also considered diversifying by tax treatment? Using a combination of investment vehicles with varied tax treatments creates flexibility when it comes time to withdraw, leaving you with more options. Each year in retirement, you may assess your tax situation and withdraw income strategically to minimize the taxes you owe.
Helping You Get There…
It may often be difficult to determine which investment alternatives are most tax-efficient given your situation. Additionally, investors aren’t always focused on the taxation of their investments until after retirement, when it may be too late to make changes to reduce their tax impact. A trusted wealth management advisor can help ensure your taxes are being factored into your investment strategy and help you make tax-efficient investment decisions.
Boulay’s wealth management team is dedicated to helping you get there with our tax optimization and investment management services. To learn more, talk to one of our team members at Boulay Financial Advisors, LLC today at 952.893.9320 or learnmore@boulaygroup.com.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The services of an appropriate professional should be sought regarding your individual situation. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.