Most people don’t like thinking about taxes, much less paying them. But it’s worth understanding—if you want to take advantage of tax savings and tax efficiencies.
Tax efficient investing is something we are really passionate about at Halpern Financial. It is one of the few ways investors can automatically increase their returns, simply by cutting out avoidable costs. Of course, we all have to pay taxes but there is no need to pay more taxes than necessary.
How can you improve your tax situation, even when it’s not tax season?
Reach out to your CPA between September and December.
Before the busy tax season is a good time to reach out to your CPA—particularly if you have been burned by an unexpectedly large tax bill in the past. By the time tax season arrives at the beginning of the year, it is too late, but in the fall, you can still make adjustments. Make sure you are withholding enough in taxes for the current tax year. If quarterly taxes are applicable, ask if you are on track to avoid an unexpected bill.
Here are a few strategies we use as part of our tax-efficient portfolios:
Hold for the long term.
When there are no outside factors that would dictate otherwise, holding for 12 months or longer will avoid short-term gains which are taxed as income, versus long-term gains which are taxed at the lower long-term capital gains rate. Design a long-term investment strategy from a broad overall allocation perspective, and select holdings which do not need to be adjusted frequently. This avoids excessive trading, and subsequently keeps realized gains low.
Avoid high turnover ratios and be aware of the distribution schedule.
Actively managed mutual funds can have high turnover ratios (sometimes over 100%) which can lead to high year-end distributions. For example, the fund may distribute 20% of the fund’s value in a taxable distribution near year-end. At the same time as the distribution, the price of the fund drops in tandem. In effect, this forces the investor to sell a large portion of the fund at a time totally out of your control. Working with an advisor who monitors these upcoming distributions can be very helpful.
Similarly, be aware of upcoming ex-dividend dates and be careful when exactly you buy or sell a holding.
Consider Exchange Traded Funds (ETFs) versus Mutual Funds within taxable accounts.
ETFs are inherently more tax efficient than their mutual fund counterparts. Mutual funds have to rebalance the fund to sell securities when there are redemptions from shareholders. These can create capital gains which are passed on to the shareholders. ETFs, however, create units for shareholder activity—thus avoiding the capital gains issue.
Know when to use active versus passive strategies.
Even with all of the reasons to be cautious with active strategies, there are still times when active may be appropriate for a taxable account. For example, right now I see value in an active fixed income strategy because the fund manager can be nimble enough to adjust their underlying holdings in response to changing interest rates. An ETF cannot adjust in the same way.
Use the proper account for each type of asset.
There are benefits to both tax-deferred accounts and after-tax accounts, but you need a bit of strategy to get the most out of each type. For example, municipal bonds are best held in a taxable account. These type of bonds have the potential to be triple-tax free (depending on where the investor lives and the state the bond is from)—so there is no additional benefit to receiving tax-free income in a tax-deferred account.
Avoid tax on collectibles and phantom tax in taxable accounts.
A common stumbling block is with precious metals exposure. Gold is considered a collectible, so it is subject to the collectible tax rates of 28%. Even a gold ETF like GLD is treated as a collectible for tax purposes.
Phantom tax is another potential tax stumbling block. This is where you are taxed on the receipt of income before you actually receive that income. Phantom tax can occur with holdings like Treasury Inflation Protection bonds if they are held in a taxable account rather than a tax-deferred one.
Remember your RMDs.
If you are over age 70.5 and have IRA assets, you are subject to RMD rules. If you need cash flow monthly from your portfolio, it could make sense to have the RMD paid monthly. However if you do not need the funds, you may consider allowing for maximum tax-deferred growth and taking your RMD near year-end.
Tax Loss Harvesting allows investors to offset capital gains with losses.
You can do tax loss harvesting throughout the year, with a special focus at year end.
Have enough in cash reserves.
How is this tax related? If you have appropriate reserves, you aren’t forced to sell from your investment accounts and generate taxable gains when the funds are needed.
Keep taxes in mind when designing a retirement income strategy.
There are tax-efficient strategies to withdraw from your investments in retirement, and not-so-tax-efficient strategies. A tax-efficient strategy can help improve the longevity of your assets in retirement.
The old rule-of-thumb advice used to be to hold “equities in taxable accounts” and “fixed income in tax-deferred accounts.” This strategy came about from a lack of access to quality tax-free income instruments in taxable accounts. Today a better strategy is to diversify both types of accounts. Generally people withdraw from taxable accounts first, which means having to liquidate positions. If your taxable account is dominated by equities, you would likely subject to excessive capital gains tax over the years.
Instead, consider withdrawing first from a more income-focused taxable account, and allow a more growth-oriented portfolio to compound over time in a tax-deferred account. (Both accounts should have a diversified allocation in line with the investor’s needs, but just with a slight tilt toward income in taxable accounts and a tilt toward growth in tax-deferred accounts). This is the complete opposite of the traditional strategy but it can be more tax-efficient.
As you can see, tax-efficiency in the portfolio can get quite involved—and this is just a sampler of ways to achieve it. Tax-efficiency is incredibly important to your long-term portfolio success because it is a cost saver. The more you keep in your portfolio, the better longevity it will have ant the more potential for growth. This is why we approach tax efficiency in a number of ways to create savings for our clients!