Investing involves assuming some risk and buying assets that will appreciate in value at a rate greater than inflation over the long term. Investments can decline in value, and it is important for investors to understand the impact of taxes on their returns. It’s not just about the tax bill, but the opportunity cost of the compounding benefit that could not be derived from that amount.
While there are tax-advantaged accounts (whether tax-deferred or tax-exempt retirement accounts) that provide tax benefits to investors, these accounts are not usually flexible, with multiple rules regarding withdrawals and limits on contributions.
On the other hand, taxable investment accounts provide flexibility and freedom in terms of withdrawals and contributions but no tax benefit.
Although taxable investment accounts do not offer additional tax benefits, investors can still minimize taxes by carefully selecting the assets they buy and using a tax-smart investment strategy. Here are eight steps investors can take to minimize their tax bill and increase their after-tax returns in taxable investment accounts:
- Prioritize long-term capital gains.
- Consider a buy-and-hold strategy.
- Choose passive funds (index funds and ETFs).
- Earn qualified dividends.
- Choose tax-efficient bonds.
- Optimize asset allocation for tax efficiency.
- Consider a charitable trust.
- Use tax-loss harvesting.
Prioritize Long-Term Capital Gains
A capital gain (the profit from the sale of an asset) is “long-term” if an investor has held the asset for at least a year. On the other hand, a capital gain is “short-term” if the asset has been held for less than a year.
Long-term capital gains are subject to capital gains tax (which ranges from 0% to 20%) while short-term capital gains are subject to the ordinary income tax rate (which ranges up to 37%).
The key point here is that for the average taxpayer, the tax rates on capital gains are lower than on ordinary income. Consequently, it is more tax efficient to hold assets for more than a year and pay capital gains tax rather than ordinary income tax.
Consider a Buy-and-Hold Strategy
Since capital gains taxes are only paid when an asset is sold, those investors who hold on to their assets for a long time instead of buying and selling often will have a lower tax bill.
Though these buy-and-hold investors (like their more active investors) will still pay tax on dividends from their assets, at least they can save on paying capital gains taxes.
This strategy might seem too simple, but when it comes to minimizing taxes, simple can be better. “Sexy sells but simplicity stands the test of time,” says Kevin Philip, managing director at Bel Air Investment Advisors in Los Angeles. “Seeking tax efficiency in taxable accounts can lead to the holy grail of investing: Long-term, patient investing in tried-and-true strategies.”
Choose Passive Funds (Index Funds and ETFs)
Passive funds don’t trade frequently, and they track the performance of a market index. Consequently, they tend to generate fewer taxable events (especially capital gains).
On the other hand, mutual funds will buy and sell frequently to earn above-market returns as well as to have enough liquidity to meet redemption requests. This leads to more taxable events and, therefore, more tax liability.
Even with passive funds, investors can further minimize taxes by choosing a fund that tracks a major stock index like the S&P 500 and avoiding niche index funds, which are costly and may experience long periods of underperformance, according to Philip.
In addition to ETFs and index funds that track the S&P 500, this includes funds tracking the Russell 2000, CRSP US Large Cap Index and other major indexes. Examples are iShares Core S&P 500 ETF (ticker: IVV), iShares Core S&P Mid-Cap ETF (IJH) and Vanguard Large-Cap ETF (VV).
Earn Qualified Dividends
While passive funds will incur lower capital gains tax than actively managed funds, they are also subject to tax on dividend income. Therefore, any efficient tax minimization will also include ways to reduce tax liability on dividend income.
One way to do this is to earn qualified dividends instead of ordinary dividends. Qualified dividends are taxed at the capital gains tax rate, while ordinary dividends are taxed at the ordinary income tax rate.
Remember that the former is lower than the latter. Therefore, earning qualified dividends instead of ordinary dividends will lead to tax savings.
According to the IRS, a dividend is qualified if the shareholder bought the stock at least 60 days before the ex-dividend date (a day before the record date) and held it for at least 61 days in the 121 days before the next dividend.
Also, the company paying the dividend must be a U.S. company or a qualifying foreign company. Plus, the dividend must not be coming from employee stock options, a money market account, a tax-exempt company or a real estate investment trust, or REIT.
Choose Tax-Efficient Bonds
Tax efficiency is not limited to stocks, however.
Municipal bonds (bonds issued by state, local and county governments) are exempt from federal taxes. If bought within the investor’s state of residence, they will typically also be exempt from state and local taxes.
Series I bonds (savings bonds tied to the inflation rate) are exempt from state and local taxes, but they are subject to federal taxes. The same applies to Treasury bonds (bonds issues by the federal government).
However, there is a point worth mentioning here. The investor must ensure that the return from these tax-efficient bonds is not less than the after-tax returns of taxable bonds. “A municipal bond yielding 2% is the equivalent of 3.08% on a taxable bond for investors in the 35% bracket,” says Greg McBride, senior vice president and chief financial analyst at Bankrate.com.
In this example, a taxable bond with, say, a 3.5% return would be more profitable. In other words, the return on the taxable bond will have to be lower than 3.08% for the tax benefit of the municipal bond with 2% return to be worth it.
Investors can use various after-tax yield calculators available online to find the after-tax yield of taxable bonds and compare with tax-efficient municipal, Treasury and Series I bonds.
Instead of individual bonds, investors can also buy tax-exempt bonds within index funds or ETFs. Examples include Vanguard CA Intermediate-Term Tax-Exempt Fund (VCAIX) and Fidelity Massachusetts Municipal Income Fund (FDMMX).
Optimize Asset Allocation for Tax Efficiency
One way to summarize the previous five points is that investors should put tax-efficient assets in taxable investment accounts and leave the tax-inefficient assets in tax-advantaged accounts such as 401(k)s, IRAs and Roth IRAs.
So, index funds and ETFs, assets providing qualified dividends, municipal bonds, Treasury bonds, Series I bonds and stocks held for more than a year would be included in a taxable investment account. On the other hand, mutual funds, actively managed ETFs, REITs, stocks from tax-exempt companies, money market accounts, employee stock options, corporate bonds and stocks kept for less than a year would be in a tax-advantaged account.
Furthermore, investors should consider adding funds specifically designed to minimize taxes to their taxable investment account. Examples include Vanguard’s Tax-Managed Capital Appreciation Fund (VTCIX) and Vanguard Tax-Managed Small Cap Fund (VTMSX).
Consider a Charitable Trust
“With a charitable trust, the consumer donates appreciated securities including stocks, bonds and funds, without paying any capital gains tax,” says Carlos Dias Jr., co-founder of Dias Wealth in Lake Mary, Florida.
By choosing to donate appreciated securities to a charity, investors can avoid paying capital gains tax while also getting a tax deduction for the donation. “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
The last strategy here is tax-loss harvesting. The IRS allows investors to earn tax credit when they sell assets at a loss. This credit can offset the taxes owed on capital gains.
For example, if an investor has a tax credit of $20,000 and a capital gain of $25,000, they can apply the tax credit to the gain such that they will only pay tax on $5,000.
If the tax credit exceeds the capital gains (say the tax credit is $30,000 in the above example), the investor can apply $3,000 of the extra ($5,000) to their tax return for the year, while the excess ($2,000) will be transferred to the next tax year.
The money from the sale can be reinvested in a different security that matches up with your investing strategy. However, you should be aware of the wash-sale rule, which states that an investor cannot repurchase the same asset (or a “substantially identical” one) within 30 days before or after the sale.
While any of these individual strategies can help reduce a tax bill, combining them all can lead to significant tax savings that will help investors maximize their returns and keep more of their profits.