When gauging the return on their investments, many people neglect one of the most important factors affecting their returns: taxes. Because when it comes to investment returns, it’s not what you make, but what you keep that really counts.
This makes tax efficiency one of the biggest keys to successful portfolio management. Your goal should be to structure and manage your portfolio in such a way that your after-tax returns are maximized — or in other words, you keep as much money as possible after Uncle Sam takes his bite.
The Schwab Center for Financial Research conducted studies to determine the long-term impact of taxes and expenses on investment returns. It concluded that minimizing taxes and expenses is almost as important as asset allocation and investment selection when it comes to maximizing returns.
Taxable and Tax-advantaged Accounts
Investments can be held in either taxable or tax-advantaged (i.e., tax-deferred or tax-free) accounts. Taxable accounts include individual and joint investment accounts, bank savings accounts and money market accounts, while tax-advantaged accounts include qualified retirement accounts like 401(k)s and traditional and Roth IRAs.
As a general rule, the more income (such as dividends) generated by an investment, the less tax-efficient the investment is. Therefore, tax-inefficient investments should generally be held in tax-advantaged accounts like qualified retirement accounts, while tax-efficient investments should generally be held in taxable accounts.
For example, taxable accounts are generally best for individual stocks that will be held for more than one year, stocks or mutual funds that pay qualified dividends, and municipal bonds. And tax-advantaged accounts are generally best for individual stocks that will be held for less than one year, actively managed funds that may generate significant short-term capital gains, taxable bond funds, and real estate investment trusts (or REITs).
What’s Your Tax Bracket?
Another factor to consider in planning for tax-efficient investing is your marginal tax bracket. The higher your tax bracket, the bigger the impact taxes will have on your investment returns. Individual tax brackets range from 10% to 39.6% while the long-term capital gains tax rate is 0%, 15% or 20%.
Taxable investments held for less than one year may be taxed at your ordinary income tax rate, which is somewhere 10% and 39.6%. But taxable investments held for one year or longer will be taxed at the long-term capital gains rate of 0% (for married couples filing jointly with adjusted gross income under $75,300), 15% (for married couples filing jointly with adjusted gross income up to $466,950) or 20% (for married couples filing jointly with adjusted gross income of more than $466,950).
Also keep in mind that an additional 3.8% Medicare investment income surtax now applies to net investment income for taxpayers with adjusted gross income over $250,000 (for married couples filing jointly) or $200,000 (for single filers).
The Spectrum of Tax-Efficiency
On a spectrum from the most tax-efficient to the least tax-efficient investments, municipal bonds would reside on the far end of tax efficiency. The interest earned on municipal bonds is free from federal taxes, and in some states it’s also state-tax free if the bond is purchased by state residents. Convertible bonds, investment-grade corporate bonds and REITs are also relatively tax-efficient investments.
At the other end of the tax-efficiency spectrum would be tax-inefficient investments like high-yield (or junk) bonds, straight-preferred stocks and convertible preferred stocks. These types of investments should generally be held in tax-advantaged accounts. Conversely, the tax-efficient investments listed above should generally be held in taxable accounts, since there’s no tax benefit to be derived by holding them in tax-advantaged account.
If you have more questions about the impact of taxes on your investment returns and how to invest in the most tax-efficient way, please give us a call. We will help you devise a strategy for tax-efficient investing that’s based on your specific investing and financial goals.