Levies on investment income and profits can undercut your returns. Consider these strategies to help reduce the impact.
Preparing for April 15th can be sobering. That’s when you see how the investment decisions you made during the previous calendar year have affected your taxes—and your progress toward your financial goals may look a lot more sluggish once you deduct what you owe the IRS.
Yet an investing truism holds that the tax tail should never wag the investment dog—that as much as you may want to reduce the tax drain on your returns, it’s important to put investment fundamentals first, choosing stocks, bonds and funds that make sense in your particular situation. But there’s also another adage: It’s not what you earn but what you keep. And there are several investment strategies that might help you keep more, minimizing the erosion from taxes.
Tax-aware investing is really just investing—your first step is always to assess what you want to accomplish, says David Carroll Johnson, Wealth Strategist for Regions Private Wealth Management in Clayton, Missouri. “It depends on your goals, the income you need, your time horizon and your risk tolerance,” says Johnson, “but once you decide what makes investing sense, you can look for tax-smart ways to get there.”
Do the math
Sometimes, when you compare two potential investments, the one that appears to deliver more income may not provide the higher after-tax return. Suppose you’re in the 35% income tax bracket and weighing a tax-free municipal bond yielding 3.3% against a taxable corporate bond with a 4.5% return.
It turns out you would need a taxable bond yielding more than 5% to equal the value of the tax-free muni. “And in this comparison, the taxable bond also carries greater risk,” Johnson says.
Meanwhile, dividend-producing stocks can also give you predictable income, and while interest on taxable bonds is considered ordinary income, taxed at rates as high as 39.6%, most dividends qualify for a 15% rate, or 20% if you’re in the top income tax bracket. Additionally, if you hold a stock for more than a year, any profits acquired when you sell will qualify for long-term capital gains rates, which are 15%, or 20% if you’re in the top tax bracket.
Look at location
Where you hold assets can also make a difference. It’s in the DNA of some investments to produce income that may be sliced by almost 40% after taxes. Assets hit hardest by taxes include taxable bonds; mutual funds that are frequently traded and generate short-term capital gains; and real estate investment trusts (REITs). Keeping such holdings in a tax-deferred account—your 401(k), an IRA or similar retirement plan—lets you postpone your day of reckoning until withdrawals begin in retirement, when you might be in a lower bracket.
On the other hand, Johnson suggests keeping “tax-efficient” assets—municipal bonds, index-tracking exchange-traded funds (ETFs) and growth stocks that don’t pay dividends—in taxable accounts. If there’s no current income you won’t owe any taxes, and any cash these investments do send your way will likely be taxed at the lower rates for long-term capital gains.
Use your losses
Timing can be everything when you’re buying or selling stocks—not only to boost profits but also to reduce taxes you may owe on those gains. When calculating investment income for your taxes, losses you’ve taken can offset an equal measure of capital gains—and if your losses exceed your gains, you can deduct up to $3,000 of the excess to reduce your taxable income. That doesn’t mean you should sell at a loss when you think a stock may rebound. But if an asset’s value is down and it makes sense to pare that holding as part of your asset allocation strategy, you might consider unloading it before the end of a year in which you’ve realized substantial profits. Similarly, an existing loss could let you take profits in a stock position without adding to your tax bill.
Consider trusts and charitable gifts
Taxes can also affect investments that you would like to pass along to your children or to philanthropic causes, and several strategies could help make sure payments to the government don’t undercut your generosity. A grantor-retained annuity trust, or GRAT, could aid such efforts, enabling you to minimize taxes while transferring stock that is gaining in value to your children. “A GRAT lets you freeze the value of your asset and maximize the gift,” says Johnson.
Other kinds of trusts—charitable remainder trusts (CRTs) and charitable lead trusts (CLTs), among others—could provide benefits to your family as well as to the causes you support. You might also consider contributing appreciated property rather than cash to charities, or making them beneficiaries of retirement account assets you don’t need. (For more about this approach, read “Give Your Giving a Boost,” page 1.)
These are just a few of the ways you might be able to better protect your investment gains against tax erosion. Of course, you still need to keep that tax tail in its place, and there are likely to be times when considering the tax implications of an investment decision are less important. If you need to send a tuition check to your daughter’s college, say, you might choose to sell a particular asset even if that will also add to your tax bill. Knowing the rules helps, but consulting your Wealth Advisor and your tax professional to consider investment moves could make tax day less taxing. That’s something any investor should welcome.
