Everyone wants to save money on their taxes, but we firmly believe that tax considerations should not drive your investment decisions. That said, we work with our clients to invest as tax-efficiently as possible within the confines of their investment strategy. Here are some thoughts on ways to invest tax-efficiently.
There are a variety of taxes that can impact your investments. These include:
For investors with assets in both taxable investment accounts and tax-advantaged retirement accounts like an IRA or 401(k), which assets are held in which type of account can have a significant tax impact.
Assets that are a good fit for taxable accounts include:
Assets that are a good fit for tax-advantaged retirement accounts include:
Think of this as guidance when you have the opportunity to place a holding of one type of investment or another in either type of account. Trying to adhere to the guidelines when possible makes sense, the reality is that it is not always possible to have your accounts perfectly aligned in this fashion.
Index mutual funds and ETFs tend to be more tax-efficient than their actively managed peers. This is because unlike actively managed funds, they typically don’t trade in and out of holdings as often. This is because the managers are trying to replicate the holdings of an index, like the S&P 500, that the fund tracks.
Additionally, since they are continually buying and selling securities to rebalance back to the percentages that those securities represent in the index. These funds often have multiple tax lots of the various securities. This means that they can sell securities as needed in the most tax-efficient fashion possible.
Interest from municipal bonds is generally free from federal taxes. If the bonds were issued by the investor’s state of residence, they may be exempt from state income taxes as well. Muni bonds, both individual holdings as well as mutual funds and ETFs that invest in them, can be a tax-efficient holding for investors in high tax brackets.
Because of their favorable tax treatment, the interest rates are generally lower than those for other types of bonds with similar maturities and credit risks. In deciding whether muni bonds are a good fit for a client, we look at both the tax-efficiency aspects as well as the overall benefits on an after-tax basis.
Tax-loss harvesting is a process where you look for holdings in taxable accounts that have unrealized losses. Realizing losses on some or all of these holdings allows these losses to be used to offset capital gains realized on other investments that were sold during the year. To the extent that there are excess losses over and above the amount of the gains, up to $3,000 of those losses can be used to offset other income. Any additional unused losses can be carried over to use in subsequent years.
As with other tax-efficient investing tactics, tax-loss harvesting should only be used as part of an overall strategy that first makes sense from an investing perspective.
Tax-loss harvesting can go hand-in-hand with periodic portfolio rebalancing. When rebalancing taxable accounts back to their target allocation, on their own or as part of your overall asset allocation, it makes sense to look for opportunities to harvest tax-losses that fit with the strategy.
Rebalancing can include using new money to shore up asset classes and holdings that are underweight, versus selling off portfolio holdings that might trigger taxable gains.
Tax-efficient investing also pertains to tax-efficiency when it becomes time to withdraw money from your accounts in retirement. Tax diversification is also a hedge against the unknown of where tax rates and rules might be headed in the future. Diversifying among types of accounts can add tax diversification and tax-efficiency when you reach retirement.
For many investors, using a Roth account, either a Roth IRA and/or contributing to a designated Roth account within their employer’s 401(k) if applicable, is a very tax-efficient way to invest. Although money goes into a Roth account on an after-tax basis, it comes out tax-free in retirement as long as certain conditions are met.
Any capital gains or ongoing income from dividends will remain untaxed in the account.
Traditional IRA and 401(k) accounts offer the opportunity for pre-tax contributions along with tax-deferred growth for your investments. In some cases contributions are made after-tax. At retirement, distributions are taxed with the exception of the amount of any after-tax contributions.
These accounts offer a solid way to allow investments gains along with any dividend income to grow tax-deferred over time.
While realized capital gains will be taxed in these accounts, along with any dividend or interest income, distributions from these accounts are not taxed like distributions from traditional retirement accounts such as an IRA.
Tax considerations are an important part of all of the planning we do and the advice we provide for our clients. Taxes impact virtually all areas of financial planning and wealth management. Tax-efficient investing is certainly a key part of this. While investing advice is given based on the investment merit of that advice, when possible we always try to be as tax-efficient as possible.
Give us a call to see how we can help you manage your investments as part of your overall financial and wealth planning.
Bill Canty, CFP®, CPA
Maureen Walsh, EA, Investment Advisor Rep.
Tina Alteri, CPA, Tax Advisor
Ed Canty, CFP®
Joe Canty, Investment Advisor Rep.