Tips for More Tax-Efficient Investing

This article was written by Todd Schanel, CFA, CFP® and Jackie Goldstick, CFP®.

An investment portfolio with a mix of stocks and bonds will produce three types of investment return: interest, dividends and capital gains. Added together, they make up what is known as “total return.” Inside an IRA or other qualified account, the relative mix of investment return does not matter. A 5% return is a 5% return, regardless of whether it comes from interest, dividends or capital gains. In a taxable investment account, however, the story is much different. (For related reading, see: Protecting Your Investments From Economic Storms.)

With a taxable investment account, taxes are generally due each year based on the interest, dividends and capital gains earned inside the account. However, each type of investment return is taxed differently. Interest income and short-term capital gains are taxed at a taxpayer’s “ordinary” income tax rate, while qualified dividends and long-term capital gains are generally taxed at a lower, preferential rate. In addition, unrealized gains are deferred. In other words, no capital gains tax is due as long as an investment is not sold. (For related reading, see: What Does Investment Diversification Really Mean?)

The table below summarizes taxes on investment income, in order from the highest to lowest tax:

Type of Investment Income

Tax Rate

Interest Income

Ordinary Income Tax Rate

Short Term Capital Gain 

Ordinary Income Tax Rate

Qualified Dividends

Zero, 15%, or 20%

Long Term Capital Gain

Zero, 15%, or 20%

Unrealized Capital Gain

Deferred

Knowing this, we can then design a tax-efficient investment portfolio accordingly. Portfolios can be weighted toward investments that generate returns through qualified dividends, long-term capital gains, and unrealized capital gains. Examples include broadly diversified index funds and passively managed stock mutual funds. These funds exhibit low turnover and produce much of their return in the form of deferred capital gains and qualified dividends.

In addition, we can avoid investments that produce higher levels of interest income and short-term capital gains. Examples include a portfolio of high-yield bonds or actively managed stock portfolios with high turnover and therefore high levels of short-term capital gains.

It is prudent to take tax considerations into account when constructing taxable investment portfolios. Depending on your tax bracket, the after-tax return on a tax-efficient portfolio can be significantly higher than on one where tax implications are not taken into account. (For related reading, see: What Does Good Financial Advice Look Like?)

 

Core Wealth Management is a Registered Investment Advisor in the State of Florida and is located at 4600 Military Trail, Suite 215, Jupiter, FL 33458, (561)491-0231. Investing in securities involves risk, including the potential loss of principal invested. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is not a guarantee of future results.