The thoughtful investor knows that after-tax returns are what matters. So the thoughtful investor adopts strategies to minimize tax on income from investments. Here are seven strategies.
1. Buy and hold, don’t trade
In a taxable brokerage account, every time you sell at a gain, the gain is taxable. The easiest way to avoid tax is not to sell.
The tax you pay on a sale depends on whether you held the investment for more than a year. If you did, you will pay federal long-term capital gains tax, which is 15% for all but the highest and lowest earners. You will also pay state tax. You may pay an additional 3.8% Medicare surtax, depending on your income. In aggregate, your tax will probably be 20-30% of the gain. If you held the investment for a year or less, you will pay tax at your ordinary rate. Your all-in tax on the gain will probably be around 30-40%.
But no tax is payable if you don’t sell.
Sure, when you eventually sell it, the gain is taxable. But if you wait for years, you delayed paying the tax. If you sell in retirement, your tax rate will likely be lower. Even if you can only wait for366 days, that’s better than suffering the higher tax due when you sell within the first year.
2. Buy mutual funds that buy and hold and don’t trade
When a mutual fund sells stock or bonds at a gain, the fund passes the proportional tax onto the holders. That seems unfair, because you sold nothing. But you will owe your share of any tax on gains.
How do you minimize this tax?
Look for mutual funds with a low “turnover ratio”. The turnover ratio is the percentage of a fund’s holdings which it sells every year. We prefer stock mutual funds with turnover ratios below 10%. That means they hold their investments for 10 years or more, on average. The typical “active” mutual fund in the US has a turnover ratio of at least 50%. “Active” fund managers believe they can beat the market by picking stocks that will out-perform. Admittedly, if they can, the extra gains will make up for the tax bill. But, on average, they under-perform. You’re left with a larger tax bill and lower returns.
Bond funds will always have a higher ratio, because bonds mature and have to be redeemed. But the fund pays no tax when they redeem a bond for the same price they paid to buy it.
3. “Locate” your investments strategically
Some investments, by their nature or due to tax law, create more tax. Real estate investment trusts (REITs) are an example. Commodities are another. So are taxable bonds.
Other investments are more tax-efficient. A good example is a stock you plan to own for years or decades. Another is an index fund which owns stock, because the fund will not trade much either.
If you have your investments split between a brokerage account (which is taxable) and a retirement account (which defers tax) or a Roth IRA (which is tax-free), you can minimize tax. Own investments that generate a higher current tax bill in tax-deferred or tax-free accounts. Own tax-efficient investments in your brokerage account.
This is a good example of why you need to take a holistic approach to your investment mix. When your employer sends you a brochure with your 401(k) investment options, they don’t know what you own outside your 401(k). They don’t care about the tax bill those investments may create. Select investments for your 401(k) based on your overall portfolio, and use this tax location technique.
4. If your tax rate is high, buy municipal bonds
The interest municipal bonds pay is free of federal tax. If you buy muni bonds from your home state, the income also avoids state tax.
Of course, there’s no such thing as a free lunch. The agencies that issue these tax-free bonds will pay you a lower interest rate. They know you are getting a tax break. But if your tax rate is high enough, it still pays off. This is especially true for high-income investors who live in high-tax states like California and New York.
We do not suggest you limit your bond investments solely to municipal bonds. That violates the cardinal rule of investing: diversification.
Own taxable bond funds in your 401(k) or IRA. If most of your money is in taxable accounts, split your portfolio between taxable and municipal bonds. You may do a bit worse, after tax, with the taxable bonds. But you will avoid having all your eggs in one basket.
To compare municipal bonds to taxable bonds, use the formula below:
TY x (1-r) = MY
In this formula, “TY” is the taxable yield on a taxable bond, “r” is the combined state and federal tax rate you pay for every additional dollar earned, and MY is the municipal yield. So, if a taxable bond pays 3% and you have a 1/3 all-in marginal tax rate, you should expect 2% from an equivalent municipal bond:
3% x (1-.33) = 2%
Warning: Capital gains on municipal bonds are not tax-free. So, if you buy a bond for $1,000 and sell it for $1,100, the $100 gain is taxed as a capital gain. Only the interest is tax-free.
5. Harvest losses to offset gains
In your taxable investment accounts, consider taking losses to net against any realized gains.
A caveat: It’s usually not a good idea to sell an investment that has dropped in value. “Selling low” locks in losses. Assuming you have bought sound, long-term investments, you should avoid it. But you can sell something with a loss and immediately buy back something similar if you need the loss to offset a gain. That strategy works particularly well with mutual funds. Tax laws prohibit buying the same security within 30 days of the sale. But you can buy a fund that is very similar. Check with your CPA or advisor to make sure the two funds are not identical.
6. Re-balance in your tax-deferred accounts
You should re-balance regularly. But it can create a tax bill. Here’s how to minimize it.
Re-balancing involves selling investments that have gone up and buying investments that have declined. You re-balance periodically to maintain your target mix. Imagine you want your investments equally split between stocks and bonds. Now imagine that, over the past several years, stocks went up and bonds remained steady. You will have more than half your money in stocks.
You need to re-balance, to reduce your risk. But when you sell what has gone up, you will owe tax on the gain. A good strategy is to sell in your tax-deferred accounts.
Here’s another reason that, when you are deciding what to own in your 401(k), you should consider your overall portfolio.
7. Let your heirs take advantage of the “step-up” at your death
The tax code allows your heirs to inherit your investments at your passing without the tax bill. So, no one will ever pay tax on gains made during your lifetime. For example, if you bought Apple for $100 and held it until your death, when it was worth $1,000, your heirs will inherit your shares with a “cost basis” of $1,000. If they sold it a year after you passed away for $1,100, they would owe capital gains tax only on the appreciation since your passing ($100).
By contrast, if you sold Apple for $1,000 the day before you passed away, you would owe tax on $900 of gain.
You also lose that benefit if you give an investment to someone else before you pass away, because you give them the tax bill with the shares.
This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.