When first jumping into the world of investing, it can be easy to forget that you will have to pay taxes on any investment income that you make. After all, you got into investments in order to grow your wealth?not pay taxes. But since taxes are one of the two things you can count on in life, it?s best to plan your investment strategy around Uncle Sam?s cut. Using such a strategy is called tax-efficient investing, and it can help you to hold on to more of your investment income.
What Is Tax-Efficient Investing?
According to Ameriprise Financial, tax-efficient investing ?means planning nearly every savings and investment decision around how, when and where to invest in order to achieve the lowest possible impact from income taxes now and in the future.?
In short, being a tax-efficient investor means that you will plan ahead for income taxes, and make your investment decisions accordingly. This means that you will organize your investment income to take advantage of tax-deferred and tax-free investments, as well as taxable investments that are taxed at different rates.
It?s important to remember that it is perfectly legal and above-board to make your tax burden as lean as you can. Allocating your funds with an eye to tax-efficiency is simply smart investing.
Tax-Advantaged Accounts
If you are saving for retirement, you are probably already practicing tax-efficient investing without even realizing it. According to Bogleheads.org, ?tax-advantaged accounts include tax-deferred accounts [which are taxed at a later time], such as 401(k) and 403b, and tax-free accounts such as Roth IRA.?
These types of accounts are already tax-efficient, and if all of your investments are in these types of accounts, then you will not see a difference in your returns by practicing more proactive tax-efficient investing. However, having these tax-advantaged accounts can be an important part of making sure you keep your tax burden low.
Asset Allocation
Some assets will have higher tax consequences than others, meaning you have to pay attention to where you place your assets in your portfolio. For example, taxable bonds, real estate investment trusts, and international bonds all generate income, meaning you will have to pay income tax. However, you can place these assets into your tax-advantaged accounts, thereby increasing the tax-efficiency of your investments.
On the other hand, more efficient investments, like tax-efficient mutual funds, can be placed wherever you feel they will give you the best return since you don?t have to worry about a huge tax burden.
The basic rule of thumb for tax-efficient asset allocation is to place less efficient investments into tax-advantaged or tax-deferred accounts, and to place more tax-efficient investments into taxable accounts.
Tax Loss Harvesting
The last piece of the tax-efficient investing puzzle is tax loss harvesting. This is technique you can use to improve your return by using a market loss to lower your tax bill. For example, let?s say you have invested $10,000 in a mutual fund in a taxable account. After a downturn, your fund is now only worth $6000. You can sell that fund, and show a $4000 capital loss, which will lower your capital gains tax. In addition, that capital loss also now entitles you to an ordinary income tax offset of up to $3000.
When selling your investment to harvest the tax loss, you cannot re-invest in it or a substantially identical investment for 30 days before or after your sale. However, on day 31, you can repurchase the same fund and basically be back where you were originally, although now with a decreased tax bill and a lower basis cost.
The Bottom Line
Tax-efficient investing is a complex strategy for maximizing your investments. Even when you know and understand the basics of this strategy, it pays to have a professional financial advisor to help you determine the best way to keep more of your money under your control.
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