- While an investment strategy shouldn’t be based solely on taxes, it should still consider any opportunities to manage, defer, and reduce taxes.
- Manage taxes by considering the role of losses, the timing of investments, and investment selection.
- Defer taxes by considering the use of tax-deferred accounts.
- Reduce taxes by considering strategies like donating appreciated securities to charity, and funding education expenses using a 529 plan.
Investors spend untold hours researching stocks, bonds, and mutual funds with good return prospects. They read articles, watch investment shows, and ask friends for help and advice. But many of these investors could be overlooking another way to potentially add to their returns: tax efficiency.
Investing tax-efficiently doesn't have to be complicated, but it does take some planning. While taxes should never be the sole driver of an investment strategy, better tax awareness does have the potential to improve your returns. Morningstar estimates investors gave up an average of 1% to 2% of return per year to taxes for the 90 years through 2016. Let's say a portfolio could earn 8% per year instead of 6%, that extra return of 2% per year on a hypothetical portfolio of $100,000 could result in an additional $1 million after 40 years.1 This could be one of the best investment decisions you make this year, or any other year. Here are some tips.
There are several different levers to pull to try to manage taxes: selecting investment products, timing of buy and sell decisions, choosing accounts, taking advantage of losses, and specific strategies such as charitable giving can all be pulled together into a cohesive approach that can help you manage, defer, and reduce taxes.
Of course, investment decisions should be driven primarily by your goals, financial situation, timeline, and risk tolerance. But as part of that framework, factoring in taxes may help you build wealth faster.
Manage your taxes
The decisions you make about when to buy and sell investments, and about the specific investments you choose, can help to determine your tax burden. While tax considerations shouldn't drive your investment strategy, consider incorporating these concepts into your ongoing portfolio management process.
Tax losses: A loss on the sale of a security can be used to offset any realized investment gains, and then up to $3,000 in taxable income annually. Some tax-loss-harvesting strategies try to take advantage of losses for their tax benefits when rebalancing the portfolio, but be sure to comply with Internal Revenue Service (IRS) rules on the tax treatment of gains and losses.
Loss carryforwards: In some cases, if your losses exceed the limits for deductions in the year they occur, the tax losses can be "carried forward" to offset investment gains in future years.
Capital gains: Securities held for more than 12 months are taxed as long-term gains or losses with a top federal rate of 23.8% (versus 40.8% for short-term gains). Being conscious of holding periods is a simple way to avoid paying higher tax rates.
Fund distributions: Mutual funds distribute earnings from interest, dividends, and capital gains every year. Shareholders are likely to incur a tax liability if they own the fund on the date of record for the distribution in a taxable account, regardless of how long they have held the fund. Therefore, mutual fund investors considering buying or selling a fund may want to consider the date of the distribution.
Tax-exempt securities: Tax treatment for different types of investments varies. For example, municipal bonds are typically exempt from federal taxes, and in some cases receive preferential state tax treatment. On the other end of the spectrum, real estate investment trusts and bond interest are taxed as ordinary income—with rates up to 37% for the top income tax bracket in 2018. Sometimes, municipal bonds can improve after-tax returns relative to traditional bonds. Investors may also want to consider the role of qualified dividends as they weigh their investment options. Like long-term capital gains, qualified dividends are taxed at a top rate of 23.8%. Qualified dividends are subject to the same tax rates as long-term capital gains, which are lower than rates for ordinary income.
Fund or ETF selection: Mutual funds and exchange-traded funds (ETFs) vary in terms of tax efficiency. In general, passive funds tend to create fewer taxes than active funds. While most mutual funds are actively managed, most ETFs are passive, and index mutual funds are passively managed. What's more, there can be significant variation in terms of tax efficiency within these categories. So, consider the tax profile of a fund before investing.
Among the biggest tax benefits available to most investors is the ability to defer taxes offered by retirement savings accounts, such as 401(k)s, 403(b)s, IRAs, and tax-deferred annuities. By deferring taxes, you have the opportunity to grow your wealth faster.
Traditional accounts: Traditional retirement accounts can offer a potential double dose of tax advantages—contributions you make may reduce your current taxable income (if income eligibility requirements are met), and any investment growth is tax-deferred. After age 70½, however, there are minimum required distributions MRDs).2
Roth IRA accounts: With a Roth IRA or a Roth 401(k), you contribute after-tax dollars, but investment gains are tax-deferred, and withdrawals in retirement are tax-free, provided some conditions are met. Roths have no MRDs during the lifetime of the original owner so they can also be useful vehicles for estate planning.3
Tax-deferred annuity: Most tax-advantaged accounts have strict annual contribution limits and minimum required distribution rules. If you are looking for additional tax-deferred savings, you may want to consider tax-deferred annuities, which have no IRS contribution limits and are not subject to MRDs.
|2019 Annual contribution limits||Minimum required distribution (MRD) rules||Contribution treatment|
||Mandatory withdrawals starting in the year you turn 70½||Pretax or after-tax|
(Traditional2 and Roth3)
||Mandatory withdrawals starting in the year you turn 70 1/2 (except for Roth)||Pretax or after-tax|
||No contribution limit*||Not subject to minimum required distribution rules for nonqualified assets||After-tax|
*Issuing insurance companies reserve the right to limit contributions.
Account selection: When you review the tax impact of your investments, consider locating and holding investments that generate certain types of taxable distributions within a tax-deferred account rather than a taxable account. That approach may help to maximize the tax treatment of these accounts.
The United States tax code provides incentives for charitable gifts—if you itemize taxes, you can deduct the value of your gift from your taxable income (limits apply). These tax-aware strategies can help you maximize giving:
- Contribute appreciated stock instead of cash: By donating long-term appreciated stocks or mutual funds to a public charity, you are generally entitled to a fair market value (FMV) deduction, and you may even be able to eliminate capital gains taxes. Together, that may enable you to donate up to 23.8% more than if you had to pay capital gains taxes. 4
- Contribute real estate or privately held business interests (e.g., C-corp and S-corp shares; LLC and LP interests): Donating a non-publicly traded asset with unrealized long-term capital gains also gives you the opportunity to take an income-tax charitable deduction and eliminate capital gains taxes.
- Accelerate your charitable giving in a high-income year with a donor-advised fund: You can offset the high tax rates of a high-income year by making charitable donations to a donor advised fund. If you plan on giving to charity for years to come, consider contributing multiple years of your charitable contributions in the high-income year. By doing so, you maximize your tax deduction when your income is high, and will then have money set aside to continue supporting charities for future years.
Instead of deferring taxes, you may want to accelerate them by using a Roth account, if eligible—either a Roth IRA contribution or a Roth conversion.3 A Roth IRA contribution won’t reduce your taxable income the year you make it; in fact you will have to pay taxes on any tax-deferred deposits and investment gains at the time of the conversion. But there are no taxes on your future earnings and no penalties when you take a distribution, provided you hold the account for 5 years and meet one of the following conditions: you are age 59½ or older, are disabled, make a qualified first-time home purchase (lifetime limit $10,000), or have died. Also, be aware that while your earnings may be subject to taxes and penalties if withdrawn before those conditions are met, your contributions can be withdrawn at any time without tax or penalty.
529 savings plans
The cost of education for a child may be one of your biggest single expenses. Like retirement, there are no shortcuts when it comes to saving, but there are some options that can help your money grow tax-efficiently. For instance, 529 accounts will allow you to save after-tax money, but get tax-deferred growth potential and federal income tax-free withdrawals when used for qualified expenses including college and, since 2018, also up to $10,000 per student per year in qualified K–12 tuition costs.
Health savings accounts (HSAs)
Health savings accounts allow you to save for health expenses in retirement. These accounts have the potential for a triple tax benefit—you may be able to deduct current contributions from your taxable income, your savings can grow tax-deferred, and you may be able to withdraw your savings tax-free, if you use the money for qualified medical expenses.
The bottom line
Your financial strategy involves a lot more than just taxes, but by being strategic about the potential opportunities to manage, defer, and reduce taxes, you could potentially improve your bottom line.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
Each Income Replacement Fund's investment objective is intended to support a payment strategy through the Smart Payment Program (SPP). Monthly payments may not keep pace with inflation, will fluctuate year over year, and will result in the gradual liquidation of an investment in the fund by its horizon date. As with any mutual fund, withdrawals will reduce the investment balance, and future returns are not earned on amounts withdrawn. The funds and the SPP may not be appropriate for all investors. Please consult the fund's prospectus for more details.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Although state-specific municipal funds seek to provide interest dividends exempt from both federal and state income taxes and some of these funds may seek to generate income that is also exempt from federal alternative minimum tax, outcomes cannot be guaranteed, and the funds may generate some income subject to these taxes. Residency in the state is usually required for the state income tax exemption. Generally, municipal securities are not appropriate for tax advantaged accounts such as IRAs and 401(k)s.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Past performance is no guarantee of future results.
Tax-sensitive investment management techniques (including tax-loss harvesting) are applied on a limited basis, at the discretion of the portfolio manager, primarily with respect to determining when assets in a client’s account should be bought or sold. With this discretionary investment management service, any assets contributed to an investor’s account that the portfolio manager does not elect to retain may be sold at any time after contribution. An investor may have a gain or loss when assets are sold.