by NerdWallet contributor Andrew Coflan
Among the thousands of theories written about investing, two stand above the rest to inspire awe and fear. The first, compound interest, is a seemingly magical property, which can take a small sum of money and 30 years time, and leave you with a veritable mountain of money. The second, taxes, will take that mountain, and reduce it back into the molehill that you started out with.
Tax-efficiency in your portfolio should be one of the top priorities if you wish to maximize your gains, and any potential investments should include tax calculations as part of their estimates.
There are two ways to be tax efficient when income tax reduction is the goal. The first is to reduce your taxable income now, and the second is to focus on your income structure post-retirement.
The standard employer-run retirement fund, a 401(k) is a tax-deferred fund that allows you to defer the payment of taxes until the time that the money is withdrawn, typically after 59 ½ years of age. The benefits of this are two fold; first, if you make $60,000 a year and contribute $4,000 to your 401(k), you will be taxed at an income of $56,000 for that year, and secondly, your withdrawals from the 401(k) will be taxed at the rate for your income during your retirement, which will likely be lower than during the middle of your career.
A separate account that can be used in conjunction with a 401(k) for maximum tax-efficiency is the Roth Individual Retirement Arrangement, or Roth IRA. Unlike a traditional IRA, Roth IRAs are not tax-deductible, but they come with the advantage of not being taxed upon withdrawal, and, more importantly, not counting towards your Adjusted Gross Income upon dispersal. As a result, drawing upon a Roth IRA during retirement will not raise the rate at which your 401(k) dispersals are taxed at, lowing your rates. This means that, unlike a traditional IRA, you’re not taxed on your gains in the account.
Roth IRAs have an adjusted gross income limit, however, of $188,000 for couples and $127,000 for single filers.
Suggested Structure: Match your employer’s contribution on your 401(k), and then max out your Roth IRA up to the yearly limit, which is currently $5,500 per year. If you have gotten this far and still have money left, max out your 401(k) contributions at $17,500.
Reducing Capital Gains
Congratulations! You’ve started down the path of a tax efficient retirement. Now let’s look at how to invest efficiently in taxable accounts. First, check out this article on Capital Gains Taxes for 2013 for a quick refresher and some great tips. If you want to start get investing now, here’s the short and sweet explanation:
– Short term gains are those realized within one year, and are taxed at your marginal tax rate.
– Long term gains are those on any investment vehicle held for over a year, and are taxed at a preferential rate of 15% for those with a marginal tax rate of 25-25%, and 20% for those taxed at a rate of 39.6%
As you can see, the savings for holding on to investments for more than a year are quite large, potentially reducing a 35% tax to a 15% tax rate. To maximize overall efficiency, we’ll focus on a few key aspects of different investment vehicles, including mutual funds and exchange-traded funds (ETFs).
Mutual Funds vs. ETFs
The goal of this article is to examine the tax efficiency of certain investments, so that’s what we’ll focus on in this part. Mutual Funds have become somewhat of a staple for investors over the past few decades, and have a degree of familiarity that ETFs do not. Does that mean that they’re the best way to decrease our taxes and maximize the efficiency of our investments? Not necessarily.
As a quick refresher, mutual funds are professionally managed investment vehicles that pool together money from large groups of investors to buy securities. Investing in a mutual fund requires paying a fee to the fund manager, the expense ratio, which lowers returns.
ETFs on the other hand are index funds that are traded on an exchange like stocks. That is, they can be short-sold, bought on margin, and rise and sink in value over the day, unlike mutual funds whose NAV is calculated only at the end of the day. ETFs also charge an expense ratio, but it is usually lower than those of mutual funds.
What does this mean for tax efficiency? First of all, the way in which these two types of funds realize capital gains is different. Actively managed funds have a higher turnover as the managers rebalance their portfolios. Whenever gains are realized during these turnovers, they are passed on to the investors and taxed as capital gains. This also happens when an investor wishes to redeem their investment. ETFs on the other hand are usually passively managed and have a lower turnover rate.
The last piece of the puzzle comes with capital losses. Ideally, you wouldn’t have any losses on your portfolio, but, when you do, you should use them to your advantage. Capital losses can be credited against capital gains to offset the tax burden. If you sell a high-performing long term ETF for a capital gain of $10,000 while selling a handful of short term ETFs for a capital loss of $2,000, you only pay capital gains tax on the $8,000 net gain. This is a useful tactic at the end of the year to maximize savings.
In summary, ETFs offer the advantages of flexibility, liquidity, and low rates, as well as a host of other minor advantages that can add up over the long term in comparison to mutual funds.
Capital gains taxes occur whenever you sell anything for a profit, so common sense will tell us that holding on to our securities for the long term is the first step in reducing our tax burden. Not engaging in high volumes of trading is an extension of this thought – every trade costs money in brokerage fees and in taxes. These have to be figured into the gains of every potential sale. Don’t eliminate your gains and increase your tax burden through excessive trading!
Putting It All Together
Once you’ve set up your 401(k), it’s time to move onto your Roth IRA and brokerage accounts. NerdWallet analyzed the largest brokerage firms and found that Scottrade is the best Roth IRA provider for long-term investors looking to minimize fees. Scottrade provides access to over 14,000 low cost mutual funds and ETFs, and charges only $7 for equity trades.
If you’re specifically interested in trading ETFs, TD Ameritrade offers 105 commission-free exchange-traded funds. In addition, their Roth IRA provides access to some of the best research and analysis software, alongside top-rated customer service.
Financial Statement image courtesy of Shutterstock.