“Tax efficient” investing means taking steps to minimize losses to taxes in an investment portfolio. However, taxes should not be the primary reason to buy, hold, or sell an investment. Afterall, paying more taxes on an investment that grows substantially can mean significantly more after-tax dollars to spend, compared to an investment that is tax-free but experiences meager growth. The calculus of what is left for after-tax dollars will also be affected by tax brackets. However, even at the highest tax bracket, there are many factors beyond taxes that could come into play.
Taxes are going to be a part of investing, but we don’t want them to cause emotional investing behaviors that might take away from our long-term growth prospects. What can we do? Understand the rules, and be opportunistic.
The tax-preferred accounts
Consider making use of accounts that have tax preferences. The government promotes saving for retirement and for healthcare, so special accounts have been created that have a tax-preferred status such as IRAs, 401(k)s, and Health Savings Accounts (HSAs).
These accounts have restrictions, such as penalties for taking money out early, but they can allow the owner to defer or even avoid (in the case of the HSA) some of the income taxes that need to be paid.
For IRAs, there are two types to consider, traditional and Roth. With a contribution to a traditional account, you don’t pay taxes now, but you pay them when you withdraw funds. With a Roth, you pay taxes now, but don’t need to pay them on the investment gains for retirement withdrawals. Read more about these types of accounts and what else to consider when making annual contributions in our recent article: When do you make your IRA contributions?
The tax-preferred investments
Interest payments from many bonds are taxed as ordinary income. Interest payments from most municipal bonds, in contrast, are free of federal income tax and, possibly, state income tax.
Short-term capital gains are generally taxed as ordinary income. Long-term capital gains are taxed at 0%, 15%, or 20%. Qualified stock dividend payments are generally taxed at the long-term capital gain rate.
When constructing an investment portfolio, a balance can be struck between the predictability of bond income, taxed at ordinary rates, and the chance for growth and lower taxes on equities.
Timing
Investments held for less than 365 days are generally taxed at ordinary income tax rates. However, if they are held for longer than a year, the lower long-term capital gains rate applies.
It’s a dangerous game to try to delay selling an investment in order to achieve a different tax status, especially when the markets are volatile. The difference in these tax rates can be a substantial incentive though, such that you may want to practice considering investments that you would like to hold on to for more than a year, knowing that the return includes the preferential tax rate too.
For example, an investor who has purchased multiple lots of stocks over time may choose which lot to sell. The common method is first in, first out, that is – to sell the oldest lot first. However, that approach tends to maximize the taxable gain. That can be a good approach for someone in a low tax bracket, while someone in a higher bracket may want to choose the lot with the lowest gain while still meeting the 365-day requirement.
Loss harvesting
Because capital gains and losses are netted against each other, tax position may be factored into investment decisions. For example, those who have capital gains from earlier in the year may want to consider harvesting some tax losses to offset those taxes. Up to $3,000 in capital losses may be deducted from ordinary income as well.
Watch out for wash sales.
The wash sale rule requires that the investor endure the risk of market change in the price of the securities when claiming a capital loss. To claim the loss, the investor must not repurchase the shares within 30 days of the date of the sale at a loss. Note that the 30-day period runs before as well as after the loss sale date. The rule cannot be circumvented by, for example, first purchasing new shares and then selling the shares with the higher basis the next day.
Charitable contribution tax rules to consider
For many people, the doubling of the standard deduction means charitable contributions no longer need to be tabulated because itemized deductions don’t exceed the new threshold. One way to still get additional tax benefit might be to bunch charitable giving into one year, and skip charitable gifts the next year.
For more substantial giving, one might consider charitable gifts from IRAs. Taxpayers who are 70½ or older may direct that up to $100,000 be sent to charity from their IRAs. Amounts distributed in this way will satisfy minimum distribution requirements for those who are 73 and older, but they won’t be included in the taxpayer’s income. Therefore, the negative tax results that may come from increasing Adjusted Gross Income, even when offset by a charitable deduction, may be avoided.
Is there more to explore?
These are only some of the basics to consider regarding ways the government has provided incentives for people to save and invest in particular ways. It shouldn’t be just about paying less taxes, but about utilizing all the options available to create a portfolio that matches your risk profile, time horizon, and other needs. Being tax-efficient is just a nice bonus.
Arvest Wealth Management does not provide tax advice, so be sure to consult with your tax advisor before taking any action. Turn to Arvest Wealth Management for answers to your investment and holistic financial plan questions. Put our experience to work for you!
This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.
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Arvest and its associates do not provide tax or legal advice. The information presented here is not intended as, and should not be considered, tax or legal advice. Consult your tax and legal advisors accordingly.