Investing tax-efficiently

Some investors spend hours researching stocks, bonds, and mutual funds with good return prospects. They go out their way to read articles, watch investment shows, and ask others for help and advice. Many of these investors can be overlooking another way to maximize  their returns, tax efficiency. 

Investing tax-efficiently doesn’t have to be complicated, but it does take time and planning. Taxes should never be the primary point of an investment strategy, but having a good tax awareness does have the potential to improve your returns.

Morningstar estimates that a typical investor gave up an average of 1% to 2% of return per year to federal income taxes for the 93 years from 1926 to 2018. Let’s say a portfolio could earn 8% per year instead of 6%, that extra return of 2% per year on a hypothetical portfolio of $100,000 could result in an additional $1 million after 40 years. This can be the best investment decision you have ever made. 

There are several things you need to in order to manage federal income taxes: choosing accounts, take advantage of losses, selecting investment products, timing of buy/sell decisions, and specific strategies such as charitable giving. This can all be pulled together to help you manage and reduce taxes.

Investment decisions should be driven by your goals, time, risk tolerance, and financial situation. Factoring in federal income taxes can help you build wealth faster.

Manage your taxes

The decisions you make when you buy and sell investments can impact your tax burden. Consider using these concepts in your portfolio management process.

Tax losses: A loss on the sale of security could be used to counterbalance any investment gains, and then up to $3,00 in taxable income annually. Some tax-loss harvesting strategies attempt to take advantage of losses for their tax benefits, but always make sure to comply with IRS rules on wash sales and the tax treatment of gains and losses.

Loss carry-forwards: In some instances, if your realized losses go over the limits for deductions in the year they occur, the tax losses can be “carried forward” to counterbalance future realized investment gains. All gains and losses are on paper only until you sell the investment.

Capital gains: Securities held more than a year before being sold are taxes as long-term gains/losses with a top federal rate of 23.8%. Being aware of holding periods is an easy way to avoid paying higher tax rates. Taxes are only one consideration. It’s also important to consider the return expectation and risk for each investment before trading.

Fund distributions: Mutual funds distribute earnings from dividends, interest, and capital gains every year. Shareholders are likely to incur a tax liability if they own the fund on the day of record for the distribution in a taxable account, regardless of how long they have held the fund. Mutual fund investors are thinking of buying or selling a fund should consider the date of the distribution.

Tax-exempt securities: Tax treatment for different types of investments varies. For instance, municipal bonds are exempt from federal taxes, and sometimes receive preferential state tax treatment. On the other side of the spectrum, real estate investments trusts and bond interest are taxed as ordinary income. Investors may want to consider the role of qualified dividends as they weigh their investment options. Qualified dividends are subject to the same tax rate as long-term capital gain, which they are lower than rates for typical income.

ETF selection or Funds: Mutual and exchange-traded funds vary in terms of tax efficiency. Passive funds tend to make fewer taxes than active funds. Most mutual funds are actively managed, most ETFs and index mutual funds are passively managed. There can be significant variation in terms of tax efficiency in these categories. Consider the tax profile of a fund before investing.

Defer taxes 

The biggest tax benefit available to most investors is the ability to defer taxes offered by a retirement savings account, such as 401(k)s, 403(b)s, and IRAs. If you’re looking for additional tax-deferred savings, you may want to consider tax-deferred annuities, which does not have any IRS contribution limits and aren’t subject to required minimum distributions. Deferring taxes can help grow your wealth faster by keeping more of it invested and potentially growing.

Reduce taxes 

The U.S. tax code provides incentives for charitable gifts. If you itemize taxes, you can deduct the value of your gift from taxable income. These strategies can help you maximize giving:

Contribute appreciated stock instead of cash:

Donating long-term appreciated stocks/mutual funds to a public charity makes you generally entitled to a fair market value deduction, and you may be able to eliminate capital gains taxes. Together, that can enable you to donate up to 23.8% more than if you had to pay capital gain taxes.

Contribute privately held business interests of real estates: 

Donating a non-publicly traded asset with unrealized long-term capital gains also gives you the chance to take an income-tax charitable deduction and remove capital gains taxes.

Accelerate your charitable giving with a donor-advised fund:

You can counterbalance the high tax rates of a high-income year by making charitable donations to a donor advised fund. If you want keep giving to charity, consider contributing multiple years of your charitable contributions in the high-income year. By doing this, you maximize your tax deduction when your income is large, and will then have money set to the side to continue supporting charities for future years.

Roth Conversions

Instead of deferring taxes, you can accelerate them by using a Roth account

529 saving plans

The cost of education for a child can be one of your biggest expenses. Similar to retirement, there aren’t shortcuts when it comes to savings, but there are options that can help your money grow tax-efficiently. 529 accounts will allow you to save after-tax money, but getting tax-deferred growth potential and federal income tax-free withdrawals when used for qualified expenses including college and, from 2018, also up to $10,000 per student per year in qualified K-12 tuition costs.

Health savings accounts

Health savings accounts help you save for health expenses while in retirement. These accounts have the potential for a triple tax benefit, you may be able to deduct current contributions from your taxable income, your savings can grow tax-deferred, and you may be able to withdraw your savings without tax, if you use it for qualified medical expenses.