Four Tax Efficient Strategies for Everyday Investors
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Death and taxes may be the only certain things in life, yet investors often don’t give as much thought as they should to the tax implications of their actions.
“People think about taxes last,” says John Piershale, founder of Piershale Financial Group. “But they have to stop and realize every transaction has a tax consequence.”
Taxes alone shouldn’t drive your investment strategy, but that doesn’t mean they should come last. Here are four tips that might reduce the tax bill on your investment income.
1. Don’t think of tax loss harvesting as a fourth-quarter thing.
Investors who generate capital gains taxes often engage in tax loss harvesting. This means they will sell a holding at a loss to offset the gains generated by the sale of another holding. This can often be a wise strategy, but one should not wait until the fourth quarter to pursue it, says Peter Mallouk, president and chief investment officer at Creative Planning. “Investors should be looking throughout the year for the opportunity to offset losses,” he says. “It should be part of the ongoing management of the tax implications of their portfolio.”
2. Hold dividend- and interest-paying investments in tax-deferred accounts
Bonds and bond funds can diversify a portfolio while providing some yield. However, if those fixed-income investments are held in a taxable account, the interest earned is taxed as ordinary income. “If you have a corporate bond paying 4%, you are not making 4%,” says David Richmond, founder of Richmond Brothers. “You are making 4% minus whatever fee you had to pay to buy the bond [and] the tax hit.”
The same goes for bond fund dividend distributions, which are also taxed at the typically higher, regular income tax rate. By comparison, dividends from individual equities and equity funds may be taxed at the lower qualified dividend tax rate. In either case, investors may benefit from keeping dividend-paying investments out of taxable accounts and instead holding them in retirement accounts, like an IRA or 401(k). This allows investors with ordinary income to avoid increasing their tax liability.
While holding high dividend- or interest-yielding securities in taxable accounts is not efficient for tax purposes, however, investors shouldn’t necessarily rush to sell their positions, says Richmond, adding that sound investment strategy requires more than simple tax efficiency. “If I wanted to make an allocation change, then I would do so over time, as the asset pricing dictates a change,” he says.
If you are considering moving interest- or dividend-earning investments from taxable to tax-deferred vehicles, such as an IRA or a Roth IRA, factors to consider include capital gains taxes, wash sale rule navigation, and your eligibility to contribute.
3. Don’t exercise gains on an investment, only to replace it with a similar one.
According to Mallouk, often investors sell a stock, ETF or mutual fund after it has had a nice run, take their profits, and buy another stock in the same asset class — and come tax time, pay the (tax) consequences.
“If you have an energy stock up 10%, sell it then buy another energy stock you like more, the odds are good you paid taxes to buy something else that is highly correlated to what you just sold,” Mallouk says. “In other words, you are in generally the same place — but have paid taxes.“
Mallouk argues that a better option when you have an outperforming stock is to take the gains and put your money in a different sector or asset class.
4. Pay attention to the turnover rate of mutual funds
Many investors allocate their non-retirement assets to mutual funds to stay diversified. What they may not realize is the turnover rates of those funds might impact how much they are going to pay Uncle Sam. “The turnover rate — or how much buying and selling the [fund manager] is doing — gets distributed to you in capital gains or losses,” says Richmond. “If the fund turned over the holdings once in the last 12 months, whatever the profit was, minus any losses, gets passed through to investors.”
Because of the tax implications, keep an eye on the turnover rate when choosing your mutual fund, Richmond says. Better yet, consider investing in passive index funds or ETFs, which have lower turnover ratios, and are often more tax-efficient as a result.
Taxes are undoubtedly a major part of any sound investment strategy, but at the end of the day, they can’t be the driving factor, either. When it doubt, most investors might be better off un-complicating things by investing in passive, low-cost ETFs.
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