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Writer's pictureSamuel Flaten

Beyond Returns: Adopting Tax-aware Investment Habits



Do you want to know how much the value of your investments has increased over time? It’s easy to find the returns for a fund, stock, or bond over a given period. If you’re really motivated and have some math skills and a spreadsheet, you could probably estimate how much your portfolio has earned this year. But what you’re really looking for is not just how much prices have gone up or down, or how much interest or dividend income your holdings generated. It’s about what you keep, and by that we mean your after-tax returns. 

 

Talking about taxes does not excite most people (except CPAs and tax attorneys, whom we greatly respect and truly appreciate). And while we don’t want taxes to dictate how we invest, ignoring tax implications can put a big dent in what you actually earn from your investments. Let’s put it this way: if you had a choice between, say, earning a 20% return and a 26% return over the same period of time, for exactly the same level of risk, which would you choose? We thought so. Investing in a tax-aware way can make that choice for you.

 

In this article, we look at ways to be tax-smart without being tax-obsessed. With some advance planning, it is possible to minimize your tax hit while maintaining the mix of investments that makes sense for your overall goals, risk appetite, and need for income in retirement.

 

Different Accounts, Different Tax Impacts

 

First things first – in the eyes of the IRS, investment accounts are categorized as follows:

 

  • Pre-Tax/Tax-Deferred Accounts: This includes traditional IRAs, SEP IRAs, 401(k)s, and 403(b)s. They are often called “pre-tax” accounts because they go into the account before your income for taxes purposes is computed – in other words, putting money into these accounts reduces your taxable income (with some restrictions). They are also called “tax-deferred” because returns on assets held in these accounts are not taxed until some point in the future when you withdraw money.


    Contributions to these accounts reduce your income for tax purposes the year you make them. Later on, you pay ordinary income taxes on distributions from these accounts – whatever you put in and the returns you earn over time. This can postpone taxes for many years. If you don’t contribute some of your income to a tax-deferred account, you owe ordinary income taxes on all of it this year.


    While deferring taxes this way makes sense for most people, particularly with a 401(k) plan that offers an employer-matching contribution (free money) it isn’t always the best choice. If you are close to retirement and will likely be in the same tax bracket later as you are today, it isn’t necessarily a slam-dunk. Talk with your financial advisor about what’s best for you and your situation.

 

  • Roth IRAs and 401(k)s: Pay ordinary income taxes today on the money you invest in a Roth account and those investments grow tax-free for the rest of your life (and beyond). Withdrawals from Roth accounts (after you turn 59½) are never taxed. If a Roth is part of your estate, your heirs also make withdrawals tax-free (note: there are many rules about inherited IRAs that are beyond the scope of this article). The amount you can contribute to a Roth each year is limited, although that can be addressed through an entirely legal “back door” Roth conversion from a traditional IRA. That gets complicated, so definitely talk with your advisor before proceeding.

 

  • Taxable Accounts: In a taxable account, you pay taxes on dividends, interest, and realized capital gains the year they occur. You can withdraw your money without penalty at any time, and returns on stocks and funds held for over a year are taxed at a lower capital gains rate. You can also offset gains with losses to minimize your tax bill.

 

Are certain investments “right” for one account or another?

 

When talking about tax-aware investing, some people like to emphasize, “It’s not just about asset allocation; it’s also about asset location.” In other words, beyond deciding what mix of equities and fixed-income investments to hold, we should choose the accounts where we hold those different investments based on their tax treatment.

 

While there is logic behind this, we are not particularly focused on the concept. Our view is that tax planning should take a holistic approach, and “location” may not be as important as you might think.

 

By rigidly following “asset location” rules, people often earn lower returns in their retirement accounts than in their taxable accounts, for reasons we’ll explain shortly. That can be unnerving – this is, after all, the money you intend to use to fund your retirement. Why isn’t it growing faster? This causes anxiety, leading people to tinker with their asset allocations and wander away from the path that was designed to help them achieve their goals.

 

Having said that, if you are disciplined and want to pursue a “location-based” strategy, here are the types of investments best suited for the different types of accounts:

 

Tax-Deferred Accounts and Roths

  • Bonds, bond funds, and stock funds focused on dividend payouts, because interest income from bonds and dividends from funds make up a big chunk of the returns these investments generate. That creates a current-year tax liability unless you hold them in a tax-deferred or Roth account.

  • Actively managed mutual funds, which tend to buy and sell their holdings frequently, generating short-term taxable income. This doesn’t affect you when you hold these funds in a 401(k), or a Traditional or Roth IRA. 

  • Real estate investment trusts (REITs) which, like bond funds, pay out most of their returns as income each year.

 

Taxable accounts

  • Equity mutual funds and ETFs that track an index, as they only buy and sell positions when the index changes (usually once or maybe twice a year). In particular, ETFs have a unique structure that allows them to largely avoid realizing capital gains.

  • Stocks you know you will hold for the long term, because you pay no taxes on capital gains until you actually sell the stock (the dividends from stocks held in a taxable account are taxed each year).

  • Municipal bonds – because investors do not owe federal income tax (and sometimes no state income tax) on the interest these bonds pay, there is no point in holding them in an IRA or 401(k).

 

Limitations of Adhering to the “Asset Location” Maxim

 

Given this, we can see that by following the asset location approach, tax-deferred retirement accounts often produce only modest returns. After all, they hold mostly bonds, and bonds are not designed to generate big returns. Bonds are there to provide income and act as a cushion when the stock market suffers a downturn. Furthermore, if you are fairly young, you may not want or need to hold much of your savings in bonds.

 

Rigidly following asset location rules also sacrifices flexibility. For example, assume you suddenly face a large, unexpected need for cash and you have no bonds or bond funds in your taxable account. If the market is in a downturn, you may have to sell equities at a loss from that account (you can’t take money from tax-deferred or Roth accounts until you are 59 ½ or have a real hardship). If you held those equities for a long time you may be hit with a capital gains tax bill even though the market has dropped. Holding some bonds in your taxable account, which tend to retain their value when equities are declining, gives you more flexibility.

 

In addition, in your retirement years, the “asset location” approach limits your options when withdrawing money. The order in which you withdraw from your taxable and tax-deferred accounts matters. You want to use your taxable accounts first, after satisfying your minimum required distributions from 401(k)s and IRAs, but you don’t want to have to sell equities to raise cash to meet your living expenses if the market has taken a tumble.

 

Getting back to the holistic approach we advocate, consider whether the tax bill you postpone using the asset location approach really “moves the needle” in terms of affecting your lifestyle. While you want to do careful tax planning and use the advantages it can offer, keep your eye on the prize, which is growing your wealth in a meaningful way. Don’t fixate on reducing taxes a little bit today if by paying those taxes you generate much more wealth over the long term.

 

Matching Gains and Losses: Tax-Loss Harvesting

 

Another way to use tax laws to your advantage in your investing is tax-loss harvesting. If you have sold investments at a loss (which is better than holding on for years, hoping for a recovery), you can use that loss to offset capital gains from other investments. Here’s how it works:

  • Offsetting gains: Capital losses can be used to offset capital gains dollar for dollar. For example, if you realized a $10,000 gain on one investment but have a $5,000 loss on another, you can sell the losing investment and reduce your taxable gain to $5,000.

  • Carryover losses: If your losses exceed your gains, you can use up to $3,000 in losses each year to offset ordinary income. Any additional losses can be carried forward to future years to offset future gains.

  • Watch out for the wash-sale rule: The "wash-sale rule," prohibits you from claiming a tax loss if you buy a substantially identical security within 30 days of the sale. To avoid this, make sure you don’t repurchase the same investment—or one that is quite similar to the one you sold—within that time frame.

 

Other Tax Strategies

In addition to tax-loss harvesting, here are other tax strategies to consider that reduce your taxes. People often focus on these things toward the end of the year, but they work the same way long before Halloween and Thanksgiving.

 

1. Max Out Contributions to Tax-Deferred Accounts

If you haven’t already done so, consider maxing out contributions to tax-deferred accounts – whether a  401(k) or traditional IRA. The contribution limits change every year, with catch-up contributions if you’re over 50.

2. Consider a Roth Conversion

If you expect to be in a higher tax bracket in the future, or your income this year will be lower than usual, a Roth conversion would allow you to pay taxes at your lower tax rate now in exchange for tax-free growth later. As noted above, Roth conversions must follow certain rules, so seek advice from a qualified financial advisor.

3. Consider Rebalancing

Given changes in the market, does your overall investment allocation still align with your financial goals? If not, consider selling some investments that have performed well and now represent a larger portion of your portfolio than you intended. If this involves taxable accounts, consider tax loss harvesting (see above). There are no tax consequences for rebalancing within 401(k)s, IRAs, and Roths.

4. Give to Charity

If charitable giving is a goal, donating appreciated assets like stocks to charity allows you to avoid paying capital gains taxes on those assets. You can also receive a tax deduction for the full market value of the donated asset if you itemize your deductions, or if you are 72 or older this helps to satisfy your minimum required distributions without increasing your income.

 

To wrap up…

The benefits of tax-aware investing can be significant. By focusing certain types of investments in the right accounts, harvesting losses to offset gains and possibly moving some savings into a Roth account, you can increase your after-tax returns over time.

 

At Gold Medal Waters, we believe that to truly serve our clients, we must examine “conventional wisdom” based on whether it works in practice, given the realities of everyday life and the quirks of human behavior. Our focus is solely on helping you to reach your financial goals based on your life’s priorities – and that’s not just some slogan; it’s our purpose.


Disclosure: Advisory Services are offered through Gold Medal Waters, a Registered Investment Advisor. This post and material presented are for informational and illustrative purposes only, and do not constitute investment advice and is not intended as an endorsement of any specific investment.  As such, this material is not client-specific, we make adjustments in individual portfolios based on each client's financial plan, income needs, risk tolerance and total asset allocation.  Interactive checklists are made available to you as self-help tools for your independent use and are not intended to provide investment advice. While Gold Medal Waters believes information derived from third-party sources to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability in regard to your individual circumstances.  Investors should carefully consider the investment objectives, risks, charges, and expenses associated with any investment.  The information discussed is not intended to render tax or legal advice.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.  Investing involves risk including the potential loss of principal, and unless otherwise stated, are not guaranteed. Past performance does not guarantee future results.  No investment strategy can guarantee a profit or protect against loss in periods of declining values.  Consult your financial professional before making any investment decision.

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