Two of the most important considerations in investing are how much you make in profits and how much you save in taxes.
Too often, though, investors focus on profits and fail to consider the tax implications when implementing their investment strategies. It can be a costly mistake because investing doesn't always produce profits - but it can produce exposure to taxable events.
Tax exposure comes from trading profits in stocks, bonds, and derivatives. These tax obligations are paid to federal, state, and municipal authorities at different tax percentages, often depending on the type of asset and how long it was held.
In many cases, especially for high-net-worth individuals, tax obligations can exceed trading profits, as well as trading costs and expenses. These resulting taxes can devastate long-term portfolio gains.
The good news is that recent changes to the tax code are offering new opportunities for tax-efficient investing in many asset classes, especially REITs, master limited partnerships (MLPs), and preferred securities. In addition, passive investing products, such as index funds, ETFs, and other strategies can deliver tax-efficient investing.
Using tax-efficient planning, strategies, and products can reduce and sometimes allow investors to avoid tax obligations.
Types of Tax-Efficient Investing
In many cases, an investor's exposure to a tax obligation depends on time - how long they held the investment and how quickly offsetting trades are implemented.
Here are some basic tax strategies that can help reduce your obligations in any individual investor's portfolio.
Long-term and short-term capital gains
Selling an investment within one year of its purchase is one of the most common ways investors are exposed to taxes. A short-term gain happens when an investor buys or sells a security or fund for a profit in less than one year. In 2020, the short-term gain tax rate was the same as your tax bracket. This could range from 10% to 37%.
If your investment loses money, you can take a long-term capital loss. Alternatively, to encourage long-term investing, the tax rate on investments held over one year drops to 0%, 15%, or 20%, depending on your income bracket. The amount of this loss can be deducted from your capital gains. If you make money on one investment but lose it on another, you can deduct the difference (up to $3,000) to reduce your tax bill. Taking advantage of this strategy requires that you time your buy and sell decisions accordingly.
If an investor has gains in a stock or basket of stocks, they can sell it in less than one year and replace it with a similar group of stocks or funds to reduce any short-term tax obligation. This action essentially replaces the capital gains (profits) from the trade with capital losses.
As an example, if you buy two funds and hold them less than one year, and you have a profit of $10,000 in one fund and a loss of $3,000 in another fund, you can sell both and use the loss ($3,000) to offset the profit ($10,000) partially. This reduces your capital gain tax obligation down to $7,000.
In some instances, this strategy can produce losses that can reduce the tax obligation on your ordinary income. This strategy can be done throughout the year.
Avoid wash sales
While tax-loss harvesting is a recognized way to deal with capital gains, the IRS has also developed rules that prevent its abuse. This abuse happens when an investor buys and sells the same or very similar fund or stock within 30 days after its purchase or sale. This is called a "wash sale," and the IRS has rules that will not recognize these losses if they happen within the 30 days.
When a wash sale is disallowed, the IRS does not recognize the losses and then increases the replacement shares' cost basis. Wash sale rules apply in any brokerage or 401(k) account and cover stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options.
Managing the tax impact of dividend income
Noting when you bought a stock or bond also applies to how dividends are taxed. Dividends can be classified as "qualified" or "ordinary" depending on how regularly the corporation issues them to shareholders.
- The tax rate of qualified dividends for individuals, trusts, and estates is 15%.
Qualified dividends are subject to the lower capital gain taxes, while ordinary dividends are taxed at the higher regular ordinary-income rate.
In addition to the dividends category, the next important consideration is how long you owned the stock.
For common stocks, shares must be held longer than 60 days during a 121-day period that begins 60 days before the ex-dividend date. This is the first date in which the stock or mutual fund price does not include the upcoming dividend payment. To receive the upcoming dividend, the investor must buy the shares before the ex-dividend date. (This date was when the stock trades without the value of the dividend included in the price.)
The holding period for preferred stocks is longer: over 90 days during a 181-day period that starts 90 days before the ex-dividend date. When these conditions are met, dividend income can qualify for a lower tax rate if the security is held longer than the minimum period.
Since 1917, the IRS has held that charitable giving is an established way to reduce tax obligations to qualified tax-exempt, non-profit groups.
For investors, this means selecting stocks that have gained in value and presenting them as a gift to a tax-exempt charitable organization, donor-advised fund, or family members in lower tax brackets. When donating, the investor will not pay capital gains tax, and they remain eligible to deduct the full fair-market value stocks or bonds they donated from their income taxes.
Roth IRA accounts
Inside 401(k)s, investors can build a portfolio that can be withdrawn without paying taxes. The reason is that taxes are paid when they are deposited into the account, so the taxes can be withdrawn without a penalty. Roths are good for investors who think their taxes will be higher after they retire. Roths also allow people to make contributions at any age; there are no required minimum distributions (RMDs); and, the Roth can be held indefinitely.
Tax Benefits of Life Insurance
Life insurance pays a large role in estate planning, primarily for its death and tax benefits. In most life insurance benefits payouts, the beneficiary gets the money without paying taxes and not as ordinary income.
In some instances, a beneficiary may be faced with paying taxes if they receive the benefit over some time. In this case, they will pay taxes on the earned interest. If the death benefit goes to an estate, the inheritors may be liable for the taxes. This area gets complicated, but there are strategies to minimize these tax obligations by designating a trust as the death beneficiary, as opposed to an individual.
Tax Benefits of Preferred Securities
Preferred securities are a class of instruments that rank above common stock but below bonds in a corporation's capital structure. As a result, they pay higher rates than fixed income securities with an equivalent rating.
Also, any proceeds paid by preferreds are taxed at the lower qualified dividend income rate (about 18%) instead of the standard net investment income rate of 3.8%.
Every time investors buy and sell securities, it appears as a tax lot in their brokerage account. A tax lot is simply a record of all transactions and their tax implications for the IRS. This record notes when the stock was bought or sold, and its cost basis.
This information helps investors maximize tax-efficient decisions about when to buy and sell stocks. In practice, these decisions can be profitable.
- Short-term capital gains are taxed as ordinary income.
- Long-term gains are 20% for single filers with more than $434,550 in income in 2019.
- For married people filing jointly, it's $488,850.
- The rate falls for single filers to 15% for incomes between $39,376 and $434,550 ($78,751-$488,850 for couples.) Below these minimums, the rate is 0%.
While all this is intimidating, this issue is handled directly by ETFs and index funds. ETFs are designed to minimize taxes as compared to a mutual fund in the same category.
Index mutual funds have low-turnovers, which means they buy and hold stocks in a specific index that reduces capital gains taxes paid to shareholders. These funds also tend to avoid companies that pay dividends or interest, which also generate tax obligations.
The Lesson of Tax-Efficient Investing
Successful investing is about more than making profits in the market and beating benchmarks. The big picture in successful investing includes the management of tax implications for any portfolio. This means that tax-efficient investors have to be aware of what they bought, as well as when they bought and sold.
This means investors have to manage their holding periods for different types of investments and evaluate when to buy and sell securities, so losing positions can be sold at the right time to obtain the available tax benefits. Knowing how taxes can add to your bottom line can make you more successful as an investor.