Tax-Efficient Investing
There are not many people who would say, “I want to pay as much in taxes as I can each year.” Most investors are trying to keep well-earned dollars in their pockets. There are many ways to minimize taxes while saving for future needs. For many, maximizing the amount that can be contributed to tax-deferred investment vehicles such as Individual Retirement Accounts (IRAs), Roth IRAs and employer retirement accounts is enough.
Some investors are looking for additional tax-saving opportunities. Higher income investors may be restricted as to how much they can invest in these retirement accounts. An insurance or annuity product may be right for some investors. These products, however, can come with high fees and lack of liquidity that may not appeal to some investors. It is important to fully understand options when seeking tax efficiency.
A taxable account may be a strong complement to tax-deferred options when it comes to long-term tax efficiency. A professionally managed taxable portfolio of exchange traded funds(ETFs), individual stocks and/or individual bonds can offer significant tax efficiency.
How Does a Taxable Account Compare to a Tax-Deferred Account for Tax Efficiency?
1. Low Cost. Broad indexed ETFs offer very low internal expenses versus most mutual funds, and individual stocks and bonds come with no internal expense. Small commissions may be involved to buy or sell the securities. These expenses are typically very low compared to high insurance and annuity product costs that also typically involve higher cost mutual funds.
2. Liquidity. In a taxable account the funds are available with no surrender charges or penalties. Life can change, and it may be important to have this flexibility to use your funds. With a taxable account there is little confusion regarding when and how the funds can be accessed.
3. Taxation. Uncle Sam will try to tax all investments at some point, even tax-deferred accounts. When funds are removed from tax-deferred products, gains are typically taxed at income tax rate, which can reach 37% in 2018 for high-income earners. Alternatively, long-term gains in a taxable account are taxed at 15% for married couples earning $77,200-$479,000 per year and 20% for those earning more. Additionally, at death, some tax-deferred accounts will require payment on gains at the heir’s income tax rate while taxable accounts will get a step-up in cost basis, thus erasing any potential gains taxation.
How Does Schenkelberg Investments Manage a Tax-Efficient Portfolio?
1. Seek Returns. The first priority is to seek risk-appropriate returns for each investor. This involves investing in core, diversified ETFs while taking a smaller portion of the account to invest in sectors, or areas of the market, that may offer increased return opportunities. Individual stocks and bonds may be used to seek greater returns.
2. Tax-Efficient Investments. Avoid mutual funds in favor of ETFs and individual securities. Mutual funds are required to pay out any capital gains or income that is generated internally at the fund each year. This may result in gains and income that are much larger than the actual gains experienced by the holder. Gains in ETFs and individual securities are not realized until they are sold, thus these securities may be held for years before any gains may be realized.
3. Tax-Efficient Trading. Investments are intended to be held over one year to avoid short term capital gains, which are subject to taxation at the income tax rate. When the portfolio manager identifies a market opportunity, the trade will be reviewed to ensure any gains will be worth the market opportunity. If available, losses will be taken to offset gains. Tax-loss harvesting may also be done to further improve a tax bill.
4. Tax-Free Bonds. Municipal bonds that generate income that is free from federal and some state taxes may be utilized to avoid taxable interest generation from bonds.
There are many tax-sheltered options that offer appealing selling points. However, when seeking additional investment options, don’t completely rule out a simple, tax-efficient taxable account. When managed properly and used in combination with tax-deferred opportunities, some nice positive attributes can emerge.