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Get Your Portfolio Into Tax-Efficient Shape

March 31, 2015
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By Matt Buckwalter

Learn more about Matt on NerdWallet’s Ask an Advisor

A good workout comes with “muscle burn” — that telltale pain experienced during exercise that is a leading indication of what will soon become muscle growth.

Now that your tax return is filed, you may feel a similar kind of burn in your personal finances. I call this the “tax burn” of portfolio growth. You’ll start to notice this tax burn when dividends and capital gains result in a sizable amount of income tax owed, and it might even take you by surprise.

For taxpayers in the highest tax bracket, the amount of tax owed on such additional income might approach 50%. Although tax burn might be a good indication of portfolio growth, taxpayers shouldn’t be complacent. They need to consider whether their portfolio is tax efficient.

Having tax efficiency is like having the right form and combination of exercises in your investment portfolio. It’s like spending less time in the gym for the same benefit, if not more.

Consider these three tips for making your investment portfolio grow more efficiently:

  1. Identify the biggest tax offender in your portfolio. This can be done by looking at your 1040 Schedule B and Form 8949 to see which investments are producing the most income. You might find certain bond funds, actively managed mutual funds, and real estate investment trusts are your biggest offenders.
  1. Place the biggest income-producing assets in your tax-qualified accounts. These accounts include employer retirement and IRAs. At a minimum, the income generated on investments in these accounts is deferred and in some cases may be tax free.
  1. Place the most tax-efficient investments in your taxable accounts. Many individual stocks, index mutual funds and exchange traded funds are tax efficient in that they produce relatively low dividends and capital gain distributions. What’s more, when sold, they may receive more favorable tax treatment.

Of course, making changes may come at some cost. The S&P 500 is up considerably since 2012, which means a sale may result in realizing gains. So, you’ll want to be sure you consult your tax advisor to understand the impact changes may have for you. Also, your emergency reserve is likely invested in income-producing short-term reserves, and these assets are an important part of an emergency reserve strategy.

A good trainer advises those new to the gym to begin slowly with good form and to add to their routine as their body gets stronger. In this sense, financial planning is like building a healthy body. It takes initiative to get started and time for improvements to show. Don’t be afraid of the tax burn — just make sure your portfolio growth isn’t coming at an unnecessary price.