No one is a big fan of paying taxes. What many investors may not realize, though, is that their investment strategy – or lack of one – might be more expensive than they think due to taxes. That’s especially true for U.S. investors, when it comes time to pay capital gains taxes on portfolios that have seen healthy gains in any given year.
And a tax-aware investment strategy isn’t as simple as only buying “tax-free” municipal (aka “muni”) bonds and thinking your tax worries are over. Even with that strategy, as my colleague David Jurca notes, an investor may have tax-related gains on selling actual municipal bonds. Plus a portfolio of only municipal bonds may not deliver the diversification and potential return an investor is looking to achieve.
Rather than relying on any single, seemingly “tax-free” strategy, a tax-aware investment approach will use several tax tactics to help reduce the potential capital gains tax hit on investments. Here are three of many approaches to consider:
Go long. Let’s say an investor has held a set of equities for 11 months, two weeks. She sells them and realizes a nice gain. But not so fast! If she had held them just another two weeks – so they were in her portfolio a full year rather than just a little short of that – her capital gains taxes would be taxed at 23.8%, as opposed to 43.4% for those in top bracket. In that scenario, she could pay more in taxes by selling too quickly. That’s because U.S. tax laws favor holding assets for longer than one year. It is important for investors to know how long an investment is being held before being sold, to better understand the potential tax ramifications.
Find the right funds. There are all sorts of mutual funds out there, and many investors have holdings in a whole bunch of them. But it is important to know that different mutual funds often have different tax-management strategies, and most don’t have tax strategies at all. Tax-managed funds are designed to be thoughtful around investing in dividend-paying stocks to help avoid capital gains tax (qualified dividends are generally treated as long term capital gains for tax purposes). They may also try to reduce their tax burden by holding assets for longer periods of time (see #1, above). It is important to research funds to find out their approach.
Find offsetting losses. In a diversified portfolio, investors will often find that some assets will perform well, while others stumble. An investor may benefit by using those “stumbling” assets to harvest the losses and apply them to offset gains of better performing assets. But note that there are rules around this method. Investors might pay a penalty if they are not careful and try a “wash sale” – the sale of a stock at a loss, followed by its re-purchase. If an investor re-purchases a stock within 30 days of selling it, any losses that one tries to claim in a tax filing will be disallowed. Within a tax-managed mutual fund, this process of looking for losses across the portfolio occurs throughout the year is one way fund managers look to provide attractive after-tax returns.
No one can make taxes go away. But working actively across portfolios to defer recognition of gains can meaningfully help to increase after-tax wealth. We’ve mentioned just a few ways here. Most importantly, collaborating with a financial advisor to help find the most appropriate tax-management approach is a prudent and effective way to help meet investment objectives. In the meantime, to learn more about approaches to help reduce capital gains on investments and the subject of tax-aware investing, click here.
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