Once you have established contingency funds and adequately funded your retirement accounts, you can consider starting a taxable portfolio. Investing in a taxable portfolio, particularly for high-income investors, can be much more nuanced than investing in an IRA or an employer retirement plan. Every investment must be reviewed not only for its potential investment return, but also for its potential tax impact. After all, an investment return is only meaningful if you get to keep it.
Here are some ways you can work to minimize the tax impact of investing outside of retirement accounts:
- Utilize municipal bonds instead of corporate or federal government bonds: The interest paid by municipalities,such as cities and school districts, is usually free from federal income tax. While the stated yields on municipal bonds will be lower than taxable bonds of comparable credit and duration, the amount you keep after taxes is more important and for investors in a higher tax bracket municipal bonds are usually a smart choice outside of retirement accounts.
- Focus on qualified dividends instead of ordinary dividends: When stocks and stock funds produce dividends, they can be treated as either qualified dividends, taxed at 15% or ordinary dividends, taxed as ordinary income, depending on when the stock is purchased and how long it is held before and after the dividend is paid. Without going into the details, when managing a portfolio for after-tax return, it is important to try and have as much of the portfolio’s dividend income treated as qualified dividends as possible.
- Manage capital gains: When a stock is sold at a profit, any gain is taxed as a capital gain. Short-term capital gains, from investments held less than a year are taxed as ordinary income while long – term capital gains, on investments held longer than a year, are taxed at an advantageous rate. When managing a taxable portfolio, it is important to defer gains so they receive long-term capital gain tax treatment and manage how much net gain an investor has at the end of any year. In certain instances, we may sell part of an investment this year and wait and sell part of an investment the next year in order to spread the tax impact.
- Harvest capital losses: Selling investments that have lost money can offset the gains taken on other investments. It often makes sense to sell losing investments and reinvest elsewhere to offset gains taken on winners. Losses not used to offset gains can be carried over to future years when you do have gains, and up to $3000 per year can be deducted from income.
- Pay attention to wash sale rules: If you sell an investment to harvest a loss, you need to avoid repurchasing that investment for 30 days or the loss is disallowed for tax purposes. This applies across accounts, so you can’t harvest a loss in your taxable account and buy the same stock in your IRA. You can, however, sell one stock and buy a different stock from a similar company. For instance, if you sold Exxon Mobile for a loss, you could reinvest in British Petroleum to maintain your exposure to the oil sector.
- Avoid asset classes that create unpredictable tax consequences: Often in taxable portfolios we will avoid allocations to asset classes that either produce a lot of ordinary income or that can have tax impacts beyond our control, such as funds that employ option strategies. If these asset classes make sense for an investor, we’ll place them in their retirement accounts whenever possible.
- Utilize Tax-Managed Mutual Funds: Most of the time, we are building portfolios using mutual funds, which means we need to be aware of not only the tax impacts of buying and selling on the fund level, but also what is going on inside the mutual fund. Mutual funds pass the tax liability of their buying, selling, dividends, and interest to the investors. When a fund has tax – advantaged or tax-managed in its name, the portfolio managers have a goal of maximizing investors after-tax return and will usually employ all of the above strategies within their funds. The managers try to minimize the capital gains created when they buy and sell their investments, and try to keep dividends passed to investors classified as qualified dividends. If the fund includes bond allocations, they are most likely municipal bonds producing tax – free interest. Index funds and similar low-turnover strategies can also be good choices as there is not much buying and selling within the funds to create capital gains.
By incorporating these strategies, you can help mitigate the tax impact of your investments and keep more of your return. However, it’s also important to remember that, if your portfolio makes money, you will have to pay some tax at some point for your efforts. Also, while we want to be aware of the tax impact of our decisions, we can’t let taxes be the only driver of our investment process. If you hold an investment that is no longer appropriate, you should find a way to replace it regardless of tax impact.