By Senior Advisor Andrew Schaetzke, CFP® and Investment Associate Bobby Adusumilli, CFA.
Why do you invest?
Each of us has our own goals for investing. For some, we want to support our families. For others, we want to donate to charitable causes. For business owners, you want to successfully grow your business over time.
If along the way we can legally save on taxes, then all the better. All else equal, lower taxes leave us with more money to achieve our specific goals.
For taxable investors, the following strategies may help you save money on taxes without lowering your potential investment returns. As always, please consult with your tax advisor as well as other advisors before implementing these strategies.
Use Tax-Efficient Investments
Taxes are only one of the criteria that investors consider when designing their portfolios. Yet there are usually multiple investment options to choose from in whatever area you want to invest in. Particularly for mutual fund and ETF investors, when choosing between multiple investment options, the below considerations may help you save money on expected taxes without sacrificing expected return.
Invest in lower turnover mutual funds / ETFs: Because they sell less of their holdings on an annual basis, mutual funds / ETFs with lower turnover typically realize less net capital gains than mutual funds / ETFs with higher turnover, and thus are likely to pay less capital gains distributions each year.[1]
Invest in tax-sensitive mutual funds / ETFs: Some investment managers actively consider tax consequences when making investment decisions, such as selling higher cost basis positions for a particular investment or selling a comparable investment with a higher cost basis. By choosing a tax-sensitive mutual fund / ETF, you may lower your annual capital gains distributions.
Consider ETFs: Because of their structure, ETFs are typically less likely to pay capital gains distributions than similar mutual funds.[2] Therefore, ETFs are becoming an increasingly popular choice for taxable investors.[3] However, particularly for larger investors as well as lower-AUM ETFs, ETFs may not outperform similar tax-sensitive mutual funds after taxes and fees, so it is important to choose the right investment for your specific situation.
Invest Via Tax-Advantaged Accounts
There are three general types of tax-advantaged accounts:
Tax-deferred: Money you contribute to the account is not taxed, but money you withdraw in the future is subject to taxes. Examples include Traditional IRAs, Traditional 401(k)s, Traditional 403(b)s, and 457 plans.
Tax-exempt: Money you contribute to the account is taxed, but money you withdraw in the future is not subject to taxes (subject to specific rules). Examples include Roth IRAs, Roth 401(k)s, Roth 403(b)s, and 529 plans.
Tax-free: Money you contribute as well as withdraw from the account is not subject to taxes, so long as the money is used for specific purposes. While these accounts are rare, a popular tax-free account is a Health Savings Account (HSA).
All of the above tax-advantaged accounts allow investing the balances. Additionally, if you already have a Traditional IRA, Traditional 401(k), or a Traditional 403(b), you may be able to convert some or all of the account balances to a Roth account - known as a Roth conversion.[4]
Depending on your employment, income, and age, you may be able to use some combination of these tax-advantaged accounts to help you save on taxes over time.
Asset Location
If you have a combination of taxable and tax-advantaged accounts, you could invest your most tax-inefficient investments within your tax-advantaged accounts. Once you decide which tax-inefficient investments you want in your tax-advantaged accounts, you could place your highest expected-return investments into your tax-free and tax-exempt accounts, and place your lower expected-return investments in your tax-deferred accounts.
Figuring out how to rank your investments based on tax-efficiency is complicated, and is highly dependent on your income, net worth, and age. For more comprehensive information on asset location, you can check out this webpage.[5]
Tax Loss Harvesting
Within taxable accounts, if you realize a net loss on an investment position, you are able to use that net loss amount to offset any current or future realized capital gains (subject to the wash-sale rule).[6] Additionally, if you have extra net capital losses at the end of the year, you may be able to offset up to $3,000 in federal income for this and potentially future years.[6] However, it’s important to emphasize that tax loss harvesting involves tax deferral, not tax avoidance.
If you want to learn more about tax loss harvesting, you can read our article on harvested losses.
Analyze Your Withdrawal Order
If you have a mix of taxable and tax-advantaged investment accounts, then you are subject to various withdrawal limitations and tax consequences. If you are able to selectively withdraw from each of these accounts over time, you may be able to pay lower your taxes in the short-term while allowing more time for your investments to grow.
Some general rules you can consider for how to generate cash from your investments:
First use the distributions - dividends, interest income, capital gains distributions - from your taxable accounts.
If you are age 72 or older, use the required minimum distributions (RMDs) from your relevant tax-advantaged accounts.
Within taxable accounts, sell positions that are subject to long-term capital gains taxes.
Within the taxable accounts, sell positions with higher cost bases.
Gifting and Charitable Donations
The ultimate goal of saving on taxes is to have money to accomplish our goals. Particularly for those who are inclined to gift money to your family or donate to charitable institutions, the below options may decrease your taxes over time.
For each member of your family, you may gift them up to $15,000 per year, via cash or investments.[8] Particularly if a family member has a lower tax bracket than you, it may be advantageous for you to gift a low cost basis investment, which could help decrease future taxes paid on that holding. For more information, you can read our article on gifting.
From your taxable accounts, you can donate cash or investments directly to a charitable institution. This can help you save on future taxes, up to federal deduction limits.[9]
As long as you are age 72 and meet the specific IRS rules, you can donate up to $100,000 annually directly from your Traditional IRA (without paying taxes) to a qualified charity through a qualified charitable distribution.[10]
Conclusion
While each of the above strategies may help, combining some or all of these strategies could significantly improve your investment portfolio over time, leaving you with more money to accomplish your goals. As always, please consult with your tax advisor as well as other advisors before implementing these strategies. If you have any questions on how you can incorporate the above strategies in your portfolio, feel free to reach out to us.
Important Disclosure Information & Sources:
[1] “Turnover Definition“. Will Kenton, 14-Jul-2020, investopedia.com.
[2] “Do ETFs Generate Capital Gains for Shareholders?“ Andriy Blokhin, 23-Sep-2021, investopedia.com.
[3] “The Future of ETFs“. Irene Huhulea, 23-Aug-2021, investopedia.com.
[4] “Roth IRA Conversion“. Julia Kagan, 23-May-2021, investopedia.com.
[5] “Tax-efficient fund placement“. Bogleheads, bogleheads.org.
[6] “Topic No. 409 Capital Gains and Losses“. IRS, irs.gov.
[7] “6 tax-saving strategies for smart investors“. Jessica McBride, 18-Feb-2021, vanguard.com.
[8] “Frequently Asked Questions on Gift Taxes“. IRS, irs.gov.
[9] “Charitable Contribution Deductions“. IRS, irs.gov.
[10] “IRA FAQs - Distributions (Withdrawals)“. IRS, irs.gov.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Advisory services are provided by SJS Investment Services, a registered investment advisor (RIA) with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice. This material has been prepared for informational purposes only.
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