For many taxpayers, successful investing is all about how much they keep after taxes. If maximizing your after-tax returns is important to you, here are some tax-efficient tips to have in mind when discussing your portfolio with your tax and financial advisers.
Tip #1: Whenever possible, go long
Part of the wisdom in investing for the long-term comes from the favorable tax treatment for assets that are held for at least a year before they are sold. Currently, the maximum tax on long-term gains is 15%. (After 2010, this may rise to 20%.) However, gains realized on short-term assets, or those held less than a year, are taxed as ordinary income. These rates can be as high as 35% (as of 2010).
Tip #2 Tax-free can be better than tax-deferred
When investing in stocks within your IRA or 401(k) retirement accounts, the day of tax reckoning is delayed. This can allow dividends and any realized capital gains to reinvest on a tax-sheltered basis. However, once you begin withdrawing from these accounts in retirement, each distribution from a Traditional IRA will be taxed as ordinary income and, if taken prior to age 59 ½, a 10% penalty may also apply. That includes any portion of the account that resulted from reinvested capital gains. (Keep in mind that the tax treatment of distributions from a Roth IRA differs from that of a Traditional IRA; consult your tax adviser.)
Tip #3: All stock dividends are not taxed equally
Not all stocks pay dividends. Among those that do, some offer greater efficiency than others. The dividends of a number of companies are considered qualified dividends. Qualified dividends are currently taxed at a more favorable rate of 15%. Owning stocks that pay qualified dividends outside of a tax-advantaged account and owning stocks that pay nonqualified dividends inside a tax-advantaged account can improve your tax efficiency. Your financial adviser can help you make the distinction.
Tip #4: Mutual funds can be more tax efficient within retirement accounts
Because mutual funds are required to distribute all capital gains realized within their portfolios each year, it can be easier from a tax administrative standpoint to hold them in a tax-advantaged account. That way, the distributions simply reinvest without tax consequences until withdrawn from the retirement account. Similarly, the advantage in owning mutual funds shares within a tax-sheltered account from a tax standpoint — as opposed to a taxable account — is that there is no need to establish cost basis or account for the gains or losses on each individual lot when the investments are sold. Bear in mind, that although it may be easier to compute your tax liability, all withdrawals are taxed as ordinary income instead of at the capital gains rate, which tends to be lower. Therefore, this may not be advantageous if you are in a higher tax bracket when you begin taking distributions.
Tip #5: Harvest your losses as they accrue
When an investment is down, and the prospects for it rising involve some very long-term thinking, harvesting that loss may make sense if it is held in a taxable account. This is because realized capital losses may be used to offset realized gains, which lowers your tax bill. Also, up to $3,000 in capital losses may be used to offset ordinary income, while losses in excess of gains—and that $3,000 limit—may be carried forward for use in future tax years.*
Tip #6: Choosing the highest yielding fixed income investment isn’t always in your best interest
Keep your eye on the after-tax yield when considering different investment types. For instance, municipal bonds typically pay their tax-exempt interest at much lower rates than taxable bonds do. The key to determining if they are a suitable investment for you is to calculate the aftertax yield of a similar corporate bond. After considering the impact of taxes, they may still provide a higher yield, especially if you are in a high tax bracket. Fortunately, your financial adviser can help you make such comparisons.
Your financial adviser can help you determine when your greatest advantage rests in holding a security inside or outside of a tax-advantaged account based on your particular tax situation and the expected tax rates under the current tax code.