Here are six strategies to help investors preserve their hard-earned investment gains and prevent them from being whittled away by taxes:
Hold Appreciating Assets in Taxable Accounts and Higher Yielding Assets in Retirement Accounts
By holding assets with the greatest expected capital appreciation potential (e.g. stocks) in a taxable account, investors defer paying tax on capital gains until the position is sold. If held over 12 months, the gain on the investment will be taxed at the lower long term capital gains rate. If held until death, heirs will receive the assets at fair market value and will never have to pay tax on the profits made prior to the time of inheritance.
Alternatively, by holding income generators (those paying higher dividends and/or interest) in qualified retirement accounts, an investor can defer taxes until they withdraw funds from the account.
Avoid Excessive Trading
Some investment managers will place trades to demonstrate ‘how hard they’re working.’ However, trading is expensive from both a tax and transaction cost standpoint. In our view, every trade must have a clear and decisive after-tax benefit to the client.
Harvest Tax Losses
Market downturns, as challenging as they are, have a silver lining: the opportunity to recognize and ‘bank’ losses that can be later used to offset future realized capital gains. To offset a gain is to temporarily eliminate a tax due. The key with this strategy is to replace the asset sold with one that exhibits similar risk/return and correlation characteristics. That way, when the market recovers, there is still an investment in place that can benefit by an eventual rebound in prices.
In lower income years, one might consider converting a portion of their IRA to a Roth IRA. The strategy here is to pay tax now at a lower rate on the amount converted and then enjoy tax-free growth forever on the Roth IRA assets.
Efficient Withdrawal Strategies
Determining when to withdraw money and from which account can be complex. The optimal combination in which assets are drawn from taxable, tax-deferred (traditional IRA), and after-tax (Roth IRA) accounts may vary from year to year based on expected income. For example, during high income years, selling high basis stock from a taxable account may be appropriate to reduce gains. Conversely, withdrawing from a traditional IRA during lower income years may be advantageous.
Don’t Let the Tax Tail Wag the Dog
The simple goal of minimizing taxes is to achieve the lowest tax bill possible, but this myopic approach is not always consistent with maximizing after-tax returns. For example, an 8% return that gives back 1.5% to taxes (an after-tax return of 6.5%) is still far superior to a tax-free return of 4%.
When it comes to your investment portfolio, smart tax management can be the difference between a good return and a great return. Of course, one size does not fit all, and so we must include the standard and important disclaimer that the information presented here should not be construed as individual tax advice.