By Michael Chamberlain, CFP, AIF
Learn more about Michael on NerdWallet’s Ask an Advisor
Most investors think about asset allocation, risk and return, and passive versus active strategies when making investment decisions. But taxes should be a primary concern as well because they can have a major impact on your overall returns.
Here’s a closer look at five areas where the right action can lower your tax bill on investments.
1. Tax reporting methodology
Tax-reporting methodology refers to how your capital gains from asset sales are reported for tax purposes. There are 12 methodologies; which one your financial services company uses will directly affect the amount of taxes you will owe. Many custodians use the “average cost” or “first in first out” (FIFO) methodologies. But there are other options, such as “high cost long term” (HCLT), that can help you save on taxes.
For example, let’s say you bought five shares of stock at $20 a share. Later you bought five more at $25 a share and then five more at $30. Two years later, the share price goes to $47, and you need to sell three shares to rebalance your portfolio.
You would have the following capital gains using the given tax reporting methodology:
- Average cost: $22 gain per share. (Your gain is based on the average price of all the shares you bought, which was $25.)
- FIFO: $27 gain per share (The first shares purchased — for $20 — are the first ones sold.)
- HCLT: $17 gain per share (The most expensive shares held for more than a year — those you bought for $30 — are sold first.)
Clearly, the HCLT method would result in the lowest taxable gain. Your taxes would be highest with the FIFO method.
Not all custodians make more tax-efficient options available, so be sure to check how your financial services company reports your gains.
2. Tax-loss harvesting
Selling securities at a loss to offset capital gains on other securities is referred to as tax-loss harvesting. Investors often use harvesting to limit the recognition of short-term capital gains, which are taxed at higher rates than long-term capital gains (at least on the federal level). This applies only to taxable accounts, not to tax-deferred accounts such as 401(k), IRA or Roth accounts.
Here’s an example. You have a diverse portfolio of U.S., international and emerging-markets mutual funds. With the recent decline in emerging markets and the stronger U.S. gains from last year, you find your portfolio’s asset allocation is off target. You need to sell some U.S. holdings, which will trigger some gains. At the same time, though, you can sell your emerging-markets funds at a loss to offset the gains. You then buy a different emerging-markets fund in the amount you need to get back in balance. (Check with your custodian to be sure you will not be violating the 30-day wash sale rule.)
3. Asset location
As people build assets for the future, most have a mix of equities (stock) and fixed income holdings (cash and bonds). Many people have a tax-deferred account such as an IRA, 401(k), or 403(b). Some have tax-free Roth accounts, and many have taxable accounts. Where you hold assets among these three types of accounts can make a big difference in your tax burden, particularly if you are in a higher tax bracket.
It is most tax-efficient to have the assets with the greatest growth potential in Roth accounts, so you never pay income tax on all the growth. The next-best option is taxable accounts, so you can take advantage of lower long-term capital gains tax rates rather than the ordinary income taxes you would pay on distributions from a tax-deferred retirement account. Fixed income assets should be in tax-deferred accounts, so that the investment income you are saving for the future isn’t taxed on top of your earned income.
Another reason to keep equities in taxable accounts: Upon death, there is a “step up” in tax basis that can save your spouse or heirs a substantial amount on their tax bill.
Unfortunately, many folks do not even know their target asset allocation, and of those that do, many will have that same allocation in all of their accounts. This can result in a greater taxes bill than if they had strategically located different asset types in the most tax-efficient accounts.
4. Passive vs. active funds
Some equity funds see very little turnover of the securities in the fund over the course of a year. Actively managed funds buy and sell with greater frequency. The added trading often results in capital gains; those gains are reinvested, but you still get a tax bill for them at the end of the year.
For instance, the Fidelity Spartan 500 Index Fund (FUSVX) has a 4% turnover rate per year and since October 2014 has generated only 43 cents of long-term capital gains per share. Meanwhile, the Fidelity Disciplined Equity Fund (FDEQX) has a 191% turnover rate and in the same time period generated $1.16 per share in long-term capital gains and $1.33 in short-term capital gains, which are taxed as ordinary income. Ouch! Avoid actively managed funds in your taxable accounts.
5. Exchange-traded funds vs. mutual funds
Exchange-traded funds (ETFs) are more tax-efficient than mutual funds when held in taxable accounts because of a difference in accounting. When a mutual fund investor sells his or her shares, the fund company must sell securities to generate the cash to fund the redemption. This creates capital gains in the fund for the other shareholders.
However, when an ETF investor wants to sell, the fund company simply sells the shares to another investor like a stock, and thus there is no capital gains transaction for the ETF. (This difference does not apply for a tax-deferred retirement account.)
By paying attention to these five areas, you can be a more tax-efficient investor, shaving a significant amount off your tax bill and boosting your overall returns. Of course, some of these issues can be complicated, so if you need help from a financial professional, consider working with an advisor who belongs to the Garrett Planning Network or the National Association of Personal Financial Advisors.
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