Each investor may have their own unique set of goals and preferred strategies for achieving financial success, but there’s one thing that rings true for all, regardless of where they are on their wealth journey: Investors want more of their returns going toward their goals and less going to the IRS. Tax season is often a time where investors reflect on their overall strategy, but when it comes to lowering investment taxes, investors will need to consider a plan of action well ahead of filing.
A good starting point for any investor developing their tax-efficient plan is to consider the following:
- Which investments to choose.
- Where to hold investments.
- When to sell shares.
- What order to withdraw investments.
- How to make the most of charitable giving.
Here are five key areas that can help investors to address the above and potentially lower their investment taxes.
In taxable (nonretirement) accounts such as brokerage accounts, most investors are aiming to maximize the after-tax returns of their portfolios. Choosing investments with built in tax-efficiencies, such as index mutual funds and index ETFs, can help minimize returns lost to taxes.
ETFs, or exchange-traded funds, may also oﬀer an additional tax advantage, given the way their transactions settle, which allows them to avoid triggering certain capital gains.
If you want to take a more actively managed approach to your investments but don't necessarily want the tax burden that accompanies it, you might consider active products that focus on tax eﬃciency. For example, those in a higher tax bracket may want to consider investing in municipal bond funds, which are tax-exempt, as they pay lower interest rates but maximize after-tax returns. However, keep in mind that you may owe taxes on any capital gains realized from trading or through your own redemption of shares, and a portion of the fund’s income may be subject to state, local and federal alternative minimum tax.
Divided Assets (Across Accounts)
When it comes to maximizing after-tax returns, the location of your investments can be impactful.
Asset location can be used to minimize taxes by dividing your assets among taxable and nontaxable accounts. Investments that are less tax‑eﬃcient, like actively managed mutual funds and taxable bonds, can sometimes be better served in accounts that defer taxes, such as 401(k) plans and IRAs. Meanwhile, tax‑eﬃcient investments like index mutual funds, index ETFs, tax-exempt bonds and stocks can be better suited for taxable accounts.
The net increase in taxable value of your investments is called capital gains. Through a strategy called tax-loss harvesting, some investors will strategically and intentionally sell some investments at a loss to lower their overall capital gains exposure. If you have realized gains this tax year or anticipate capital gains in the future from a sale of a business or other investment, for example, it may make sense to look for opportunities to realize losses to offset them.
An example of this could be selling shares of funds or stocks that have lost value since you’ve bought them. As with any tax-related topic, tax-loss harvesting has rules and restrictions (such as the wash sale rule) that you should familiarize yourself with before using this method. Partnering with a financial adviser can help avoid mishaps, and for those not yet engaged with a human adviser, many robo advisers today include tax-loss harvesting as an integrated feature.
Withdrawal Order Optimization
It’s important to factor in taxes when you withdraw money from your investment portfolio.
If you decide to reinvest income produced from your investments and then sell the shares for a gain, note that you'll owe taxes on the income produced and capital gains taxes on the appreciation. When drawing down from your nonretirement accounts, consider taking the income produced from the investments and moving it into a money market (rather than reinvesting it) to avoid paying taxes twice.
If philanthropy is part of your investment goals, you can give in a way that can help lower your taxes. There are a few strategies to consider in order to make the most of your giving, and one of them should be gifting investments such as mutual funds, ETFs or individual stocks instead of cash, if the organization allows. If these appreciate, you can minimize future capital gains taxes on the asset, and you can still receive a charitable deduction.
Also, if you do gift cash, itemizing these donations on your tax return can help you take advantage of tax deductions up to certain limits.
Additionally, you can donate up to $100,000 annually from your IRA directly to a qualiﬁed charity through a qualiﬁed charitable distribution, or QCD. As long as certain rules are met — such as you're at least age 70½ when making the gift, and the check is payable directly to the qualiﬁed charity — then the distribution shouldn't be taxable income.
For many investors, the above approaches may seem like a lot to manage, and although these strategies can help you see higher returns, all investing is subject to risk — including the possible loss of the money you invest. That’s why I recommend consulting with a financial adviser and a tax adviser to create a tax-smart investment plan.
Remember, you don’t have to do it alone! Happy tax season.
Neither Vanguard nor its ﬁnancial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice.
Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions, and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties regarding such information, or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal advisor about your individual situation.
Julie Virta, CFP®, CFA, CTFA is a senior financial adviser with Vanguard Personal Advisor Services. She specializes in creating customized investment and financial planning solutions for her clients and is particularly well-versed on comprehensive wealth management and legacy planning for multi-generational families. A Boston College graduate, Virta has over 25 years of industry experience and is a member of the CFA Society of Philadelphia and Boston College Alumni Association.
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