
Taxes can be one of the biggest hindrances to investment returns, so understanding how to minimize federal income tax liabilities through asset selection, location selection and tax-loss harvesting strategies will help increase after-tax returns.
Your investment decisions should always take your goals, financial situation and timeline into consideration, but factoring taxes into your calculations can help build wealth faster.
Tax-Advantaged Accounts
Taxes shouldn’t dictate your investment decisions, but carefully evaluating asset classes and accounts can help you devise a plan to manage, defer and lower federal income taxes. Selecting tax-efficient investments like municipal bonds and index funds can lower the tax burden while keeping more of your returns in your pocket. Rebalancing portfolios using tax-advantaged accounts using strategies like selling appreciated assets to reduce liabilities may also lower liabilities.
Understanding how your taxes impact investments is vitally important if you’re saving for retirement, generating income or building wealth. While selection and asset allocation often garner most of the focus of investors, tax efficiency should also play a vital role. Acting tax efficiently can help you meet your financial goals faster while enjoying after-tax returns that exceed expectations. 1. IRAs, 401(k)s, 529 Plans and HSAs all offer tax advantages by deferring or eliminating taxes on gains made in investments.
Tax-Inefficient Accounts
Investment choices and account types can have a dramatic effect on investors’ post-tax returns. Therefore, tax planning must form part of any holistic financial plan.
Tax-efficient investing can boost savings efforts by decreasing the burden of taxes on returns. Individuals can lower their tax liability by increasing retirement contributions, contributing to health savings accounts (HSAs) or selling tax-inefficient assets from taxable accounts.
Municipal bonds, which tend to be more tax-efficient than bond index funds, should be moved from taxable accounts into tax-advantaged ones and stocks should move the other way. Low turnover equity funds that do not pay dividends but can take advantage of long-term capital gains treatment can also help lower taxes; before making these moves it’s important to carefully consider their effect on risk exposure and discipline as it could take a while before any benefits from tax-efficient strategies manifest themselves in taxes saved.
Tax-Loss Harvesting
The IRS allows investors to offset investment gains with investment losses up to an annual limit of $3,000 or $1,500 for married filing separately filing status. Any excess losses can also be carried forward to future tax years.
However, this strategy must be used with care. For instance, the “wash sale rule” states that selling at a loss and then purchasing substantially identical securities immediately thereafter may incur trading costs such as commissions and bid/ask spreads that reduce any potential tax benefit.
Tax-loss harvesting can be a complex and time-consuming process, which is why you should always consult with a financial advisor to make sure that the strategy you employ aligns with both your risk profile and long-term goals.
Asset Allocation
While tax-efficient investing shouldn’t dictate investment selection or asset allocation decisions, keeping taxes in mind can help reduce tax drag and maximize how much money remains after taxes have been deducted.
Be mindful that when making any changes that could have an impactful tax impact, consulting a financial planner or certified investment advisor first is always advised. They can keep abreast of ever-evolving tax laws while creating tailored strategies tailored specifically for you and your financial profile.
If you have significant investment losses, selling them off may help offset some of your tax liability. But before doing this, review your asset allocation plan to make sure you have an appropriate mix of stocks and bonds in each account type. Your location of investments can also make a big difference in their after-tax returns, so reviewing them from a tax-efficient perspective is also recommended; holding tax-efficient assets such as municipal bonds that generate tax-free income within taxable accounts while more tax inefficient assets such as actively managed stock funds should be held within tax-advantaged ones for optimal tax efficiency.