The tax benefits of retirement accounts are well known. But investing in a taxable account can also be tax efficient. There are ways to minimize investment tax liabilities for returns earned outside traditional retirement accounts. Most investment income is subject to taxes. The tax rates vary, ranging from zero to 37% on short-term asset sales for those in the highest tax bracket. Greg McBride, senior vice president and chief financial analyst at Bankrate.com, says: "Favor long-term capital gains over short-term, qualified dividends on common stock and to a lesser extent preferred stock over bond coupons and bank interest, and municipal bonds over Treasurys or corporate bonds of comparable credit quality." Here are eight tips to reduce your tax bill.
Minimize turnover and avoid incurring short-term capital gains
It’s important to understand the difference between short- and long-term gains tax rates. The tax rates for long-term capital gains, incurred on profits of an investment that is owned for a minimum of one year and range between zero and 20%, depending upon the investor's taxable income and filing status. Selling that same investment during the first year of ownership can result in taxes equal to one’s ordinary income tax rate, which is typically higher than the long-term capital gains rate. The highest federal tax bracket tops out at 37% and that doesn’t include the cost of state and possible municipal tax payments. No capital gains taxes are due unless an investment is sold, so it’s important to consider the tax consequences before pressing the “sell” button.
Consider municipal bonds and funds for taxable accounts
Income from individual municipal bonds and bond funds is typically federally tax-free. If bought within one’s state of residence these investments can also avoid state taxes. But before buying a municipal bond or fund, it’s important to check the tax-equivalent yield. It's important to compare after-tax yields between a municipal bond and a comparable taxable bond to find out which offers a higher return. “A municipal bond yielding 2% is the equivalent of 3.08% on a taxable bond for investors in the 35% bracket," McBride says. There are many tax-equivalent yield calculators online to help. Many fund families offer state-based muni funds such as the Vanguard CA Intermediate-Term Tax-Exempt Fund (VCAIX) and the Fidelity Massachusetts Municipal Income Fund (FDMMX).
Reduce taxes with charitable planning
“With a charitable trust, the consumer donates appreciated securities including stocks, bonds and funds, without paying any capital gains tax,” says Carlos Dias Jr., a wealth advisor at MVP Wealth in Orlando, Florida. If an investor sells $100,000 worth of appreciated stock that was originally worth $25,000, that person would owe capital gains tax on $75,000. If someone donated the appreciated stock to a charitable trust, the $100,000 would go to a charity that would sell the stock, while the investor incurs no capital gains tax liability. Depending upon the type of trust, the investor receives income from the trust and a tax deduction during the next five years after the gift is bequeathed, Dias says.
Use tax-loss harvesting to cut income taxes
“Investors can assume losses on securities that have fallen in value, take the tax credit that the government gives you for that loss and immediately apply it to gains that are realized by selling other securities during the same year,” says Simon Brady, founder of Anglia Advisors in New York. Losses must first offset gains of the same type. Among any remaining loss, only $3,000 that hasn't been offset by gains, can be realized in a year; the remainder will carry over into the future. But be aware of the wash-sale rule that prevents taxpayers from taking the deduction if they buy the same or a similar asset within 30 days after selling the same or similar security.
Optimize asset locations
Place the most tax-efficient assets in a taxable account and assets with the highest potential tax bills in a retirement account. For example, place aggressive investments in a taxable account, in which there’s a tax benefit to capturing losses, says Kelly Crane, president and chief investment officer at Napa Valley Wealth Management. Typically owning individual stocks and stock funds are preferred for a taxable account because investors won’t pay any capital gains taxes until the asset is sold. Also, most qualified dividends are taxed at low rates. There are even funds designed to keep taxes low within a taxable account such as Vanguard’s Tax-Managed Capital Appreciation Fund (VTCIX) and Vanguard Tax-Managed Small Cap Fund (VTMSX).
Be passive with efficient index funds
Passively managed stock index funds are ideal investments for taxable accounts. The idea is that owning a fund that tracks a major stock index like the S&P 500 (.SPX) can help avoid niche index funds, which are costly and may experience long periods of underperformance, says Kevin Philip, managing director at Bel Air Investment Advisors in Los Angeles. "An investor can have a diversified approach in a hallmark investment category that will not need to be, or should not be, traded in an attempt to time the market,” he adds. Sample tax-efficient index funds include iShares Core S&P 500 ETF (IVV), iShares Core S&P Mid-Cap ETF (IJH) and Vanguard Large-Cap ETF (VV).
Choose ETFs over mutual funds
Because of the way that exchange-traded funds are structured, building a portfolio of ETFs can help investors reduce internal capital gains that can plague mutual funds, Brady says. Mutual funds must sell underlying securities to free up cash for redemptions, which can create capital gains. While ETFs trade on the open market between buyers and sellers. But it's important to realize that ETFs and mutual funds with dividend-paying assets will rack up a fair amount of taxable dividend income. Before investing, review the potential tax implications of a fund. Also, avoid actively traded mutual funds, which accumulate high transaction costs, fees and greater capital gains.
Stay simple, avoid exotic investments
"Sexy sells but simplicity stands the test of time. Seeking tax-efficiency in taxable accounts can lead to the holy grail of investing: Long term, patient investing in tried-and-true strategies. In this quest, it's easy to get fooled into a world of complexity,” Philip says. Investors should be wary of financial advisors offering investors with taxable accounts exotic investments or structures that mention words like depreciation, shelter, annuity, insurance wrapper or tax deferral. These investments typically include high fees and are better for the advisor than the client. If an investment seems too complex, run the other way. Attention to the tax consequences of investments allows investors to keep more of their investing profits.
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