Tax Management Strategies
Taking advantage of tax-deferred accounts is a key step in building a tax strategy, but it’s only part of the story. You may have more opportunities for tax efficiency by being strategic about the accounts you use to hold the investments that generate the most taxes, choosing investments that may create less of a tax burden, and taking advantage of tax deductions to reduce your overall bill.
Taxes are an important factor in an investing strategy, but they certainly aren’t the only factor. The potential tax benefits of any strategy need to be viewed in the context of your overall investing plan. That said, there are some choices that can have a potential impact on your tax bill.
Match Tax Management Goal with Tax Efficient Product
An asset location strategy may sound complex, and it can be, but the basic idea is straightforward: Put the investments that may generate the most taxable income in accounts that provide tax advantages. Tax-efficient assets, like municipal bonds, stock index ETFs, or growth stocks you hold for the long term, may generate relatively small tax bills and may make more sense in a taxable account.
On the other hand, relatively tax-inefficient assets such as taxable bonds, high-turnover stock mutual funds, or real estate investment trusts (REITs) may be better kept in tax-advantaged accounts like 401(k)s, IRAs, and tax-deferred variable annuities. Of course, you also need to consider your overall asset allocation, the account rules, the potential tax implications of making changes, your investment horizon, and other factors before making any changes.
In general, the less tax efficient an asset is, the more you may want to consider putting it in a tax-advantaged account like a traditional IRA, 401(k), deferred variable annuity, or Roth IRA or 401(k).
Investments that generate less income reduce taxes
For taxable accounts, you want to factor in the potential tax implications of your investments. Passively managed ETFs and index funds have major tax advantages compared with actively managed mutual funds. Actively managed mutual funds typically make more capital gains distributions than passive funds because of more frequent trading.3 Moreover, in most cases, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas actively managed mutual funds pass on taxable gains to investors throughout the life of the investment.
Beyond choosing between ETFs, index funds, or actively managed funds, consider a tax-managed mutual fund or separately managed account. These investments try to take advantage of tax lots and purchase dates, gains, and losses to manage the tax exposure of the portfolio. In some cases, managed accounts may be personalized to certain aspects of your tax situation.
Don’t Miss The Tax Deadlines!
A good tax strategy requires timing. If you are considering investing in a mutual fund for your taxable accounts, you may want to consider the distributions history of that fund. Mutual funds are required to distribute at least 90% of net investment income and 98% of net capital gains income every year, and investors are likely to incur a tax liability on the distribution. It doesn’t matter whether you have owned the fund for a year or a day, if you own it when it makes a distribution, you are obligated to pay taxes. To avoid this potential tax liability, pay close attention to the distribution schedules for any funds you own—and if you have the ability to be flexible, you may want to avoid purchasing fund shares just before the distribution date.
If you are thinking of selling a fund just before the distribution, you may also want to reconsider. The downside of selling funds in an attempt to avoid a distribution is that depending on how much you paid for your shares, you could generate a significant capital gain—and the tax bill to go with it. So you need to factor in the potential tax impact of your decision against other criteria, including your asset allocation strategy and market outlook.
You also need to be aware of how long you hold an investment. If you sell a fund or security within one year of buying it, any gain could be subject to short-term capital gains rates, currently as high as 39.6% at the federal level—and some high earners may be subject to the 3.8% Medicare surtax as well. You can qualify for a lower rate on gains by holding assets for more than a year—the highest federal rate for long-term capital gains is 20%, plus an additional 3.8% if you are subject to the Medicare surtax. (Note: this discussion does not reflect state taxes). Timing means a lot to gains and losses in investing.
Reduce Taxes By Offsetting Gains With Losses
If may sound counter-intuitive, but realizing losses are sometimes a tax strategy. The stock you own that continues to tank? Consider letting it go, and the capital loss with offset the gains. Tax-loss harvesting is when you sell an investment in a capital asset like a stock or bond for a loss and use that loss to offset realized capital gains from other securities or other income. While you shouldn’t let tax decisions drive your investing strategy, tax-loss harvesting can be a powerful way to help you keep more of what you earn. Each taxpayer is allowed to use capital losses to offset capital gains, and can use any remaining losses to offset up to $3,000 of ordinary income each year. Any losses not used in a given tax year can be carried forward and used in future years. So selling losing investments and using those losses to offset gains can be used to reduce your tax bill. The strategy is typically most effective during volatile markets, especially during downturns.
Tax-loss harvesting may feel counterintuitive, because the goal of investing is to make money, not to lose it. But everyone experiences investment losses from time to time, and if handled properly and consistently, this strategy can potentially improve overall after-tax returns. The challenge is that a systematic tax-loss harvesting strategy requires disciplined trading, diligent investment tracking, and detailed tax accounting.
Reduce Taxes Through Charity
Giving to charity may not be the path to greater material wealth, but the use of charitable deductions can be a powerful part of a tax strategy for those who were planning to make donations. This can help with all kinds of tax strategies, from offsetting Roth IRA conversions to complex strategies such as charitable lead or charitable remainder trusts.
One way to make the most of charitable giving is to donate securities that have increased in value. You may donate the securities directly or use a donor-advised fund—these funds let you take an immediate tax deduction and then give you the opportunity to make grants to different charities later. Donating appreciated securities lets you avoid paying capital gains tax or the Medicare surtax, allowing you to donate more to charity compared with selling the stock and then donating the proceeds.
Many investors with stocks that have significant gains are worried about the capital gains tax bill they may see down the road. If those investors are planning to make charitable contributions, donating securities with significant capital appreciation to charity may help them reduce their capital gains tax.