While tax issues should not be the driver in your investment strategy, managing taxes on your investments can help maximize your portfolio’s total return. There are a number of tax-smart tactics investors can use to manage the tax bite on their investments.
This is an area where a knowledgeable financial advisor can add value to clients in terms of investment tax management in the context of a properly managed portfolio.
Here are some ways investors can manage the tax hit on their investments. (For related reading, see: Tis the Season for Tax-Loss Harvesting.)
Tax-loss harvesting involves selling investments held in a taxable account with an unrealized loss in order to realize that loss. While this is often done near year end, you can do it anytime. A major reason to use this tactic is to offset capital gains on other taxable investments generated either via the sale of the investment vehicle or capital gains distributions received from mutual funds or ETFs.
Capital gains can either be long-term or short-term in nature depending upon the holding period of the investment. When figuring out net gains and losses, there is a matching process that occurs. First is matching gains and losses of a like nature against each other and going on from there. To the extent that losses exceed net gains, an additional $3,000 can be used to offset other income.
In going this route, it is important not to let the prospect of tax savings motivate you. Rather, it should be done for investment specific reasons first.
Asset location refers to which types of accounts you use to hold certain investments. For example, taxable accounts might be preferable for:
- Individual stocks that you plan to hold for more than a year in order to get the preferential capital gains tax treatment if sold for a gain.
- Tax-managed mutual funds and ETFs.
- Stocks, ETFs and mutual funds that pay qualified dividends with their preferential tax treatment.
- Municipal bonds (including mutual funds and ETFs), individual bonds and savings bonds. (For related reading, see: Minimize Taxes with Asset Location.)
Tax-deferred accounts such as a traditional IRA might be preferable for:
- Individual stocks that will be held for less than one year in order to avoid the higher short-term capital gains rates if sold for a gain.
- Actively-managed mutual funds or ETFs that tend to generate a high level of short-term capital gains.
- Bond mutual funds and ETFs such as taxable bond funds, high yield bond funds and TIPs funds. Zero coupon bonds are also a good candidate for tax-deferred accounts.
- Real estate investment trusts (REITs).
This is an optimal strategy in general, but each investor’s situation and his or her ability to carry this out varies. Knowledgeable financial advisors can assist clients in optimizing asset locations.
Tax diversification refers to the ultimate taxation of the money when withdrawn from the account. Money in a taxable account is taxed based upon whether there is a gain or loss on the investment in question and the time the investment has been held. There are preferential tax rates for long-term capital gains, which refer to investments that have been held for at least a year and a day.
Money in tax-deferred retirement accounts such as a traditional IRA, a 401(k) plan or a similar employer-sponsored plan grows tax-deferred, but it is taxed at the investor’s ordinary income tax rate when withdrawn. There are no preferential rates for capital gains and capital losses cannot be deducted.
Tax-free accounts such as a Roth IRA allow for tax-free withdrawals once you have reached age 59.5 and have had a Roth account in place for at least five years.
When combined, tax diversification and asset location can help investors go a long way towards optimizing their investing tax decisions. (For related reading, see: Why Doing Your Taxes is Good Retirement Planning.)
In general, passively-managed index mutual funds and ETFs are more tax-efficient than actively-managed funds. By their nature, actively-managed funds will usually have more turnover during the year, which often results in capital gains. Long-term capital gains are at least taxed at preferential rates. Very active funds may also generate a high level of short-term capital gains, which are taxed at higher ordinary income tax rates.
Smart beta ETFs are based upon slices of popular indexes like the S&P 500. However, these slices — or factors — can cause more frequent trading to rebalance back to this contrived benchmark resulting in higher capital gains distributions that your typical index mutual fund or ETF.
One of the most tax-efficient ways to make a charitable donation is to give appreciated securities such as individual stocks, ETFs and mutual funds. Many charities are equipped to accept gifts in this format and major custodians can help you facilitate your donation. As long as the security has been held for at least a year and a day, you will receive credit for the donation as the market value of the security on the date of the transfer to the charitable organization. Besides the charitable tax deduction, there are no taxes on the capital gains on the security.
If you are charitably inclined and would otherwise give such a donation in cash, consider this more a tax-efficient method. (For related reading, see: Choosing the Best Charitable Gift Annuity.)
This can also be a tax-efficient method to rebalance your taxable account in that you can choose a security in an asset class that needs to be pared back in order to bring your portfolio back in balance. You'll suffer no tax consequence on this transaction.
Rebalancing your portfolio is not a tax strategy in and of itself. However, when tactics such as using appreciated securities for charitable giving, asset location, tax diversification and tax-loss harvesting are used as part of the rebalancing process, it can really help investors minimize the tax bite while not deviating from the overall investment strategy.
This is an area where a skilled financial advisor can add real value to their clients. Helping clients design a portfolio suited for their needs and objectives is a skill unto itself. Doing this and helping clients minimize the tax hit from their investing activities can add even more to their investment returns.
The Bottom Line
The first priority in any investing moves should be investment related and not based upon tax considerations. That said, an investment plan that helps clients minimize the related tax hits adds even more value for them. (For related reading, see: Tax Tips for the Individual Investor.)