Our clients often come to us with questions about the tax implications of their investments. We certainly understand their concern; after all, the IRS Tax Code is about a million words long. Who has time for a close reading of that?
Well, accountants, for one; after all, that's their job. But keeping up with the ever-changing rules and regulations contained in a document that's seven times the length of the bible doesn't leave a lot of time for accountants to seek tax-saving possibilities outside the tax code. Fortunately, that's where your wealth advisor comes in.
As noted by Vanguard in a 2008 report entitled "Tax-Efficient Equity Investing." taxes have the potential to significantly reduce your returns -- more than many other factors. These tax tips will help reduce your tax burden and increase your tax efficiency.
Financial Strategies: Harvesting Your Tax Losses
While, of course, no investor likes to see their portfolio's value shrink, you can actually take advantage of a loss in value. Through a process known as tax-loss harvesting, you can sell your investments, take a loss and then potentially use these losses to offset gains on other investments.
Say, for example, that you purchased a fund for $20,000 in July; three months later, that fund's value has declined to $10,000. Because you've held that fund for less than a year, you can harvest the loss -- i.e., characterize it as a short-term loss. At a 35 percent federal tax rate, you'll save $3,500 in taxes, reducing your loss to $6,500.
Tax-loss harvesting isn't simple; it involves:
- Determining whether the loss is significant enough to warrant harvesting
- Evaluating whether the risk of exiting that market and losing out on potential gains is worth it
You may be able to avoid this second issue through what's known as the wash-sale, which allows you to sell a fund or stock and purchase a replacement investment that's not considered identical. Because "loss harvesting" is complicated, we recommend you working closely with a tax professional when deciding whether this strategy is right for you.
Ask Your Retirement Plan Fiduciary About Investing in Retirement Accounts
Does your employer offer a 401(k) or 403(b) retirement plan? If so, take full advantage of this opportunity. Both types of retirement plan allow you to invest funds pre-tax; you won't have to pay taxes until you start withdrawing your distributions.
Also consider contributing to a traditional individual retirement account (IRA) or to a Roth IRA. Although you'll contribute after-tax funds to a Roth, you won't have to pay taxes on your disbursements.
Asset Management Solution: Allocation is Key
Allocating your funds between nontaxable and taxable accounts can have a significant impact on your post-tax returns. To avoid taxes on distributions, tax-deferred accounts should generally hold:
- Funds that pay taxable dividends and capital gains
- Taxable bond funds
- Real estate investment trusts
- Alternative investments
Your taxable accounts should generally hold:
- Individual stocks that you plan on holding long-term
- Index funds and exchange traded funds or ETFs
When you're allocating investments, tax implications are important, but also remember that tax-deferred accounts often have restrictions -- and penalties -- associated with early withdrawals.
Strategic Wealth Management: Focus on Indexing
In general, index funds -- or funds that track an index like the S&P 500 -- tend to be more tax efficient, as do ETFs and passively managed investments. Indexing also results in lower transaction costs and fees. In contrast, actively managed funds rack up more costs and fees and are less tax-efficient.
Overall, active management's additional tax costs -- and higher fees -- serve to minimize returns.