After the headline risks of the market and inflation, taxes present the biggest obstacle to your building wealth. Your best investment strategy seeks to not only generate returns on your capital but also to save as much of your money as possible to keep it working for you. One of the surest ways to preserve your capital: Reduce your taxes on investment income and gains.
Here are some strategies:
Asset allocation. One of the first rules of wealth accumulation: Sock as much income as possible into a tax-qualified retirement plan, such as an individual retirement account, a 401(k) or a 403(b) if you work for a school or tax-exempt organization. Such plans do give you an immediate and long-term tax advantage, either deferring taxes until your payouts or allowing you to withdraw in retirement tax-free.
For an overall asset-allocation strategy, though, how you place various investments among your tax-qualified plans and your non-qualified investment accounts counts almost as much as your selection of investments. Place your tax-efficient investments in your non-qualified investment accounts and your non-tax efficient investments in accounts that give you a tax break.
• Non-tax efficient investments include securities and income-producing assets that tend to generate more taxable returns, such as taxable bonds, bond funds and dividend-paying stocks or mutual funds.
• Tax-efficient investments include tax-exempt bonds and bond funds, tax-managed mutual funds, exchange-traded funds and broad market stock index funds.
What and when to buy. If you invest in mutual funds in your non-qualified accounts, consider the portfolio holdings of the fund, how much of the portfolio turns over each year and the amount of unrealized gains that exist only on paper.
About your worst move as a mutual fund investor is to buy shares of an actively traded mutual fund that has a high turnover ratio and sits on a boat-load of capital gains. These types of funds notoriously sell their most profitable stocks, especially to meet share redemption demands, and distributing big – and fully taxable – gains to shareholders. That reduces the share price in some proportion to the distribution, which means you the shareholder are left with a lower share price and a taxable distribution.
Instead, consider investing in funds that temper your capital gains through minimizing taxes with tax harvesting – selling some holdings at a loss to counterbalance the gains – or in broad index stock funds that are more passively managed, and don’t run up a lot of cap gains.
If you feel a need to sell securities to lock in gains, use that opportunity for tax harvesting. You can do this each year to keep your target asset allocation in line with your investment objectives.
You use the proceeds of the stocks sold for gains and losses to add to the portion of your asset allocation that needs increasing.
Avoid the 3.8% surtax. Beginning in 2013, if your modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 if you file your return with the status of married filing jointly), your investment income above a certain threshold may incur an additional 3.8% surtax. This tax doesn’t affect your income earned in qualified accounts or your income from certain investments, such as tax-exempt bonds and qualified dividend-paying stocks.
Seek the guidance of a qualified tax professional to analyze immediate and long-term implications of your investment decisions.
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