By Landen Gill, Tax Associate, Exencial Wealth Advisors
When managing your investments, understanding and applying tax-efficient strategies is crucial. Tax-advantaged strategies can significantly enhance wealth accumulation over time, minimizing your tax burden and maximizing after-tax returns. In this article, we will explore several key strategies you can employ to help achieve greater tax efficiency in your portfolio. To determine if these strategies are appropriate for your specific situation, please consult with your advisor or CPA.
Tax-Advantaged Accounts: Maximize contributions to tax-advantaged accounts such as 401(k)s, IRAs, or Roth IRAs. The unique tax benefits of these accounts can accelerate the growth of your investments.
Tax-Efficient Asset Location: Strategically place investments based on their tax efficiency utilizing the tax advantages of the different account types. Investments prone to generating taxable income or short-term capital gains should be held in tax-advantaged accounts. Conversely, tax-efficient investments, like index funds, are better suited for taxable accounts.
Tax-Loss Harvesting: Employ tax-loss harvesting to offset capital gains where it makes sense. You can reduce your overall tax liability by selling investments at a loss, making your portfolio more tax efficient.
Consider Longer Term, Lower Turnover Investing: Aim for long-term capital gains by holding investments for more than a year. Long-term gains are taxed at a lower rate compared to short-term gains, often resulting in significant tax savings. All else being equal, utilize lower turnover strategies, mutual funds or ETFs as they realize fewer capital gains. Gains recognized on stocks held longer than a year are subject to the federal long-term capital gains tax rate, which currently stands at 15% for the majority of investors and 20% for high-income taxpayers. Additionally, there may be a potential 3.8% net investment income tax to consider.1
Dividend Stocks in Tax-Advantaged Accounts: Hold dividend-paying stocks in tax-advantaged accounts to defer taxes on the dividend income. Assets that consistently produce taxable income, like taxable bonds or stock funds with frequent trading, are often more suitably housed in tax-deferred accounts, such as traditional IRAs. Keep in mind that withdrawals made in retirement could be subject to taxation at your prevailing ordinary income rate, which might be lower during that period. In the case of a Roth account, withdrawals could potentially be tax-free.2
Invest Higher-Expected-Return Assets in a Roth IRA: Investing in higher-expected-return assets in a Roth IRA can be a smart strategy. Since Roth IRAs offer tax-free withdrawals in retirement, maximizing returns within this account can potentially lead to significant long-term benefits to you and your beneficiaries. Higher-expected-return assets typically consist of equities and private assets. If you have decided to convert assets from an IRA to a Roth IRA, consider converting only higher-expected-return assets to the Roth and leaving lower-expected-return assets like bonds in the IRA to get a bigger benefit for the taxes paid.
Municipal Bonds: Invest in municipal bonds, which typically offer tax-free income at the federal level and possibly at the state and local levels.3 They are ideal for taxable accounts due to their minimal tax implications.
Investments with minimal tax implications, like municipal bonds and tax-managed mutual funds, are typically more appropriate for a non-tax-deferred account such as a taxable brokerage account. When your investments don't result in significant tax obligations, there's less urgency to defer them. Consequently, stashing them in an account like an IRA that might limit your access doesn't make much sense.
Gifting and Inheritance Planning: Consider gifting appreciated securities to family members in lower tax brackets or leverage the stepped-up basis benefits for inherited assets. This can optimize the tax implications for both givers and recipients.
Tax-Efficient Withdrawal Strategies: When withdrawing from retirement accounts, plan strategically to minimize tax liabilities. Withdrawals from IRAs or 401(k)s are taxed at ordinary income rates versus a taxable account where withdrawals are taxed only on the gains realized. Techniques like delaying Social Security benefits can also be employed to optimize your financial situation in retirement.
Foreign Investments: Investing in foreign securities can offer unique tax advantages. While these investments often yield higher dividends than U.S.-based companies, they also come with the possibility of receiving a foreign tax credit.4 This credit can offset the U.S. tax liability on the same income. It is advisable to hold these investments in taxable accounts, as holding them in qualified or Roth accounts may result in the loss of the foreign tax credit benefit.
Other tax-advantaged vehicles include Qualified Opportunity Zone Funds, real estate investments and direct energy investments. These vehicles can be particularly appealing for investors with long-term horizons; however, they do come with their own set of complexities. It’s essential to weigh the potential tax benefits against the specific requirements and risks associated with each type of investment.
Tax efficiency is a critical component of successful wealth management. By implementing these strategies, investors can significantly reduce their tax burden, thereby enhancing the growth potential of their portfolios. Remember, it's not just about what you earn, but what you keep after taxes that truly counts in building wealth. If you have any questions, please don’t hesitate to reach out to your Exencial Advisor.
- IRS (December 21, 2023) Topic No. 409, Capital Gains and Losses
- Finra (December 21, 2023) Taxation of Retirement Income
- Morningstar (October 9, 2023) How to Use Municipal-Bond Funds in a Portfolio
- IRS (December 21, 2023) Foreign Taxes that Qualify for the Foreign Tax Credit
Exencial Wealth Advisors is an SEC registered investment adviser. Any references to the terms “registered investment adviser” or “registered,” do not imply that Exencial or any person associated with Exencial has achieved a certain level of skill or training.