One thing that people often neglect to consider when planning investing strategies is the impact of taxes on their investment returns. Taxes can take a bite out of annual returns, which can jeopardize your ability to meet long-term investing goals.
In fact, a study conducted by the Schwab Center for Financial Research determined that lowering taxes and other investment expenses is as much of a factor in boosting investment returns as asset allocation. Therefore, it makes sense to understand how taxes affect returns so you can implement portfolio management strategies designed to minimize this impact and thus boost long-term returns.
Here are 5 strategies for minimizing the impact of taxes on your investment returns:
- Max out your retirement accounts. Qualified retirement accounts — including IRAs, 401(k)s and 403(b)s — are one of the most tax-efficient ways to invest your money. Different types of retirement accounts offer different kinds of tax advantages.
For example, traditional IRAs and 401(k)s offer the potential for tax-deferred long-term growth because contributions are made with pre-tax dollars. Conversely, Roth IRAs and 401(k)s offer the potential for tax-free growth because post-tax dollars can be withdrawn without the burden of income taxes during retirement as long as you’re age 59½ years of age or over.
- Select investments that are more tax-efficient. Some investments operate in a more tax-efficient way than others. Investments that generate lots of current income (including dividends) tend to be less tax-efficient, while investments that don’t generate as much current income tend to be more tax-efficient.
The former category generally includes actively managed mutual funds, while the latter category generally includes passively managed index funds and ETFs that track a benchmark index like the S&P 500. Among the most tax-efficient investments are municipal bonds, whose interest is free from federal taxes as well as state taxes in some states if bonds are purchased by state residents.
- Put investments in the proper account types. Investments with different tax treatments need to be held in the right types of accounts. Investments that are not tax-efficient should generally be held in tax-advantaged accounts like IRAs and 401(k)s. Meanwhile, tax-efficient investments should generally be held in taxable accounts in order to maximize the current tax benefits.
For example, investments that generate taxable income, such as taxable bonds and high-turnover stock mutual funds, should generally be held in tax-deferred accounts like traditional IRAs and 401(k)s. And tax-efficient investments such as municipal bonds and tax-managed mutual funds should generally be held in non-tax-deferred accounts like brokerage accounts, since there’s no need for tax deferral.
- Hold onto investments long enough to avoid short-term capital gains. Gains realized on taxable investments that are held for one year or less are taxed at ordinary income tax rates, which range between 10% and 37%. But if you hold an investment for longer than one year, gains are taxed at the capital gains rate of between 0% and 20%, depending on your adjusted gross income and filing status:
Single Married filing jointly Capital gains tax rate
0% $0-39,375 $0-78,750 0%
15% $39,376-434,550 $78,751-488,850 15%
20% $434,551 or higher $488,851 or higher 20%
- Practice tax-loss harvesting. With this strategy, you will sell securities that are worth less now than you paid for them at a loss if you don’t expect the performance to turn around anytime soon. You can then use these losses to offset capital gains you may have realized on other securities you’ve sold this year. Investment losses can also be used to offset ordinary income.
You can use up to $3,000 in annual losses to offset capital gains during the year. Any amount over this can be carried forward to offset capital gains in future years. So if you realized a $5,000 loss this year, you could carry $2,000 forward to offset capital gains that you realize next year.
Please contact us if you have more questions about the effect of taxes on your investment returns and strategies that can help you minimize this impact.