Savvy investors have long realized that what their investments earn after taxes is what really counts. After factoring in federal income and capital gains taxes, the alternative minimum tax and potential state and local taxes, your investment returns in any given year may be reduced by 40% or more. Luckily, there are tools and tactics to help you manage taxes and your investments.
#1: Invest in Tax-Deferred and Tax-Free Accounts
Tax-deferred investments include company-sponsored retirement savings accounts such as traditional 401(k) and 403(b) plans, traditional individual retirement accounts (IRAs) and annuities. In some cases, contributions to these accounts may be made on a pretax basis or may be tax deductible. More important, investment earnings compound tax deferred until withdrawal, typically in retirement, when you may be in a lower tax bracket. Contributions to nonqualified annuities, Roth IRAs and Roth 401(k) savings plans are not deductible. Earnings that accumulate in Roth accounts can be withdrawn tax free if you have held the account for at least five years and meet the requirements for a qualified distribution. Unless certain criteria is met, Roth IRA owners must be 59 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.
#2: Consider Investing in Municipal Bonds Municipal bonds, or "munis" as they are frequently called, are bonds issued by state or local municipalities to fund public works projects such as new roads, stadiums, bridges or hospitals. A municipal bond can also be issued by legal entities such as a housing authority or a port authority. For this reason, municipals can be an excellent way to invest in the growth and development of your community.
In addition, because the interest earned on municipal bonds is exempt from federal income taxes and may be exempt from state and local taxes (if they are purchased by residents of the issuing municipality), munis have the potential to deliver higher returns on an after-tax basis than similar taxable corporate or government bonds. What this means is that although the interest paid on municipal bonds is typically a lower percentage than is paid on taxable bonds, because it is tax free, it is, in effect, not as low as it appears. A simple calculation known as the "taxable-equivalent yield" can be used when considering an investment in a municipal bond.
For instance, if your income tax rate is 35%, a municipal bond paying 5% interest is actually a better investment than a taxable bond paying interest at 7.7%. Thus, for investors in a high tax bracket, the benefits of using municipal bonds in a fixed-income portfolio can be significant. Municipal bonds are subject to availability and change in price. Subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
#3: Manage Investments for Tax Efficiency
Tax-managed investment accounts are managed in ways that can help reduce their taxable distributions. Your investment manager can employ a combination of tactics, such as minimizing portfolio turnover, investing in stocks that do not pay dividends and selectively selling stocks that have become less attractive at a loss to counterbalance taxable gains elsewhere in the portfolio. In years when returns on the broader market are flat or negative, investors tend to become more aware of capital gains generated by portfolio turnover, since the resulting tax liability can offset any gain or exacerbate a negative return on the investment.
#4: Put Losses to Work At times, you may be able to use losses in your investment portfolio to help offset realized gains. It's a good idea to evaluate your holdings periodically to assess whether an investment still offers the long-term potential you anticipated when you purchased it. Your realized losses in a given tax year must first be used to offset realized capital gains . If you have "leftover" losses, you can offset up to $3,000 against ordinary income. Any remainder can be carried forward to offset gains or income in future years.
#5: Keep Good Records Keep records of purchases, sales, distributions and dividend reinvestments so that you can properly calculate the basis of shares you own and choose the most preferential tax treatment for shares you sell.
Keeping an eye on how taxes can affect your investments is one of the easiest ways to help enhance your returns over time. For more information about the tax aspects of investing, consult a qualified tax advisor.
Joshua D. Mosshart CHFC,CASL, CEA
Chartered Financial Consultant, Chartered Advisor for Senior Living, Certified Estate Advisor, President
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