- Taxes shouldn't be the primary driver of your investment strategy—but it makes sense to take advantage of opportunities to manage, defer, and reduce taxes.
- Manage federal income taxes by considering the role of losses, the timing of investments, and investment selection.
- Using tax-deferred accounts when appropriate can help keep more of your money invested and working for you—and then you can pay taxes on withdrawals in the future.
- Reduce taxes by considering strategies like donating appreciated securities to charity, and funding education expenses using a 529 plan.
- Educate yourself on the tax implications of your employer's stock plans.
Some 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 primary driver of an investment strategy, better tax awareness does have the potential to improve your after-tax returns. Morningstar estimates that a hypothetical investor gave up an average of 1% to 2% of return per year to federal income taxes for the 93 years from 1926 to 2018. 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 federal income 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 federal income 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 impact 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 wash sales and the tax treatment of gains and losses. Harvesting tax losses on shares you have acquired through an employer stock plan can be complicated by window periods and wash sale rules.
Loss carryforwards: In some cases, if your realized losses exceed the limits for deductions in the year they occur, the tax losses can be "carried forward" to offset future realized investment gains. All gains and losses are "on paper" only until you sell the investment.
Capital gains: Securities held for more than 12 months before being sold 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. Taxes are, of course, only one consideration. It's important to consider the risk and return expectations for each investment before trading. Note: Special rules may apply to shares acquired through tax qualified equity compensation plans.
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. 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. Qualified dividends are subject to the same tax rates as long-term capital gains, which are lower than rates for ordinary income. (See Qualified Dividends for more information.)
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.
Employer stock plans: Participation in your employer's stock plan benefit may carry nuanced, and potentially significant considerations both when selling company stock or filing taxes. (See Understanding Stock Plan Taxes for more information).
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, and IRAs. 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 required minimum distributions (RMDs). Deferring taxes may help grow your wealth faster by keeping more of it invested and potentially growing.
You may already be familiar with tax-advantaged retirement saving accounts.
|2020 Annual contribution limits||Required minimum distribution (RMD) rules||Contribution treatment|
||Mandatory withdrawals starting in the year you turn 72*||Pretax or after-tax|
(Traditional2 and Roth3)
||Mandatory withdrawals starting in the year you turn 72* (except for Roth)||Pretax or after-tax|
||No contribution limit**||Not subject to required minimum distribution rules for nonqualified assets||After-tax|
*The change in the RMD age requirement from 70½ to 72 only applies to individuals who turned 70½ on or after January 1, 2020. Please speak with your tax advisor regarding the impact of this change on future RMDs.
**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.
Read Viewpoints on Fidelity.com: Why asset location matters
Stock options: If you receive stock options from your employer, you may have the opportunity to manage taxes by planning ahead on your exercise strategy. One risk to timing your stock plan transactions around taxes is building up an excess of one single company. This is called concentrated risk, or too many eggs in one basket, so always consider all aspects of your investment, and not just the tax implications.
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. Shares acquired through an employer stock program are generally good candidates for donation if held long-term and can reduce a concentrated position.
- 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.
Read Viewpoints on Fidelity.com: Strategic giving: Think beyond cash
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 (Read Viewpoints on Fidelity.com: Answers to Roth conversion questions.)
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.
Read Viewpoints on Fidelity.com: 5 ways HSAs can fortify your retirement
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.