This is the eighth installment in our series on how individual investors can assess their financial health
With investment gains, as with other types of income, it’s not how much you make that ultimately matters, but how much you keep. In other words, you only get to spend what's left after you pay taxes. There are various ways to make your investments tax efficient, and it’s crucially important that you know what they are.
To make sure you don't incur an excessive tax bill from your investing, take the following steps:
- Avoid realizing short term capital gains.
- Make full use of tax-advantaged accounts.
- Harvest your losses.
- Match assets to account type.
- Choose tax efficient mutual funds.
Avoid Realizing Short Term Gains
Selling an investment that you have held for less than a year at a profit triggers short term capital gains, and the tax rate for short term gains is markedly higher than for long term gains. Short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. The difference between the tax rate on your long term versus short term gains depends on your tax bracket, but it is usually sensible to hold investments for at least a year, although this must be considered in light of the need to rebalance.
Make Full Use of Tax-Advantaged Accounts
There are a number of types of investment accounts that have tax advantages. There are IRAs and 401(k)s, which allow investors to put in money before taxes. These accounts allow you to defer taxes until you retire, whereupon you will be taxed on the money that you take out. By paying taxes later, you get what amounts to a zero interest loan on the money that you would ordinarily have paid in taxes.
Another alternative is Roth IRAs and Roth 401(k)s. In these accounts, you put money in after tax, but you are not taxed on the future gains. If you have concerns that tax rates will be higher in the future, the Roth structure allows you to essentially lock in your total tax burden.
529 plans for college savings have tax advantages worth considering. While you pay taxes on 529 contributions, the future investment gains are not taxes at all as long as the money is used for qualified educational expenses. There may also be additional state tax incentives offered to residents, depending upon your home state.
Harvest Your Losses
If you make a profit by selling a security, you will owe taxes on the gain. However, if you sell security in a taxable brokerage account at a loss, the loss can be used to offset realized gains and can even offset up to $3,000 in ordinary income. If you then wait more than a month, you can buy the same position in the losing security and have reduced or eliminated your tax bill on the gain simply by selling the losing position and then waiting more than a month before buying that security back. Alternatively, you might buy another similar security to the one that you took a loss on and then you don't have to wait a month. The key in this latter approach is that you can buy a similar but not functionally identical security if you want to take a loss and then immediately buy another security back.
It should be noted that tax loss harvesting does not eliminate taxes, but defers them into the future. In general, paying taxes later is preferable to paying them today.
Matching Assets to Account Type
Different types of investment assets have different tax exposure, so it makes sense to put assets into the types of accounts in which taxes are lowest. This process is sometimes referred to as selecting asset location. Actively managed mutual funds are most tax efficient in tax deferred accounts, as are most types of bonds and other income producing assets. The exceptions are those asset classes that have special tax benefits. Income from municipal bonds, for example, is not taxed at the federal level and is often also tax free at the state level. Holding municipal bonds in tax deferred accounts wastes these tax benefits. Qualified stock dividends are also taxed at rates that are lower than ordinary income, so qualified dividend-paying stocks typically make the most sense in taxable accounts. Real estate investment trusts, on the other hand, are best located in tax deferred accounts because they tend to generate fairly high levels of taxable income.
Choose Tax Efficient Mutual Funds
When mutual fund managers sell holdings at a profit, fund investors are liable for taxes on these realized gains. The more a fund manager trades, the greater the investor’s tax burden is likely to be. Even if you, the investor, have not sold any shares of the fund, the manager has generated a tax liability on your behalf. It is even possible for investors holding fund shares that have declined in value to owe capital gains taxes that result from one or more trades that the manager executed. You can minimize this source of taxes by either investing in mutual funds only in tax deferred accounts or by choosing funds that are tax efficient. Index funds tend to be very tax efficient because they have low turnover. There are also funds that are managed specifically to reduce the investor’s tax burden. One academic study found that funds engaged in tax efficient practices generate higher returns than peers even on a pre-tax basis.
Don't Pay More Tax Than You Have To
Everyone needs to pay their fair share of taxes. But if you manage your investments with a consideration of tax consequences, you can avoid paying more tax than is required. If the various considerations outlined here seem too complicated, a simple allocation to a few index funds will tend to be fairly tax efficient. That is a reasonable place to start.
An old adage about tax planning is that a tax deferred is a tax avoided. In general, the longer you can delay paying tax, the better off you are. The various forms of tax deferred savings accounts are very valuable in this regard.
While it is more interesting looking for productive investment opportunities, spending a little time understanding how to minimize your tax burden can help to ensure that you actually get to spend the gains that you make.
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