Minimizing Taxes on Your Investment Portfolio

Nobody likes paying taxes on the money they’ve worked hard to save and invest for their future. The taxes paid over a lifetime of investing can have a big impact on the amount of money that will be available to use for future spending and achieving goals, but commonly get overlooked when people are planning for retirement. Fortunately, you have many options to minimize the taxes on your investment portfolio. Some of them are so simple anyone can do them, while others are more complicated and may require the help of a professional.

The Easiest Options

Hold Tax Efficient Investments

Index funds generally have lower turnover than actively-managed funds which means fewer capital gains distributions and a lower tax bill. (For more, see: Investment Tax Basics for All Investors.)

You can also lower the amount of buying and selling that needs to be done in the management of your portfolio by holding fewer, more broadly diversified mutual funds rather than a whole bunch of less diversified niche funds.

If you are investing in a taxable account, find out if there are “tax-managed” or “tax-advantaged” versions of the same funds you are considering investing in. Tax-managed versions of funds usually hold almost identical investments as their counterparts, but are just managed in a way that considers taxes and aims to generate the best after-tax return possible.

Invest in a Traditional 401(k) or IRA

In a traditional 401(k) or individual retirement account (IRA) you invest before-tax dollars. That is, when it comes time to file taxes, the amount you contributed is deducted from income and lowers your tax bill. The proceeds grow tax deferred, but you eventually pay taxes on withdrawals at your ordinary income tax rate at the time of withdrawal.

Invest in a Roth 401(k) or IRA

In a Roth 401(k) or IRA you invest after-tax dollars (that you have already paid taxes on), your investments grow tax-deferred and if you follow all the rules you can withdraw the funds without having to pay taxes on gains. The original amount is considered return of principle so you don’t have to pay taxes on that either.

The Complicated Options

Strategic Asset Location

Asset location, the allocation of assets between taxable and tax-advantaged accounts, is another tool you can use to lower your taxes on your investment portfolio. You can minimize the impact of taxes on your portfolio by holding tax efficient, broad-market equity investments in taxable accounts and by holding taxable bonds and less tax efficient asset classes like REITs within tax-advantaged accounts. You may also want to consider holding the highest returning assets in a Roth IRA to maximize tax-free growth. (For related reading, see: Comparing Long-Term vs. Short-Term Capital Gains Tax Rates.)

Withdraw from Your Accounts in the Correct Order

Conventional wisdom suggests that it is best to withdraw funds from your accounts in the following order:

  1. Required minimum distributions (RMDs)
  2. Taxable accounts (personal brokerage accounts)
  3. Tax-deferred accounts (traditional 401(k)/IRA accounts)
  4. Tax-free accounts (Roth 401(k)/IRA accounts)

You take any RMDs from your accounts first because they are required to be taken by law. If you do not take them, you will receive a penalty of 50% of the required minimum distribution amount.

You would then withdraw from your taxable accounts before spending from your tax-deferred accounts because it lowers the amount of income taxes paid in the beginning years of retirement and enables as much of your portfolio as possible to continue to benefit from tax-deferred/tax-free growth.

However, this is one of those situations where conventional wisdom isn’t always the best strategy. It can lead to low taxes in the early years of retirement, but very high taxes at the end of retirement. If you’re in a low tax bracket (15% or below) in the early years of retirement, you may be better off taking a portion of your withdrawals from your IRA even if you have enough assets in taxable accounts to cover all of your spending needs. This allows you to pay taxes at your current low tax rate and avoid being taxed at potentially higher rates in the future. (For related reading, see: Minimize Taxes with Asset Location.)

The Very Complicated Options

Roth Conversions

You can take advantage of years when you’re in a low tax bracket by performing Roth conversions. This process involves converting some of the money in your traditional IRAs into a Roth IRA. You pay taxes on the amount you transfer now, but once the money is in the Roth IRA it will never be taxed again. In practice, it’s common to convert enough to create a taxable income equal to the threshold for the 10% or 15% marginal tax brackets. Performing Roth conversions allows you to take advantage of tax deductions that go away if you don’t use them. They can also reduce the risk of big RMDs in the future that could force you into a higher tax bracket.

Capital Gains Harvesting

In the early years of retirement if you are in the 15% ordinary income tax bracket or below, your capital gains tax rate is 0%. That means if you own an investment that has appreciated, you can sell it, pay no tax on the gains and buy the same investment again at a higher basis. Having this higher basis on the investment will lower your tax burden in the future. It is a good idea to take the step up in basis when possible if it costs you nothing in taxes now and saves you from having to pay taxes down the road.

Consider Your Unique Situation and Consult the Experts

I have outlined several strategies that can help reduce your tax bill, but it’s important to consider your individual circumstances when determining which strategies to implement. If you need help determining if one of these strategies is right for you, there are many professionals who can help you. It is without a doubt worth your time to give them a call and benefit from their expertise. (For more, see: A Beginner's Guide to Tax-Efficient Investing.)

Disclaimer: Everything mentioned in this article was for purely educational purposes and does not represent a specific recommendation for anyone. With all tax planning decisions you should consult a CPA or tax planning professional.