Taxes are one of the constants in life. It is how savvy investors deal with taxes that sets them apart from the pack.
Everyone knows that attractive returns should be realized when investors and their financial advisors effectively weigh a portfolio's risks against its potential return. But while you can't control the market, you can exert more control with these tax saving tips.
This is why a well-considered evaluation of an investmentís risk in relation to its after-tax return is so important. Choosing investments that provide greater tax-efficiency can allow you to reduce or postpone the amount of taxes that are due, a smart strategy that may help you reach any short or long-term investment goals.
Taxable or Municipal
Let's assume you've taken advantage of any 401(k), IRA and other tax-advantaged ways of investing. The first taxable aspect of your portfolio to examine is the portion made up of municipal bonds that take advantage of the inherent tax efficiency of these securities. Interest income generated by holders of municipal bonds is often exempt from federal income taxes and taxes of the state in which they are issued. Fixed income investments like this within your overall portfolio may provide diversification benefits for investors, as well as the tax exemptions. However, it should be noted, a growing segment of the investment community raise concerns that these vehicles may present materially greater risk.
Some financial advisors suggest allocating a portion of taxable portfolios to municipal bonds. That percentage will vary, obviously, depending on your investment goals, tolerance for risk, and tax bracket along with other factors. Investors in high income brackets will typically find a benefit in investing in municipal bonds.
Passive vs. Active
The next step in tax efficient investing for those trying to save money on taxes is to decide between passive and active investing. Passive investing looks to closely replicate the returns of a given sector of the market while active investing attempts to select individual securities that that the portfolio manager believes will generate returns better than a given sector of the market.
With more actively managed funds, you typically incur greater overhead, and higher trading costs as you move between securities, while potentially generating greater tax liability. Passive funds, which don't see as much trading, may result in lower fees and less capital gains to impact your bottom line when you are filing taxes. If tax efficiency is your goal, the choice is pretty clear.
ETFs vs. Mutual Funds
Finally, Exchange Traded Funds (ETFs), can offer advantages for those seeking tax efficiency, but it depends on your needs, size of your account, and size of the purchase and how long you hold onto it. This not-so-new kid on the investment block came into vogue a few years back, but today ETFs are fairly established alternatives to mutual funds.
Generally speaking, ETFs tend to follow inherently tax efficient passive management strategies. The organization of ETFs tends to avoid the kind of selling that would trigger undistributed capital gains that can occur even in passively managed mutual funds. This is because most ETFs track indexes and are held over time, so the manager is not attempting to beat the market buying and selling in an attempt to find over or undervalued stocks. That in turn means there's not as much chance to realize capital gains when dealing with ETFs vs. mutual funds. It quickly becomes a bit complicated, and at this level, most people will require a personal financial planning professional to help them navigate the waters of ETFs.
When looking at tax efficiency, begin with the idea that costs matter - all costs. If an investor can save on taxes, it's a benefit, regardless of how well they do in the market.
There is no shortcut to sound investing and there are few guarantees. But one thing is for certain: taxes.
* Investments in securities and insurance products held in trust accounts are not FDIC-insured, not deposits of Regions Bank or its affiliates, not guaranteed by Regions Bank or its affiliates, not insured by any federal government agency, and may go down in value.
This information is general in nature, is provided for educational purposes only, and should not be relied on or interpreted as accounting, financial planning, investment, legal or tax advice. Regions neither endorses nor guarantees this information, and encourages you to consult a professional for advice applicable to your specific situation.