When we invest, we strive to maximize returns for our targeted level of risk. In that quest, a common oversight by investors is to focus on “return” and not after-tax return. After-tax return is the money you actually get to spend after you pay taxes on any gains or income received. Anytime you make money in the markets, the IRS is along for the ride and, if you live in a state with a personal income tax, the state will want their share as well. By employing a tax-wise, year-round investment strategy, you can keep more of what you earn.
Following are some best practices for maximizing your after-tax returns.
Think Ahead and Plan
Invest with a strategy in mind; don’t wing it. By clearly outlining what you intend to achieve with your assets, and how you intend to do it, you'll improve your chances of a successful outcome, and your tax strategy is an essential component of the planning process.
"If you don't know where you're going, you'll end up someplace else." – Yogi Berra
Maximize Tax Sheltered Accounts
With the passage of the SECURE Act and SECURE Act 2.0, the government has given you a host of ways to defer tax or pay no tax with respect to your retirement assets. The more money you can pack into IRAs, Roth IRAs, 401(k)s, Roth 401(k)s, 529 college savings plans, health savings accounts (HSAs), and more, the more opportunities you have to defer taxes, or eliminate taxes, as you build wealth.
Do Your Research
Assuming you have a globally diversified portfolio, you probably utilize several, or many, different investments. You have probably looked at your investment’s annualized returns, but when was the last time you looked at the investment’s after-tax return, if ever?
For example, not all mutual funds or Exchange-Traded Funds (ETFs) are created equal; some are significantly more tax-efficient than others. Two similar funds might have a 5-year annualized rate of return of 8%, but the after-tax return for one might be 7.4% and the other could be 6.5%, which is a 12% difference in relative terms!
When comparing funds, make sure you compare after-tax returns or the “tax cost ratio” to determine the tax efficiency of each investment.
Use Tax-Efficient Investments
Depending on your tax situation, here are some considerations for tax-efficient investments (this is not an exhaustive list):
Municipal Bonds: Municipal bonds are issued by a local government or its agencies. These can be powerful tools for those looking to avoid paying taxes on bond income as the interest paid is exempt from Federal income tax. Additionally, if the bond issuer is in your home state, you won’t pay state income taxes either. If the bond issuer is outside your home state, the income is still exempt from Federal taxes, but you will pay state income taxes if you live in a state that has a personal income tax.
Treasury Bonds: If bonds make up a portion of your portfolio, you may want to consider U.S. Treasuries as they are exempt from state income taxes (you still pay taxes on the Federal level). For those who live in a state with no personal income tax, this means little to you, but for those who live in states with a high personal income tax (California, Hawaii, New Jersey, etc.), this could amount to significant savings over time.
Qualified Dividends: If a fund pays ordinary dividends or ordinary income, that income will be taxed at your highest incremental tax rate, which is currently 37% at the Federal level for the highest earners. However, if a fund pays qualified dividends, the income receives preferential tax treatment and is taxed at the same rate as long-term capital gains, which for the highest earners is 20%. Depending on your income and your marital status, you may also be subject to the net investment income tax, which will add another 3.8% to your tax bill, but is still considerably lower than the rate for ordinary income. When researching funds, look to see if they pay ordinary dividends or qualified dividends.
Capital Gain Distributions: Fund managers often buy and sell securities throughout the year, which can lead to capital gains. Those capital gains are typically distributed to shareholders near the end of the year and can either be long-term capital gain distributions, taxed in the same way as qualified dividends mentioned above, or they can be short-term capital gains, which are taxed as ordinary income. Fund companies release guidance near the end of the year letting shareholders know if they expect to pay a capital gain distribution and if the distribution might be long-term, short-term, or both. Make sure to understand the tax implications of the distributions and factor them into your year-end tax planning.
Index Funds: Index funds, or passively managed funds, tend to be tax-efficient because trading is often minimal, while actively managed funds have a tendency to trade more often, which can generate more capital gains. Additionally, there are “tax-managed” funds that make it a primary goal to keep income and capital gains at a minimum. If you are sensitive to capital gain distributions, consider the tax efficiency of index funds or tax-managed funds.
Some investment accounts are more tax-efficient than others and some funds are more tax-efficient than others, so how do you arrange your investments in the most tax-efficient manner?
Asset location is a vital strategy that places your most tax-efficient investments into your taxable accounts and your least tax-efficient investments into your tax-sheltered accounts. It’s a simple concept, but the execution can be tricky.
Due to restrictions on the amount you can contribute to 401(k)s, IRAs, and the like, you can only cram so much money into tax-sheltered accounts. Given their limited space, start with the least tax-efficient investments (ones that generate the most ordinary income) and work your way down, leaving your most tax-efficient investments (think passively managed equities and tax-exempt bonds) for your taxable accounts.
An optimal asset location strategy should also take into account other tax-saving tactics such as the ability to harvest losses in taxable accounts to offset gains (discussed next), donating appreciated shares to charity for a tax deduction, taking advantage of a step-up in basis, or utilizing foreign tax credits. Paying close attention to asset location can save you a substantial amount of money in taxes over the long run.
If you have a diversified portfolio, chances are that at some point during the year at least one of your investments will be worth less than what you paid. If you sell that investment in a taxable account, it generates a capital loss that can be used to offset a capital gain, or even personal income, and potentially reduce your tax bill. This intentional loss can create significant tax savings if done correctly. However, the details of tax-loss harvesting can be complex, and close attention should be paid to ensure you don’t trigger the IRS wash-sale rule. Consulting an investment and/or tax professional would be a wise move to maximize the benefit of this strategy, as well as side-step any landmines.
Industry studies show the more you “tinker” with your portfolio, the more likely you are to underperform the market over the long run. Jumping in and out of the market, and from one investment to another, is not only likely to hurt your long-term performance, but it’s quite possible you’ll be adding to your tax bill. The more you trade, the more “opportunities” you create to be taxed on the gains.
Furthermore, if an investment is held for more than one year before it’s sold, the resulting gain will be taxed as a long-term capital gain. However, if you’re trading frequently and your holding period is less than one year, you will incur short-term capital gains which are taxed as ordinary income.
Lastly, it’s common for active traders to rack up losses. If you are incurring frequent losses, you can only deduct $3,000 a year in capital losses against your income, so substantial losses could take years to fully deduct.
Try to accomplish your investment strategy with as few trades as possible to limit tax consequences.
Tax-efficient investment strategies can add considerable value to your wealth, especially when combined into one all-encompassing plan. Although I hope to offer you ideas that you can apply to your investment portfolio, be sure to tread lightly as taxes are far from simple, and not one-size-fits-all. If you’re attempting to navigate the complex world of tax-efficient investment strategies on your own and find the process difficult or intimidating, be sure to seek the help of a professional who can help you create a plan tailored to your unique tax situation.
Tad Jakes, CFP®, EA