5 Ways to be a Tax Efficient Investor

Let’s face it; no one wants to pay more taxes than they have to.  Here are five strategies that may be integrated into your financial plan to help you become a more tax efficient investor.

Tax Loss Harvesting

It is easy to be disappointed when the stock market goes down, but dips in the market can create a tax opportunity to realize losses.   It’s human nature to shy away from recognizing losses – it goes against everything we’re taught from an early age.  However, when executed appropriately, this strategy allows the investor to maintain exposure to a desired allocation while recognizing losses that can offset future gains.  This is accomplished by selling a position at a loss and then investing in a similar asset for a 30 day period.  The IRS will not allow investors to buy an asset and sell it for the purpose of paying less tax.  Therefore, the IRS will disallow the loss if the investor purchases the same or a substantially identical asset within a 30 day period.  Given the numerous choices investors have in the market today, it’s not difficult to find a substitute position.  After the 30 day period, the investor may repurchase the original asset.

Investment Vehicle Selection

Investors today have a lot of options.  Stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs) are a few popular options.  Certain investments are more tax efficient than others because of how they are structured.  For example, an ETF is generally more tax efficient because it has low turnover.   It is important to pay close attention to turnover because it can create capital gains for the investor.  The best way to illustrate turnover is via an example comparing mutual funds and ETFs.  Mutual funds and ETFs each own a basket of securities.  The difference comes in when the baskets are rebalanced or changes are made to holdings.  When a mutual fund buys or sells a security, this creates a taxable event for the investor.  Even if the mutual fund has an unrealized loss, the investor could still be assessed a capital gain due to this rebalancing.  In the case of an EFT, there is no taxable event because ETFs do not buy or sell securities within the basket.  Instead, they have a structure that allows the holdings within the ETF to be exchanged without a taxable event.

Charitable Giving

In order to align a tax-efficient investment strategy with charitable intentions, consider gifting highly appreciated assets instead of cash.  Highly appreciated assets are those that have been held for longer than one year and have significant appreciation.  The win-win of this strategy is that the donor is able to deduct the full market value of the appreciated securities up to IRS limits and not pay capital gains taxes.  The charity is not assessed any capital gains tax if they sell the assets due to their tax-exempt status.

Tax Optimized Withdrawal Strategy

Which accounts do you take distributions from and in what order when you’re retired?  Traditional thinking dictates exhausting the following accounts in this order:  first taxable accounts, then tax deferred accounts, and finally tax free accounts.  Taxable accounts can include living trusts, individual and joint brokerage accounts.  Holdings in these accounts can benefit from a capital gains rate.   Traditional thinking indicates that theses accounts should be depleted first because of the lower tax rate on capital gains while continuing to defer withdrawals from pre-tax accounts.  While this might be optimal in some cases, in many circumstances it is not.  The reason is that withdrawals from tax deferred accounts are taxed at ordinary income tax rates.   The additional deferral might create a situation where ordinary income tax is higher in later years of life.  Many factors come into play, including you income levels, account balances, financial goals and spending needs.   Your asset withdrawal strategy should be reviewed regularly to look for ways to mitigate taxes.

Municipal Holdings

A municipal (muni) bond is a debt obligation issued by a state or local government for the purpose of financing its expenditures.  When an investor purchases a muni bond, they make a loan to the government so that the government can fund a project, like building a bridge, school or stadium.  The terms of loan determine the interest that the government is required to pay the investor for the use of their money.  When the muni comes due, the investor gets their principal back.  Generally speaking, the interest paid is tax-exempt.  This can be attractive to a high income investor.

It is prudent for all investors to take the time to review the holdings in their investment portfolios to see if there are opportunities to be more tax efficient.  Work with a competent financial professional to understand how best to integrate tax efficient investing into your overall financial plan.