What’s the goal of tax efficiency?Tax efficiency is all about maximizing your return—the amount you actually get to keep after paying fees and taxes.
One of the simplest ways to maximize your return is to focus on lowering your investment costs and the taxes you pay on your investment returns.
Other common strategies for maximizing the tax efficiency of your portfolio include maximizing the contributions you make to tax-advantaged accounts, maintaining an appropriate asset allocation that’s invested in the right type of account (asset location), and making tax-efficient withdrawals from your portfolio in retirement.
What’s the difference between taxable and tax-advantaged accounts?Taxable (nonretirement) accounts generally don’t offer special tax breaks—and you have to pay income taxes on interest, dividends, and capital gains as your investment grows.
“Tax-advantaged” is the umbrella term for accounts that offer tax benefits, such as tax-deferred accounts (which don’t require you to pay income taxes on your earnings until you make a withdrawal) and tax-free accounts (which offer tax-free withdrawals, assuming you meet certain rules). These include IRAs, employer-sponsored retirement plans, and Roth accounts.* Maximizing how much you save in tax-advantaged accounts—before investing in taxable accounts—is a fundamental tenet of tax planning.
How important is asset location?Asset location is just as important as asset allocation.
Your asset allocation refers to the mix of stocks, bonds, and short-term reserves you own, while your asset location refers to the account type—taxable versus tax-advantaged—that holds those assets. Rebalancing your portfolio on a regular basis will help you maintain the appropriate asset allocation and preserve the tax efficiency of your portfolio.
Regarding asset location, we encourage investors to hold index equity funds and ETFs in taxable accounts. Although the investment income (including dividends and capital gain distributions) you receive in a nonretirement account is taxed, it’s taxed at your capital gains rate (unless the dividends are nonqualified), which is generally lower than your ordinary income tax rate. Capital gains tax rates range from 0%–20%, while income tax rates range from 10%–39.6%.
Holding taxable bond funds and actively managed equity funds and ETFs in tax-advantaged accounts (to shelter the interest and dividend distributions from current taxes) is generally a good practice. Outside a tax-advantaged account, bond interest is taxed as ordinary income. Clients in high tax brackets may consider investing in municipal bond funds in a taxable account to benefit from federal—and possibly state—tax-free interest.
Can capital gains push someone into a higher tax bracket?No, capital gains generally can’t push someone into a higher income tax bracket. Your tax bracket is determined by the amount of ordinary income you earn, which includes compensation, self-employment income, rental property income, etc.
A capital gain is the profit an investor realizes when he or she sells an asset for more than the original purchase price, which is called its basis. The rate at which a capital gain is taxed depends on your tax bracket and the amount of time you held the asset before selling.
For example, many investors can expect to pay 15% on long-term capital gains (on assets that have been held over a year). High earners can expect to pay up to 20%, while low earners can expect to pay 0% on their capital gains. (Note that the Medicare investment surtax may also apply.) Special types of capital gains can be taxed at 25% or 28%.
Short-term capital gains (on assets you’ve held for a year or less) will be taxed at your ordinary income tax rate.
Tax efficiency is part of our DNA
When is the best time for investors to think about tax planning?You should always think about it—year round! Investors should look for opportunities to manage and minimize their taxes, both now and in the future.
One of the strategies investors should consider is tax loss harvesting, which is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” a loss, investors are able to offset recognized capital gains—and possibly up to $3,000 of ordinary income—which can provide tax savings for the year.
This balancing act can be tricky, though, so you should speak with a tax advisor for help.
What tax law changes—or potential changes—should be on people’s radar in 2016 and beyond?The only constant in our tax environment is change, but when you’re investing, you can only take the current tax laws and rules into account—you can’t predict what the future will hold.
That being said, we may be due for tax law reform. Looking at the past 90 years, Congress tends to reform tax laws about every 25 years or so. The Tax Reform Act of 1986 was our last major reform, so historically, we’re overdue. However, it’s unlikely that we’ll see major changes in 2016 because it’s an election year.
It’s also worth mentioning that at the end of 2015, Congress made substantial updates to its “annual tax extenders” package, making a number of the rules permanent and extending others for a few years, relieving some of the pressure to make updates later this year. Most notably, the RMD charitable tax break became permanent, allowing investors to make a tax-free RMD distribution if it’s directed to a charity.
Last year, Congress also made a number of changes to the Social Security claiming strategies available to retirees. From a tax efficiency perspective, it’s still advisable to delay your Social Security benefits so less of your benefits are subject to income tax. This benefit of delaying your Social Security start date often flies under the radar, but you shouldn’t overlook it.
Do you have any final thoughts?Timing is everything. Don’t wait until December or 2017 to consider tax-efficient investing strategies. Seek a qualified advisor to assess the opportunities you have for this year, and act accordingly.
*Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account.
Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares.
For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
You may wish to consult a tax advisor about your situation.
The article is not meant as a substitute for consulting a qualified tax advisor, or to provide tax or legal advice.