Tax management tips for investors
While it’s impossible to predict what’s going to happen in the stock market, tax season provides investors with an opportunity to reflect on what they can control. When you look back on the year, it’s important to consider not just what you made from your investments, but how much of it you get to hold onto after taxes. From investing in different asset classes to opting for tax-advantaged accounts, there are some strategies you can use to help manage your investment-related tax burden.
How Are Your Investments Taxed?
Investments can generate returns in two ways, and you’re taxed on both. The first is through appreciation — if the price of the asset increases between the time of acquisition and the time of sale, your revenue is taxed as a capital gain. The second is through paying out income — dividends in the case of stocks and interest payments (or coupons) in the case of bonds and other fixed-income instruments. Interest payments and ordinary dividends are subject to your standard income tax rate, but qualified dividends are treated as capital gains.
Capital gain taxes are assessed based on how long you hold the investment before selling. Assets held for over a year are considered long-term gains and incur a tax rate of between 0% and 20% depending on your income that year. Assets held for under a year are considered short-term capital gains and are taxed based on your income tax bracket, up to 37%. In most cases, investors will earn a more favorable tax rate by holding assets for at least a year.
How to Manage Investment Taxes
While your individual income tax rate will play a major role in determining the taxes you pay, there are some strategies that can help you manage your tax burden over time.
Take Advantage of Retirement Accounts
Retirement accounts such as IRAs and 401(k)s differ from standard brokerage accounts in that they entitle you to certain tax advantages.
Which retirement plan (or plans) you have access to may depend on your employer, with plan details varying greatly from workplace to workplace. Here are the differences between the three most common types of retirement accounts:
Traditional IRA
Personal retirement account. Contributions are made pre-tax, gains and distributions are tax-deferred, and withdrawals are taxed as ordinary income.
Roth IRA
Personal retirement account. Contributions are made post-tax, but both gains and withdrawals are tax-free assuming certain conditions are met.
401(k)
Employer-sponsored retirement account. Employee contributions are pre-tax (or post-tax, if the employer offers a Roth option) and may be matched by the employer up to a certain amount. Annual contribution limits are higher than IRAs. If your employer offers 401(k) contribution matching, think about contributing the maximum matchable amount every period — it’s an easy way to get additional funds into your account at no additional cost!
Diversify Your Portfolio with Different Assets
Stocks, bonds, and other investment types carry different tax implications. Imagine you’re playing a game of Tetris and different asset classes represent blocks of different shapes. The key to success is finding where the holes are and filling them with the correct block. If you’ve done it right, your portfolio (or your figurative Tetris wall) will look like a beautiful tapestry of patchwork shapes and colors.
Both Treasuries and municipal bonds can offer unique tax insulation. Treasury bonds are exempt from state and local taxes, while municipal bonds are exempt from state, local, and federal taxes. Municipal bonds are called “triple free” for this reason, and they can be a strong addition to a taxable brokerage because they’re already hyper-efficient.
The Elevage Partners team can help you assemble the right mix of investments to align with your goals and risk tolerance.
Allocate Your Assets Wisely
How frequently you generate capital gains (i.e., how often you make transactions) can have a significant impact on your overall tax burden. ETFs and other tax-conscious funds tend to trade with less regularity, thus triggering fewer capital gains. Actively managed funds, on the other hand, tend to buy and sell securities at a higher frequency and thus have the potential to generate more frequent capital gains taxes.
In addition to the timing and frequency of your investment transactions, you should also consider which accounts you keep your investments in. While it would be nice to put all of your securities into a tax-advantaged account, annual contribution limits make that impossible for many investors. As a rule of thumb, investments that are less impacted by taxes belong in your brokerage account and investments that are more impacted by taxes belong in your retirement account.
Work With an Advisor
When it comes to navigating your unique financial situation and taking advantage of all of the resources available to you, consider seeking the advice of subject matter experts. Tax issues can be complicated to deal with, and the best solutions are often sourced from a broad team of specialists working on your behalf.
Think of your Elevage Partners wealth advisor as a financial quarterback, or even your personal CFO, who focuses on your entire financial picture and guides the discussions with the rest of your advisory team. In partnership with your tax professional, our financial advisors can help ensure your interests are well cared for and in continual alignment with your financial plan and personal goals.
This material is intended for informational/educational purposes only and should not be construed as tax, legal or investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Certain sections of this material may contain forward-looking statements. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results. Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption of any kind. Please consult with your financial professional and/or a legal or tax professional regarding your specific situation and before making any investing decisions. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Mutual Funds and Exchange Traded Funds (ETFs) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest. Tax loss harvesting is a strategy of selling securities at a loss to offset a capital gains tax liability. It is typically used to limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates than long-term capital gains, though it is also used for long-term capital gains.