How to Use Your Portfolio to Save on Taxes All Year
This article was originally published on this site
Having a tax-efficient strategy for your portfolio is an ongoing process – and it can save you money that can be used to compound and grow for the future. There is no way to avoid paying taxes, but there are ways to make your portfolio more tax-efficient – and avoid transactions that can be unnecessarily costly in taxes.
An important first step is to enlist the help of a tax professional such as a certified public accountant. There are many aspects that go into how you are taxed, beyond just your portfolio. A tax professional will be able to advise on your individual situation.
Reach out to your CPA between September and December. It’s a good idea to reach out to your CPA well before tax season. If you wait until January (or even procrastinate until April), it’s too late to a make adjustments because the year you are being taxed on has already happened.
In the fall, you can plan ahead, and make sure you’re not withholding too much. If you pay taxes quarterly, it is a good idea to update your CPA periodically on your income to ask whether you need to make any adjustments.
Being a long term investor rather than a short term trader has many benefits. From a tax perspective, holding for 12 months or longer means you will avoid short term capital gains which are taxed as income, versus long term gains which are taxed at the lower long term capital gains rate.
Avoid high turnover ratios and be aware of the distribution schedule. Actively managed mutual funds can have high turnover ratios – the percentage of holdings that change every year (sometimes over 100%). A high turnover ratio can lead to high year-end distributions.
For example, the fund may distribute 20% of the fund’s value in a taxable distribution near year-end. At the same time as the distribution, the price of the fund drops in tandem. In effect, this forces the investor to sell a large portion of the fund at a time totally out of your control. Working with an advisor who monitors these upcoming distributions can be very helpful.
Similarly, be aware of upcoming ex-dividend dates and be careful when exactly you buy or sell a holding.
Consider exchange traded funds, or ETFs, versus mutual funds within taxable accounts. ETFs are inherently more tax efficient than their mutual fund counterparts.
Mutual funds have to rebalance the fund to sell securities when there are redemptions from shareholders. These can create capital gains, which are passed through to shareholders. ETFs, however, create units for shareholder activity – thus avoiding the capital gains issue.
Use the proper account for each type of asset. Both tax-deferred accounts and after-tax accounts are beneficial, but you need a bit of strategy to get the most out of each. For example, municipal bonds are best held in a taxable account. Depending on the state where the bond is issued and the state where the investor lives, muni bonds have the potential to be triple-tax free (federal, state, and local). Holding a tax-free instrument in a tax-deferred account does not confer any real benefit.
Many investors use collectibles as an alternative investment, but be aware that they have a different tax treatment than equities or bonds. Gold is considered a collectible, so it is subject to the collectible tax rates of 28%. Even a gold ETF like SPDR Gold Shares (GLD) is treated as a collectible for tax purposes.
Phantom tax is another potential tax stumbling block. This is where you are taxed on the receipt of income before you actually receive that income. Phantom tax can occur with holdings like Treasury inflation protection bonds if they are held in a taxable account rather than a tax deferred one.
Also, remember your required minimum distributions. If you are over age 70.5 and have individual retirement account assets, you are subject to RMD rules. If you need cash flow monthly from your portfolio, it could make sense to have the RMD paid monthly. However if you do not need the funds, you may consider allowing for maximum tax-deferred growth and taking your RMD near year-end.
Tax loss harvesting allows investors to offset capital gains with losses. You can do tax loss harvesting (offsetting investment gains with losses) throughout the year, with a special focus at year end.
And, keep enough in cash reserves. How is your emergency fund related to taxes? If you have appropriate cash reserves, you aren’t forced to sell from your investment accounts and generate taxable gains when the funds are needed.
Usually anywhere from three to six months’ worth of your core living expenses is recommended.
