You work hard to earn a buck. The government taxes your income a few different ways, including federal income taxes, FICA taxes (Social Security and Medicare) and a state income tax depending on where you live. Your remaining money is used to pay your bills, support your family and if you’re frugal, have enough left over to save and invest. Investing can be risky, but it comes with the potential for profit.
A capital gain occurs when you sell an investment for a profit. The federal and many state governments will tax this gain, with a capital gains tax. So how can we limit and control the capital gains tax we pay our government?
Tax Efficient Investments
One of the most common investment vehicles used to invest our hard earned dollars are mutual funds. They have been around for decades and have been a fantastic tool for providing professional management to the everyday investor; but they have never been tax efficient. For long term mutual fund investors, you are subjected to year-end capital gain distributions from these funds, even if you don’t sell shares of your fund. This distribution happens as a result of the fund portfolio manager making changes in the portfolio during the year, potentially realizing both long-term AND short-term capital gains. This lack of tax control can have a negative impact on your tax situation as you plan forward.
A new investment vehicle has been created that provides all of the benefits of a mutual fund, with the tax control that you want. Exchange traded funds (ETFs) have been around for 15+ years, but have become more popular in the last decade as investors have recognized their tax efficiency. With an ETF, you won’t pay a capital gains tax until we choose to sell the fund, unlike the capital gains tax incur with periodic/annual capital gain distributions of mutual funds. This provides us the ability to control your tax destiny year after year.
Different Tax Rates for Different Investments
It’s important to know how the IRS taxes your investments when structuring your portfolio. Income producing assets, such as bonds, CDs, real estate investments, energy partnerships, etc.. are taxed as ordinary income. If you’re in the higher income tax brackets, your investment income will be taxed somewhere between 25-39.6%, plus an added tax of 3.8% if your income is above certain levels. Dividends and capital gains are taxed at the much lower rate of 15%, unless you’re in the highest bracket where you would pay 20% tax + the 3.8% tax. The types of investments you own are critical to minimizing your tax liability. Tilting portfolios towards investments that focus on dividends and capital gains can dramatically reduce your tax liability.
Relative to above, it’s important to own some level of conservative investments which are typically taxed at your ordinary income tax rate. Assuming you have taxable investments (brokerage accounts, mutual fund accounts, bank accounts), tax-deferred accounts (IRAs, 401ks, 403bs, etc.), and tax-free accounts (Roth IRAs), we are able to structure a plan to own less tax efficient (conservative) assets inside the tax-deferred accounts and the more tax efficient securities (ETFs) inside your taxable accounts. This concept of placing assets in specific accounts based on their tax status is called householding. To facilitate householding across multiple accounts can be difficult, but advances in technology have made this possible.
We all understand the concept of rebalancing – the discipline of selling some of our winners and purchasing some of our laggards. This investment discipline has been proven to add value over time. The challenge with rebalancing is that it creates tax liability every time you trade in your taxable accounts. So how do we rebalance tax efficiently? With householding, we’re able to sell ‘winning securities’ in your tax-deferred accounts (no tax) to avoid generating unnecessary capital gains and redirecting the proceeds into lagging securities. For taxable accounts, we proactively sell securities that may be at a loss (tax loss harvesting) which you can then write-off on your taxes. This is a delicate process which has been made possible in recent years given advances in technology.
Every Tax Counts
The old adage that ‘every penny counts’ can be rephrased within your financial plan to ‘every tax counts.’ The more we are able to limit what you pay in capital gain taxes, the more flexibility we have throughout your financial plan when encountering other tax issues. Be proactive in understanding your investments relative to your tax situation and take control of your tax destiny.