You may not be earning as much as you thought on your taxable investment portfolio. Just as you pay taxes on the income you earn at your job, you also must pay taxes on the income or gains earned on your non-retirement investments. Here are five ways to make your portfolio more tax-efficient:
1. Choose tax efficient investments
Some investments are more tax efficient than others. For example, mutual funds pass on to the end investor capital gains recognized on the underlying securities. This means that even if you minimize trading of the funds you hold, you still might have a tax bill, because of a capital gains distribution due to the trading of the fund manager. For this reason, choosing mutual funds with low turnover can help minimize these capital gains distributions and increase your tax efficiency.
Exchange traded funds (ETFs) tend to be even more tax efficient than mutual funds. ETFs typically track indexes and are traded on exchanges like stocks. In some ways, ETFs are like mutual funds, because they both invest in a pool of securities. However, ETFs have some operational advantages that can allow them to be more tax-efficient. Specifically, they typically do not distribute any capital gains. There are other things to consider before deciding between a mutual fund or ETF, but investing in ETF’s can generally help increase your tax efficiency.
2. Invest in Municipal Bonds
Just because the stated yield on a corporate bond or CD might be 3%, it doesn’t mean you keep that full 3%. This is because the interest income you earn on CDs and many other bond and cash investments is subject to ordinary income tax. For example, if you are in the 35% federal tax bracket, the after-tax yield (what you keep) on a 3% corporate bond is only 1.95%, and that is not including the state and local taxes you may pay on top of this.
Municipal bonds may be a better option, because they are generally exempt from federal income taxes. In some cases, they can be exempt from both federal and state income taxes if you invest in a municipal bond issued in your state of residence. There are many other things to consider before investing in municipal bonds, but they are generally a good option for non-retirement accounts, especially for those in higher tax brackets.
3. Minimize Trading
Every time you trade in a taxable investment account, you create a potentially taxable event. For example, if a security was originally purchased for $1,000 and now has a current market value of $1,500, you will owe tax on the $500 difference (the capital gain) when the security is sold.
Therefore, it is important to be mindful of the potential tax implications before trading.
Excessive trading can be especially harmful if you sell an investment with a holding period of less than one year. This is because the gains recognized would be characterized as short-term capital gains, which are taxed as ordinary income. Long-term capital gains tax rates are generally lower for most taxpayers than ordinary income tax rates. Generally, it is a good idea to minimize trading because it can minimize taxes.
4. Maximize Tax-Loss Harvesting Opportunities
Capital markets can be volatile, and it is not uncommon to see investment holdings fall below their original purchase price, resulting in a capital loss. In order to realize the loss for tax purposes, the investment must be sold, turning the unrealized loss into a realized loss. These losses can be used to offset capital gains in your account, and doing so can help minimize your tax burden.
5. Donate Appreciated Assets Using a Donor Advised Fund
If you regularly give money to a church and/or charitable organization, consider donating appreciated assets, instead of writing a check. A great tool to facilitate the donation of appreciated securities is a Donor Advised Fund (DAF).
To better explain the tax advantage of donating appreciated securities, let’s review the example from earlier. If a security was originally purchased for $1,000 and now has a current market value of $1,500, you would owe tax on the $500 difference (capital gain) when the security is sold. Instead, if you transfer (donate) the entire $1,500 to a DAF, you can go without having to pay tax on the $500 capital gain, and the charity of your choice gets the full $1,500. You may also qualify for a charitable deduction in the same year. To complete the strategy, you take the $1,500 in cash that you would have otherwise donated and repurchase the shares of the gifted security at the higher price. Gifting away the unrealized capital appreciation and establishing a higher cost-basis in the newly purchased shares likely reduces your tax burden associated with this investment in the long-run.
Overall, using a DAF can be a powerful tool to help you minimize your tax burden. In addition, there are many other ways that Donor Advised Funds can be used for planning purposes which Lead Advisor, Walt Mozdzer, covers in his blog Discover the Many Uses of Donor Advised Funds.
These 5 ways to make your investment portfolio more tax-efficient are part of Foster Group’s service to clients, and each could be written about at length. It’s worth taking the time to review the tax-efficiency of your portfolio, so that you can potentially keep more of your hard-earned dollars. Everyone’s situation is different, which is why it is important to have a conversation with your financial advisor. We truly care about our clients’ goals, whether they’re planning for their families’ futures or planning to make the future better for people on the other side of the world.