Wednesday, August 3, 2022

Basics of Tax-Efficient Investing

As I wrote in my book, Flipping a Switch, the investment firm Nuveen, many years ago, created the advertising slogan “It’s not what you earn, it’s what you keep.” This phrase was designed to encourage investors to buy tax-free municipal bonds that provide a higher after-tax return than higher-yielding taxable bonds.

In a more general way, the advertisement was also promoting the concept of tax-efficient investing. This is the process of (legally) structuring an investment portfolio so the least amount of tax is paid. Paying more taxes than necessary is a drag on investment returns, resulting in investors keeping less of what they earn.

The good news is that there are steps people can take to increase the tax efficiency of their investment portfolio. Below are six tax-saving ideas gleaned from recent webinars and research for my book:


Look Toward the Future- Absent new tax legislation, the Tax Cuts and Jobs Act is scheduled to sunset after 2025, tax rules will return to what they were in 2017, and tax rates will be higher than they are right now. Knowing this provides an incentive to take proactive action. For example, some people are converting traditional IRAs to Roth IRAs in one or more transactions through December 2025. Also consider potential income in later life. If you expect to be in a higher tax bracket, consider Roth (after-tax) investments.


Consider Municipal Bonds- Municipal bond earnings are tax-free, which means that they are exempt from federal income taxes. States and cities also waive taxes on investment earnings from their own securities (e.g., no tax for New Jersey residents on a New Jersey-issued bond). Investors in higher tax brackets can often benefit from this strategy. To compare returns on taxable and tax-free accounts, use this calculator. There is also a math formula: taxable equivalent rate = tax-free yield ÷ (100% -marginal tax bracket).


Consider Tax-Saving Gifts- Only about 10% of taxpayers today can itemize deductions and it generally requires a plan to aggregate sufficient deductible expenses that exceed the standard deduction amount ($12,950 for singles and $25,900 for married couples filing jointly). Specific tax-advantaged strategies include gifting appreciated securities, qualified charitable distributions, and funding a donor advised fund. People can also lower their account balances that get taxed by gifting up to $16,000 to individuals (2022).


Consider Asset Location- Consider selecting these securities for taxable accounts: stocks held for more than a year (to qualify for long-term capital gains), low-turnover stock and index funds, municipal bonds, and stocks/mutual funds paying qualified dividends. For tax-advantaged accounts (e.g., IRA, 401(k)/403(b) plans), suitable investments include stocks to be held a year or less, funds that generate significant short-term capital gains, and taxable bond funds. In other words, generally place investments likely to lose more return to taxes in tax-advantaged accounts and those poised to lose less return to taxes in taxable accounts.


Practice Tax Diversification- To hedge uncertainty about taxes, experts recommend selecting different types of investments that are taxed in different ways. Specifically, taxable investments (e.g., a regular bank or brokerage account) where earnings are taxed in the year they are received, tax-deferred investments (e.g., traditional IRAs and 401(k)/403(b) plans) where earnings are taxed at a future date, and tax-free investments where taxes are not due on earnings (e.g., municipal bonds and Roth IRAs for qualified distributions). When rebalancing a portfolio back to its target asset allocation weights, consider selling securities within tax-deferred accounts to avoid having to take taxable capital gains from taxable accounts.


Choose Tax-Efficient Investments- In addition to Roth and traditional IRAs, 401(k)/403(b) plans, and municipal bonds, all mentioned above, there are other investments that can help minimize income taxes. They include 529 college savings plans, flexible spending accounts (FSAs), tax-deferred annuities, and health savings accounts (HSAs) for people with high-deductible health insurance plans.

Bottom Line: tax-efficient investment strategies allow investors to retain more of their investment earnings. Again, what really matters is not what you earn, it is what you keep!

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