When it comes to your investments, it is after-tax returns that really count, not what you earn before taxes. So how can you boost your post-tax results? Let’s take a look at a few strategies.*
Contribute to Tax-Advantaged Accounts
Fund your qualified retirement plan – such as a 401(k) or 403(b) – at the maximum yearly contribution. If you cannot make the maximum yearly contribution, contribute enough to qualify for any employer matching contributions. Contributions to retirement accounts are pretax, and earnings accumulate tax-deferred.
Even though the current-year tax savings of a traditional 401(k) might appeal to you, don’t overlook the Roth 401(k). Your contributions won’t be pretax, but earnings accumulate tax-free, not just tax-deferred.
A Health Savings Account (HSA) provides great savings and tax advantages. Contributions are pretax or deductible (though you can contribute only if you have a high-deductible health plan), plus distributions used for qualified medical expenses are tax-free. After age 65, you can use HSA funds for any purpose without penalty, including retirement, but taxes apply.
Consider Municipal Bond Funds
If one of your investment goals is generating income, municipal bond funds might be good choices, especially if you’re in a high tax bracket. These funds invest in debt issued by states, cities, counties and public revenue authorities.
Generally, investments in municipal debt are exempt from federal income taxes and some state and local income taxes as well. However, know the tax impact of investments you consider, because some bonds may lack one or more of these tax benefits, or may even be subject to the alternative minimum tax.
Also, keep in mind state and municipal bonds usually pay a lower interest rate. This means their rate of return might end up being lower than the after-tax rate of return of a taxable investment. To compare the returns, you can calculate the tax-equivalent yield of the municipal bond:**
Tax-equivalent yield = actual yield/(1 − your marginal tax rate).
The formula incorporates tax savings into the municipal bond’s yield.
The Right Investments in the Right Accounts
It’s generally best to put not tax-free investments and tax-efficient investments in taxable accounts. Tax-efficient investments include: equity index funds, tax-managed stock funds and stocks or mutual funds that pay qualified dividends. These investments generate less in taxable income and capital gains, so you receive a lower tax penalty.
Exchange-traded funds (ETFs) are also good choices for taxable accounts because ETFs rarely make capital gains distributions. This allows investors to pay all or most of their capital gains when the ETF is sold, thereby delaying tax liability.
Conversely, tax-deferred and tax-free accounts are good places to put any investment that generates a substantial amount of ordinary income, such as taxable bond funds and certain real estate investment trusts (REITs). When you withdraw earnings from these accounts, the government taxes the earnings at ordinary income tax rates. Actively managed stock funds with high turnover rates are also good candidates for tax-favored accounts, given you will not be penalized for the manager’s active buying and selling.
Take Smart Profits and Losses
If you sell a security within one year of purchasing it, any gain you earn will be classified as short term and taxed as ordinary income, at a rate as high as 39.6% in 2016.
On the other hand, if you hold a security for at least a year, your capital gain is considered long-term and taxed at 15% or 20% depending on your filing status and income. There are other risks in holding for a longer time – such as your investment losing value – so you should not only consider taxes when deciding whether to sell.
Selling an investment at a loss allows you to “harvest” the loss and use it to offset realized capital gains. With a wide variety of mutual funds and ETFs available, you can purchase an investment similar to the one you sold, allowing you to maintain a presence in that asset category. Just be aware of the IRS wash sale rule, which prohibits taking a current loss if you sell and then rebuy “substantially identical” securities within 30 days.
If you purchased a security at different times, it might pay to track the potential impact of those lots for tax purposes. Selling one lot as opposed to another might trigger a much larger tax bite — or a greater tax loss you can use to offset gains elsewhere in your portfolio.
Planning now can be valuable later
Even though few investors enjoy thinking about taxes, taking a little time to plan strategically in this area can have a significant effect on your results.
To maximize the tax efficiency of your investment portfolio, contact a Fifth Third Bank financial advisor.