Tax Management: 4 Key Areas for Investors

in Investing, Personal Finance Essentials by

Improper tax management can cost you more than a quarter of your long-term return, severely limiting spending power in retirement. The good news is that taxes can be managed. There are four key areas where investors can place their tax focus:

Tax Efficiency

Thousands of potential investment vehicles exist today, each with radically different tax implications. Choosing and using tax-efficient investments is a vital first step toward keeping more of your money. Here are some general guidelines when it comes to common investment vehicles:

  • MUTUAL FUNDS are notoriously bad in terms of tax management.
  • EXCHANGE TRADED FUNDS (ETFs) are generally more tax efficient than mutual funds.
  • INDIVIDUAL STOCKS can be the most tax-efficient way to gain exposure to equities.
  • BOND ETFs and passive bond mutual funds are generally more tax efficient than actively managed bond mutual funds, but the tax treatment of income generated from bonds differs from that of equities.
  • REAL ESTATE INVESTMENT TRUSTS (REITs) dividends are generally taxed as ordinary income to shareholders.

Tax Location

If you have multiple investments, do you consider the most appropriate account for each of your assets? If not, you should. Each of your accounts has unique tax characteristics, and if you understand these characteristics, you can place your assets in the most advantageous accounts, thereby minimizing your tax liabilities. This is called tax location. Depending upon the underlying characteristics of the investment, strategically placing it in either a taxable, tax-deferred, or tax-exempt account may improve your annual return.

So what securities go where? One general rule is to place high-yield stocks in tax- deferred or -exempt accounts, like IRAs and Roth IRAs, and low-yield or no-yield
stocks in taxable accounts. Fixed income investments are a little trickier. It’s good to keep in mind, optimizing around long-term growth rates and tax rates can get very complicated, so you should consult a professional.

Tax Loss Harvesting

Tax loss harvesting is the process of intentionally realizing losses to offset realized gains. It’s slightly counterintuitive — after all, you’re supposed to sell high, right? But the idea is not to eliminate exposure entirely; it’s only a temporary sale to reduce your tax bill, after which you buy back the same stock.

Tax-loss harvesting works even if you want to maintain exposure to the stocks that have lost value, but there are some rules. To avoid the “wash sale” rule, you cannot repurchase the same or a substantially identical stock within 30 days before or after selling at a loss. Even if you don’t have any gains to offset, you can deduct up to $3,000 in losses from your taxable income, resulting in a higher net after-tax return.

Roth Conversions

Starting in 2010, it became possible for high-income people to convert their traditional IRA accounts to Roth IRAs. This can be an important decision, and it’s worth spending the time to figure out if it is right for you. Generally speaking, if you expect your tax rate to be higher, then you may want to consider converting. If you expect it to be about the same, a more detailed analysis is required. Often there is still an advantage to the Roth conversion because the converted money will be able to grow tax free while the opportunity cost from the taxes paid from post-tax accounts will be subject to taxes on dividends and capital gains along the way.

A Roth conversion can also generate a large tax bill, and it matters how you go about paying it. A Roth conversion only makes sense if you can pay the tax bill with funds from an outside non-retirement account.

To learn more about tax management as well as three smart steps you can take to manage your money overall, read our free Personal Capital Guide to a Better Financial Life.

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This blog is for informational purposes only; we are not in the business of providing tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk leads the Personal Capital Advisors Investment Committee and serves as the Chief Investment Officer. His focus is translating improvements in technology into better financial lives. Craig has been widely quoted in the Wall Street Journal, Bloomberg, CNN Money, the Washington Post and elsewhere. Prior to Personal Capital Advisors, he was a leader within the portfolio management team at Fisher Investments, helping assets under management grow from $1.5 billion to over $40 billion. Craig graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.

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