There’s a lot of focus on minimizing fees when investing, but investors should also pay attention to another harsh drag on returns: taxes.
For those who invest exclusively through retirement accounts, taxes matter little on an annual basis. Those accounts defer taxes until retirement or, in the case of the Roth IRA, avoid them on investment growth. In standard taxable brokerage accounts, however, taxes matter a lot.
The investments in these accounts can increase your tax bill in a variety of ways. Investments sold for a profit can trigger a capital gains tax, either short-term if held for a year or less or long-term if held for longer. Income generated, like dividends or interest payments, may be taxed, and actively managed mutual funds that trade frequently can pass capital gains on to investors.
You can’t avoid taxes altogether, but these steps will limit the damage.
Choose your mutual funds wisely
Some mutual funds can generate what Martin Small, a managing director at BlackRock, calls “bad taxes” — taxes that come without a corresponding increase in value for investors.
“Mutual funds are required to distribute stock dividends, bond dividends and capital gains to shareholders, and investors have to pay taxes on those in the year they are received,” Small says. That’s true even if the distribution is reinvested into the fund.
When comparing mutual funds, investors should look at the net after-tax return, he says. “That will show you what financial results you can really achieve by holding those positions,” Small says. You’ll find that information in the fund’s prospectus and at its company website.
You may also choose to avoid managed mutual funds in favor of index funds and exchange-traded funds, which tend to be more tax-efficient. As a bonus, these funds typically have lower expenses than managed funds.
Practice asset location
You’ve probably heard of “asset allocation,” or the process of dividing your money among stocks, bonds and cash or cash equivalents. “Asset location” takes that a step further by making sure the investments you selected in each asset class are housed in the accounts with the most favorable tax treatment.
“Assets that might create ordinary income tax, like taxable bonds, are placed in accounts that are sheltered [from taxes],” says Andy Schwartz, principal of Bleakley Financial Group. Examples of those accounts would be retirement accounts like 401(k)s or individual retirement accounts.
Investments that are tax efficient, such as municipal bonds — which are exempt from federal and often state taxes — and equity index funds are typically well-suited for taxable accounts. If you invest in stocks, those you plan to hold for a long time may also go into taxable accounts.
Allocation like this is most appropriate when your time horizon and risk tolerance are similar across accounts. In that case, you can look at the accounts as one big pool of money. If your taxable account is invested for a near-term goal and retirement is several decades away, asset location may not make sense; the time horizon for each account, and your willingness to take on risk while working toward that deadline, should come first.
Use losses to offset gains
A practice called tax loss harvesting makes lemonade out of losing investments by selling them to offset the gains from investments that are doing well. This service is frequently provided by robo-advisors — computerized investment managers — without an extra fee, but you can also do it yourself or with a tax professional.
“If there are assets that are underwater, swap them out. Buy a similar asset so you’re not out of the market, but sell the losing one so you can book that loss and use it to offset gains you might have otherwise,” Schwartz says.
The IRS puts a limit on losses that exceed capital gains; the amount of excess you can claim each year is the lesser of $3,000 or your total net loss ($1,500 if you’re married but filing separately). You can carry amounts above that forward to later years.
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This article was written by NerdWallet and was originally published by USA Today.