Plan wisely — four steps to tax-efficient investing
For investors, the difference between investing and intelligent investing might not be how much you earn on each investment but how much you keep, after taxes. By implementing tax-efficient strategies into your overall financial planning you can learn to manage, defer, and/or reduce your income tax burden and hold on to a larger portion of your wealth.
Incorporate these four tax-efficient strategies into your investment decisions:
Type of Investment Account
Where you own certain investments (taxable/tax-advantaged accounts) has a tax impact. Investments that generate certain types of taxable distributions and capital gains can be sheltered within tax-advantaged accounts.
Tax-deferred accounts: Saving for retirement in tax-deferred accounts such as 401(k), 403(b), and IRAs provide substantial tax benefits. The contributions are pretaxed (lowering taxable income in the year of the contribution), and savings grow tax-deferred until funds are distributed, i.e., required (RMD), or by choice. Distributions are treated as ordinary income. Health Savings Accounts (HSA) and tax-deferred annuities can also provide additional tax-deferred savings.
Taxable accounts (brokerage accounts, etc.): The decision to buy or sell an investment in a taxable account impacts your tax burden, and while the tax implications should not drive your investment strategy, incorporating a tax-efficient lens into your ongoing portfolio management process adds value.
Selection of Investment Product
Mutual Funds vs. Exchange Traded Funds: There can be differences in tax efficiencies for mutual funds vs. ETFs. Be sure to review the tax profile before investing. Mutual funds are required to distribute earnings of interest, dividends, and capital gains annually. Actively managed mutual funds can have high turnover and incur higher capital gains that are distributed to shareholders. Passively managed mutual funds and ETFs tend to have less capital gains and, therefore, are often more tax efficient.
Tax Exempt Securities: The tax treatment varies for different types of investments. Municipal bonds, for example, are usually tax-exempt for federal tax purposes and can receive special tax treatment (often tax-exempt) from state and local income taxes, if investing in a municipal bond from your state of domicile. The interest income from treasury bonds is exempt from state and local income taxes but is taxed for federal income tax purposes. Corporate bonds and real estate investment trusts income does not have tax-exempt status and is taxed as ordinary income.
The Timing of Buying and Selling
Capital gains: Securities sold at a gain and held for more than 12 months are taxed as a capital gain with a top federal rate of 23.8% (20%, plus 3.8% Medicare surtax). Securities sold at a gain but held less than 12 months are taxed as ordinary income at your effective income tax rate.
Tax Losses: The sale of a security at a capital loss can be used to offset any realized capital gains. Up to $3,000 of capital losses can be claimed against taxable income in a current year, and any remaining losses can be carried forward to offset future realized gains or income in future years. Managing capital losses can have significant income tax benefits, i.e., tax loss harvesting.
Roth IRAs, 401(k), and Roth Conversions
Roths: Roth IRAs and Roth 401(k)s are tax-exempt accounts. Your contribution is made with after-tax dollars (no tax deduction), but all growth and future distributions are tax-free (over age 59½ and the account has been in existence for 5 years). In addition, the tax strategy of converting a traditional IRA to a Roth IRA accelerates the tax payments, but future growth is tax-free. Roth contribution eligibility has income limits, so plan accordingly.
Your financial strategy focuses on a lot more than taxes but with knowledge and planning you can incorporate these techniques of tax management, tax-deferred investing, and tax deduction wealth planning into your plan and obtain the potential benefits. Consider working with a qualified investment adviser, financial planner, or tax specialist to help you choose the best tax strategy for your situation and goals.
Ellen T. Jordan is an investment advisor providing comprehensive financial planning services to clients of Bryn Mawr Trust. She works collaboratively with all divisions of the Bank to ensure that each client’s financial needs are fully addressed and met. Jordan is a Certified Financial Planner professional.