Tax season can be a daunting period of time for avid investors. Not only does it involve gathering various statements and paperwork, but you are also tasked with managing the ever-changing tax codes. Minimizing the taxes you owe on investment gains and income can allow you to keep more of your money and maximize your overall returns.
If you are looking for ways to reduce your tax burden, there are a variety of different strategies you can implement into your portfolio including exchange-traded funds (ETF’s), municipal bonds or funds, and the use of tax-advantaged accounts. As always, we recommend working with a CPA or tax professional for the best course of action.
The Importance of Tax Optimization in Investment Portfolios
Before going into tax optimization strategies, it is crucial for you as an investor to understand the basics of taxes on your investment account. Taxable accounts like brokerage accounts or individual retirement accounts (IRAs) are subject to taxes on investment gains and income.
The specific tax treatment on the accounts will depend on factors such as the type of account, holding period of the investment, and the investor’s tax bracket.
Some of the common taxes you may face as an investor may include:
Capital Gains Tax
Capital gains tax is the tax assessed on the profits earned from the sale of an investment. Short-term capital gains, which are investments held for less than a year, are taxed at the investor’s normal income tax rate. Long-term capital gains, which are investments held for more than a year, are subjected to a lower tax rate.
Dividends are a sum of money paid regularly by a company to its shareholders out of its profits or reserves. Dividends earned from investments are subject to income tax. The tax rate will depend on the investor’s tax bracket.
Interest Income Tax
Interest earned from bonds and other fixed-income investments is subject to income tax. Like other tax burdens, the rate will depend on the investor’s tax bracket.
Tax-Efficient Investment Strategies
A major part of your portfolio’s tax burden can be contributed to the structure and strategies you implement within it. There are a variety of strategies and resource allocations designed to help reduce the taxes placed on your gains or income.
Let’s take a look at some of the common forms of tax reducing strategies for investment accounts, again, a tax professional can help identify which strategy is best for you.
Tax Efficient Investments
One strategy to reduce taxes on your investment portfolio is to invest in tax-efficient investments such as index funds, exchange-traded funds (ETFs), and municipal bonds or funds. These types of funds can lower your tax burden and increase your overall return.
One thing you will want to distinguish is your passive and active strategies. Passively managed funds are typically associated with lower turnover rates. Turnover rates are a metric of how frequently a fund replace its holdings.
Actively managed funds tend to be associated with higher turnover rates due to the frequency of trade. More trading in an effort to beat the market can result in capital gains that are subject to taxes.
On the other hand, a passive fund’s main agenda is to duplicate the market by mirroring the holdings of its benchmark. This means the fund does not need to be traded as frequently.
Exchange traded funds minimize the capital gains that are distributed due to trading. Due to a structural ability, capital gains distributions from equity mutual funds are typically twice as high as ETF capital gains.
Tax-efficient funds are designed to generate fewer taxable events like capital gains or dividends. Fewer taxable events allow you to reduce the taxes you owe on your investments over time. Be sure to consult with a financial advisor to make sure these funds support your goals and risk tolerance as well.
Another key strategy you can implement into your portfolio to reduce taxes is the use of tax-advantaged accounts versus taxable accounts. Accounts such as a Roth, IRA, or 401k would be considered tax-advantaged accounts. Your individual brokerage account would be considered a taxable account.
The benefit of utilizing tax-advantaged accounts like an IRA is the amount of taxes you are subject to pay before you withdraw your money. Take a Roth account for example. Since the account is funded with after tax income, you are eligible to realize tax free growth and tax-free withdrawals.
Identifying the option that is more beneficial to you will depend on your current and expected future tax brackets. By personalizing your strategy to your specific situation, you can minimize your tax obligation.
Additionally, contributions to a 401k or IRA are tax-deductible. This means you will not pay taxes on the money allocated to these funds until you withdraw your money.
A well-known strategy in investing, tax-loss harvesting can also be utilized to reduce your overall tax liability. This strategy involves selling underperforming investments to offset realized gains from other investments that have exceeded performance expectations.
Tax-loss harvesting is optimal in portfolios with a combination of positive and negative investment gains. This strategy is typically implemented into taxable investment accounts.
By selling a stock that has decreased in value since you purchased it, you can offset gains from other investments by utilizing the loss.
A key factor to consider when implementing a tax-loss harvesting strategy is the compliance with the IRS wash sale rule. The wash sale rule prohibits an individual from buying back the same or substantially identical investment within 30 days of selling it. If you are found to be in violation of this rule, you will not be able to utilize the loss to offset other gains.
Tax-harvesting can be a powerful tool for reducing tax liabilities on taxable investment accounts. It is not a solution to all taxation liabilities, however. It is important to consider the overall performance of your investments to make sure you are not sacrificing long-term gains for short-term tax savings.
Proactive tax planning year-round can help offset hefty tax obligations. By discussing the potential use of the strategies described above with your financial advisor and tax professional, it is possible to mitigate some of your tax burdens from investing. In addition, Fragasso Financial Advisors, long withstanding Pittsburgh financial advisors, recently published a blog post on the power of tax-efficiency, providing valuable insights into this important topic. So, if you want to keep learning more on this topic so you can keep more of your wealth and avoid unnecessary taxes, be sure to check out the informative blog post from Fragasso Financial Advisors.
Investment advice offered by investment advisor representatives through Fragasso Financial Advisors, a registered investment advisor.
Review Optimizing Your Portfolio to Reduce Taxes.