An investment’s performance is only as good as its after-tax return. That’s why tax efficiency is important to your overall portfolio strategy.
Two Variables That Affect Your Tax Liability
Your tax liability on an investment generally is driven by two variables.
The first is the tax treatment. It’s determined by how the investment generates earnings. Common examples are long-term capital gains, qualified dividends, ordinary income (such as interest from bonds or bond funds, and short-term capital gains), tax-free income (think municipal bonds), or tax-deferred income (from investments held in many retirement-savings vehicles, for example).
The second variable is your personal tax situation, which includes your marginal tax rate, as well as specifics related to the investment — for example, its sale price, the adjusted tax basis, and any capital gain or loss.
3 Tax-Efficient Portfolio Guidelines
Following these three guidelines can help you effectively manage your overall tax burden:
1. Maximize Tax-Advantaged Retirement Accounts
With an employer-sponsored plan such as a traditional 401(k) plan, you make contributions with pretax dollars, automatically lowering your current-year income tax burden.
Additionally, your earnings grow tax-deferred, allowing you to sell securities without owing capital gains taxes. Distributions, however, are taxed at ordinary-income rates, not long-term capital gains rates. But, generally, this will be in retirement, when you may be in a lower tax bracket. With a Roth 401(k) plan, contributions are after-tax, but qualified distributions are tax-free.
Both traditional and Roth IRAs also grow tax-deferred. With a traditional IRA, these earnings, as well as amounts attributable to contributions, are taxed at ordinary-income rates upon withdrawal. However, qualified Roth IRA withdrawals are tax-free.
Contributions are also treated differently. Traditional IRA contributions may be tax deductible, depending on whether you or your spouse participates in an employer-sponsored retirement plan and your income level.
Roth IRA contributions aren’t deductible, and the amount you’re allowed to contribute will be reduced or eliminated if your income exceeds certain levels.
Another option is to convert some or all of your traditional IRA to a Roth IRA account. This may prove beneficial if you could be in a similar or higher tax bracket after retirement and you can afford to pay the taxes now, at conversion.
2. Consider Tax-Efficient Investments
Municipal bonds’ interest income is typically exempt from federal income taxes and, if you live in the state where the bond is issued, sometimes also from state and local taxes.
Index funds may be more tax efficient than actively managed mutual funds because an indexing strategy tends to generate a lower turnover of securities in the fund.
3. Consider the Tax Implications of Selling an Investment
An investment sold at a gain after it’s been held for at least one year will be subject to the applicable long-term capital gains rate. This may be around 20 percentage points lower than your marginal ordinary-income tax rate, which applies to short-term capital gains. So holding on to an investment for more than one year can significantly increase your after-tax return.
An investment sold at a loss can be used to offset capital gains elsewhere in your portfolio, reducing your overall tax liability. In addition, you can offset up to $3,000 per year of ordinary income with net losses, as well as carry unused losses forward to future years.
However, tax-loss selling has some limitations, including the potential for higher taxes later on and a potential loss of value when substituting a new investment to maintain the same risk exposure. Also, be aware that the IRS’s wash sale rule prohibits you from claiming a loss if you buy a “substantially similar” security within 30 days of the sale (before or after).
Balancing Tax and Investment Goals
It’s important to weigh tax ramifications within the broader context of your time horizon and risk tolerance.
In some cases, the potential gains from an investment may be worth accepting a larger tax burden. Discuss the appropriate strategy for your situation with your tax and financial advisors.
Contact Kemper Capital Management
Kemper Capital Management is your comprehensive financial planning firm for all of your individual, family, and business needs.
Our team of financial advisors is committed to providing our clients with holistic investment advisory services, helping them to achieve their immediate and long-term goals.
Content written by Thomson Reuters, as distributed to Symmetry Partners, LLC. Our firm utilizes Symmetry Partners, LLC for investment management services. Symmetry Partners, LLC, is an investment adviser registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. All data is from sources believed to be reliable, but cannot be guaranteed or warranted.
Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, product (including the investments and/or investment strategies recommended or undertaken by Symmetry Partners LLC), or any non-investment related content, made reference to directly or indirectly in this article will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. The article contains the opinions of the author(s) but not necessarily Symmetry Partners, LLC. Please note that you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Symmetry Partners or your advisor.
Please be advised that Symmetry Partners, LLC does not provide tax or legal advice and nothing either stated or implied here should be inferred as providing such advice. The information is provided for educational purposes only. Please be advised that Symmetry Partners is merely relaying this information and has no control if some of the timelines are amended.