Published On
November 11, 2015

In the world of private wealth management, investing gets all the glory. The media cannot get enough coverage of recent stock market updates and predictions. This is interesting because the stock market is volatile and largely unpredictable. Taxes may have less mass appeal, but as Ben Franklin famously said, “the only things certain in life are death and taxes.”

Actually, your investments and taxes are more related than you may think. By ignoring how your investments affect your taxes, you could be leaving money on the table. Using the tax code to your advantage and having a financial plan that incorporates investing and taxes will allow you to keep more money in your pocket. At the end of the day, it’s not your gross return that matters. It’s how much of that return, net of taxes, that you keep.

Let’s Look at 3 Ways Your Investments Affect Your Taxes:

  1. Where you hold the investments
  2. What types of investments you choose
  3. How you trade those investments

Where You Hold the Investments

Before you select your investments, you have to pick which account to hold them in. Should you choose a traditional or Roth IRA? Nonqualified account or retirement account? Your decision will have important tax consequences both when you put money in and take money out. With most traditional retirement accounts, you receive a tax deduction on your contributions and pay ordinary income tax on your withdrawals. Roth accounts are the opposite; there is no tax benefit for contributing, but all growth and withdrawals are tax-free. For some, taking the tax deduction today is more valuable, but for others, the tax-free withdrawals will benefit them down the road.

What Types of Investments You Choose

The next step is deciding which investments to purchase. You should be aware that investment income is taxed differently depending on the type of investment. Stocks, for example, may pay out dividends. If the dividends are qualified, they receive preferential tax treatment (15% for most). Bonds, on the other hand, pay interest, which is taxed as ordinary income. Municipal bonds are unique in that their interest is usually income tax-free, which may make a good choice for investors in higher tax brackets. Before buying, make sure you understand what type of income your investments will produce.

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How You Trade Those Investments

A third way your investments affect your taxes is how often you buy/sell them. When you buy an investment, the idea is to buy low and sell high. When you do this, you have to pay taxes on the difference. This is called capital gains tax. Conversely, if you sell the investment for less than you bought it for, that is a capital loss. Capital gains are taxed at a lower rate than your ordinary income, which is the benefit of investing. However, you only get this special rate if it is a long-term capital gain. That means you held the investment for over a year before you sold it. If not, you pay short-term capital gains which are taxed at higher rates. This is where having a long-term approach versus constantly buying and selling will increase your odds of success and decrease you taxes.

How to Minimize Investment Related Taxes

  1. Choose the Correct Accounts: Decide whether traditional accounts, Roth accounts or a combination of both makes sense for your situation. Doing so will require some forward tax planning, but could save you thousands of dollars in the long run. Remember that deferring taxes today could mean paying more taxes down the road.
  2. Asset Location: Strategically hold different assets in different accounts. Place investments with higher expected returns in taxable or Roth accounts so all that growth is tax-free. Place your lower expected return assets in tax-deferred accounts. This can add up to 75 basis points to your returns[1].
  3. Don’t Day Trade: Constantly buying and selling isn’t a sound investment strategy to begin with, and you also will end up paying higher taxes because of it. Taking advantage of long-term capital gains is a great way to lower your tax bill. This means not buying an investment unless you plan to hold it for at least a year.
  4. Avoid High Turnover Funds in Taxable Accounts: Even if you are not buying and selling all the time, your mutual fund might be. When they do, they pass all the costs along to you. Index funds or tax-managed funds typically have lower turnover, which means fewer taxes.
  5. Tax Loss Harvest: Tax loss harvesting is a technique that allows you to take advantage of the natural ups and downs of the market, and generate tax savings while staying invested in the market. It allows you to offset future gains with losses, thus reducing your tax consequences. Watch out for the wash sale rule.

Managing taxes is just as critical to your financial success as picking the right investments. For most people, taxes will take a larger piece of your portfolio than any down market will. Paying less in taxes means higher net returns. Or, thought of another way, controlling taxes allows you to get the same net return while taking less risk. Your investments and your taxes go hand in hand, which is why having a comprehensive strategy in place is so important.

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Sources & Disclosures
“Putting a value on your value: Quantifying Vanguard Advisor’s Alpha, March 2014”
Potential value-add: 0 to 75 bps, depending on the investor’s asset allocation and “bucket” size (the breakdown of assets between taxable and tax-advantaged accounts). The majority of the benefits occur when the taxable and tax-advantaged accounts are roughly equal in size, the target allocation is in a balanced portfolio, and the investor is in a high marginal tax bracket. If an investor has all of his or her assets in one account type (that is, all taxable or all tax-advantaged), the value of asset location is 0 bps.
Intended for educational purposes only and are not intended as individualized advice or a guarantee that you will achieve a desired result. Before implementing any strategies discussed you should consult your tax and financial advisors.
Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
Neither diversification nor asset reallocation can ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.
All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.