Taxes are everywhere, every day, to such an extent that one might let that all-important, mid-April deadline for filing your annual tax returns sneak up on you. One problem with waiting until the last minute: by that point, it may be too late to implement an efficient investment strategy for minimizing your tax bill.
Returns lost to taxes
For investors, it's not just how much you make that matters—it's how much you keep after taxes. Like investment selection and asset allocation, the amount lost to taxes and other costs is a key factor affecting your returns. Even small amounts can add up over the years, so anything you can do to reduce the drag will help in the long run.The good news is you can exercise some control here. With a bit of planning, you can make your portfolio more tax-efficient and hold on to a greater share of your returns.
How do I maximize tax efficiency?
A big part of tax efficiency is putting the right investment in the right account.Investment accounts can be divided into two main categories:Taxable accounts, such as brokerage accounts, are good candidates for investments that tend to lose less of their returns to taxes.Tax-advantaged accounts, such as an IRA, 401(k), or Roth IRA, are generally a better home for investments that lose more of their returns to taxes.What does that mean in practical terms? Here we've matched some common kinds of investments with taxable or tax-advantaged accounts:
Diversifying by tax treatment
Holding your investments in the most tax-appropriate type of account can complement your savings plans by helping to reduce taxes (or, in the case of a Roth, eliminate entirely the taxes on investment returns).1 Spreading your investments across accounts with different tax treatments can also give you more flexibility in managing your taxes when you start drawing from your savings in retirement. Call it "tax diversification."Diversifying by tax treatment can be especially important if you're uncertain about the tax bracket you'll end up in in retirement. For example, by investing in a taxable brokerage account and then splitting your retirement-savings contributions between a tax-deferred IRA or 401(k) and an after-tax Roth account, you would have more options for managing your income in retirement, regardless of your tax bracket.
So, if your goal is to minimize your overall tax burden, you could focus on taking tax-free municipal bond income, qualified dividends, and long-term capital gains (which currently tend to be taxed at lower rates) from your taxable accounts and tax-free income from your Roth accounts. Then you could take only enough money from your taxable IRA or 401(k) to cover your spending needs or satisfy required minimum distributions, if applicable.Of course, this is just one approach. Some investors may prefer to rely on their taxable and tax-deferred accounts (along with Social Security and pensions) for income and allow their tax-free Roth savings to continue growing for as long as possible.
Estate planning, charitable giving considerations
Making strategic use of your different accounts according to their tax treatment can also help you formulate your charitable giving and estate planning goals—different accounts receive different types of gift and estate tax treatment. For example, you might want to give appreciated securities from your taxable accounts to charity for a full fair market value deduction and no capital gains tax.You can also leave such shares to your heirs, who will receive a step-up in cost basis after you're gone (more on that below). Roth IRAs also make a great bequest, as distributions are free from income tax for your beneficiaries.No matter how you decide to split up your portfolio between account types, remember that for asset allocation purposes, you should still think of all your investments as being part of a single portfolio. Here's a simplified illustration:If you kept all your stocks in your taxable account and an equal amount of money in bonds in your tax-advantaged account, that would not constitute two portfolios, one 100% stocks and the other 100% bonds. You would actually have one portfolio consisting of 50% stocks and 50% bonds. The different assets just happen to be in different accounts.
Other tax-related investment considerations
In general, holding tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts should have potential to add value over time. However, there are other factors to consider, including:Periodically rebalancing your portfolio to maintain your target asset allocation. Rebalancing involves selling and buying assets that have either grown beyond or fallen below your original allocation. When you take profits from your winners and buy assets that have underperformed, it could cause an additional tax drag on returns in your taxable accounts.
Keep more of your money with tax-efficient investments
If you want to keep more of your returns, managing your investments with tax efficiency in mind is a must. What's more, tax efficient investing techniques are accessible to almost everyone—it just takes some planning to reap the potential benefits. Learn more by contacting Corners Financial Planning, LLC