In today's post, I want to take a look at a topic we don't hear much about in the media or personal finance bloggers. The theme – tax-efficient investments. I'm not talking about things like IRAs, Roth IRAs, and company retirement plans. These should be an essential part of any investment strategy.
Maxing out contributions to as many of these as you qualify for makes sense. But that's more about accumulation than tax-efficient investments. These are tax-efficient investment accounts. Not to mention the fact that with most company retirement plans, you get free money in the form of employer matching contributions. So, by all means, take advantage of these opportunities. If you can max out contributions, you should. If not, the minimum should be the percentage that the company matches.
We're going to talk about investing money outside of 401(k) plans and IRAs. I want us to consider what kind of tax-advantaged investments are available and how best to utilize them. We will also talk about a little know strategy that, over time, can save a lot of money in taxes.
With that brief background, let's get started.
Three areas of emphasis
If you're reading this article, it's likely you are an investor. At the very least, you're considering becoming an investor and trying to learn.
You might be investing via your employer-sponsored retirement plan. Maybe you own rental properties. You might have a traditional or Roth IRA. Perhaps you're investing for your kids’ college education in a 529 plan. Most of you probably have individual investment accounts or, if married, a joint account with your spouse.
It’s hard enough to decide the types of investments to own. When we add the burden of trying to make those investments tax efficient, the problem seems even more significant. But if you will take the time to learn about and focus on making your portfolio as tax efficient as possible, it will increase your returns.
We’ll talk about tax-efficient investing by covering three major areas.
- The types of taxes paid on various investments
- Investments that offer tax efficiency and how ways to invest in them
- Asset location – placing your multiple investments in the accounts that provide the most favorable tax treatment
Taxes – what you need to know
I don't know about you, but I don't like paying taxes. I doubt you do either.
It seems like there is a tax around every corner. There are federal, state, and local income taxes. We pay sales tax on items purchased, tax on gasoline, carbon tax, and property tax. When we die or when we give away money to individuals, we have to consider the gift and estate taxes. Do you travel and stay in hotels? Of course, you do. It's likely you pay an additional hotel tax for the privilege. Do you smoke or enjoy your favorite adult beverages? If so, you pay a tax called the sin tax on those smokes and drinks.
We're told these are necessary taxes that pay for the services the government provides. Fair enough. But how much is enough? Ok. That's a rabbit trail I don't want to pursue. So we'll move ahead.
Most of us try to reduce or eliminate as many of these taxes as we can. There’s nothing wrong with that. Doing so via all legal means possible and playing by those rules helps reduce our taxes. If we can reduce the amount of tax we pay, it puts money into our pockets. And let’s face it, most of us feel we can do better with our money than the public entities to whom we pay our taxes.
Let's talk about the kinds of taxes we might pay on our investments.
For further reading:
What You Need to Know about Your Old 401(k)
Investors pay capital gains taxes on investments like stocks, bonds, real estate, and other property sold at a profit
The tax rate on the profits depends on the holding period of the investments. If held less than one year, the tax rates come from the 2019 ordinary income tax rates table.
Here are those rates:
If the holding period is one year or more, the tax rate comes from the capital gains tax table as follows:
Let’s look at an example.
We will assume that you’ve owned a stock, ETF or mutual fund, sold it and have a gain of $50,000 after selling. For this exercise, we assume we have a married couple, filing a joint tax return with a combined income of $200,000.
Short-term gains taxes (assets held < one year):
$50,000 x 24% = $12,000
Long-term gain taxes (assets held > one year)
$50,000 x 15% = $7,500
$12,000 – $7,500 = $4,500
Before selling an asset (stocks, bonds, etc.), look at how long you’ve held the investment. Calculate the tax rates both ways to see which one makes the most sense.
In the example above, if your income were $100,000 instead of $150,000, the tax would be $13,717 instead of $24,717. The blended tax rate would be 13.7% instead of 15% for the capital gains tax.
Note: These examples are meant to represent a simple example of the impact of taxes on sales of investments. It does not account for any other deductions or adjustments, which could alter the tax rate. It is meant to show the difference in tax rates at ordinary income vs. capital gains. Before deciding what to do, take into consideration your total tax picture.
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Gains and losses
Another way to lower the tax bill on sales of investments is by matching losses and gains against each other. The tax rule allows us to offset any gains from investment sales against any losses from sales. You may have heard this called tax-loss-harvesting.
Taking advantage of this means selling securities you own that have capital losses to offset securities you’ve sold that have capital gains.
Let's say you had $10,000 in capital gains and lost $5,000 from selling other investments; your net capital gain is $5,000.
Here's how gains/loss offsetting works.
First, deduct short term losses against short term gains. Next, subtract long term losses against long term gains. You would then deduct any excess losses against the opposite gain
Let’s say you sold securities with the following gains:
- Long term gains – $10,000
- Long term losses – $6,000
- Net long-term gain – $4.000
And these losses:
- Short term gain – $5,000
- Short term loss – $9,000
- Net short-term loss – $4,000
The $4,000 net long term gain is used to offset the $4,000 net short term loss resulting in zero tax due on these transactions. Can you see how this exercise benefits you?
What if you don't have any losses to offset the gains? There's still a benefit. You can deduct any excess gains against ordinary income up to $3,000. Any losses not used during the current tax year can be carried over into subsequent years
Start planning for this tax-loss-harvesting early to take advantage. Waiting until the last minute may be too late. All sales must be final before December 31 of the tax-filing year.
Do you own stocks bonds or mutual funds in your taxable accounts? If so, you pay taxes on dividends you receive from them. Even if you don't take the dividends in cash and reinvest them, you have still “received” them and owe a tax.
Two types of dividends determine the tax rates – qualified and nonqualified. Qualified dividends come from publicly traded stocks of U.S. companies listed on major U.S. stock exchanges. If you own these stocks (or mutual funds and ETFs that do) and receive dividends, you benefit with a reduced tax rate on those dividends.
The tax-rate for qualified dividends matches the capital gains tax rates (15% or 20%). There is a holding period requirement to be eligible for favorable tax treatment. You must have owned the stock for 61 days of a 121 time-frame. The stock cannot be part of an ESOP plan or issued by a tax-exempt organization.
Nonqualified dividends come from companies (or mutual funds and ETFs) who own companies that don’t meet these criteria. If that's the case, you will lose the favorable tax rates and pay ordinary income taxes on the dividend income.
Before investing in any stock, mutual fund or ETF, be sure the companies owned are companies that pay qualified dividends.
Examples of tax-efficient investments
With the tax background behinds us, let's look at some investments that offer a tax advantage to us when we own them. There are several I'll highlight here. The list is not meant to be exhaustive. I'm only highlighting some of the more common and most often used investments.
Tax-free municipal bonds
Bonds are loans investors make to the issuing entity. That's different from stocks, which represent ownership interests in companies, Like other loans, investors (called bondholders) receive interest from the issuing entity. Typically for individual bonds, the entity pays the interest semi-annually. Corporations, along with federal, state, and local governments can issue bonds (loans) to raise money.
State, county, and local governments issue municipal bonds. Like other bond investments, they pay investors regular interest payments. Bonds issued by municipalities are free from federal income tax. If you invest in a bond within your state of residence (can be issued by the state, county, or local government), it will likely be both federally, and state tax-free.
Here's an example. You live in Indiana (my home state) and invest $50,000 in a bond issued by the State of Indiana paying 3% interest (one can hope, right?). Your federal tax rate is 24%. The state tax rate in Indiana is 3.25% for a total of 27.25%.
To match the after-tax yield of a bond issued by the State of Indiana, you would need to buy a taxable bond paying 4.12% (3% / 72.75% =4.12%). If you had a blended federal rate of 32%, the taxable equivalent yield to match it becomes 4.63%. The higher your tax bracket, the greater the benefit from municipal bonds, especially if you enjoy the double tax=free benefit of in-state bonds.
Ways to invest in tax-free bonds
Investors can buy individual bonds issued by states, cities, towns, and counties through a broker. They come in 5,000 increments. In this case, you own the bonds directly and get the face value of the bond back when it matures. There are several things to consider when buying individual bonds (like purchasing the bond at a premium or discount) that are outside the scope of this article.
Here is how individual bonds work. If you invest $100,000 in a bond and pay face value for it ($100k); you will get that original principal back when the bond matures. Assuming the bond matures in five years, that’s when you get your money back. If it’s a ten-year bond, it’s ten years.
Regular readers know how important I think having a diversified investment portfolio is. When buying individual municipal bonds, it takes a hefty investment to get a properly diversified portfolio. As part of a balanced asset allocation strategy, that may not be feasible.
The other way to invest in tax-free bonds is through a mutual fund or ETF. Like stock mutual funds or ETFs, you don't own the bonds yourself. Instead, you own shares of the mutual fund which in turn buys the bonds on your behalf. Like any mutual fund, the minimum investment required is smaller and offers a more broadly diversified portfolio to reduce the risk of bonds defaulting.
The value of your shares will go up and down during the time you hold the shares. Unlike holding individual bonds to maturity, when you sell shares of bond mutual funds, you could get more or less than you paid for them. You get the market price of the fund shares on the day you sell. The dividends paid on bond funds, and ETFs that invest in municipal bonds are federally tax-free. The portion of the bonds the fund owns in your state may be state tax-free as well.
What about annuities?
There are numerous types of annuities to purchase. I'm going to stick with the basics for this discussion. For the purposed of this post, we're going to talk about deferred annuities.
Like an IRA, money invested in a deferred annuity delays taxes until withdrawals begin. Like an IRA, withdrawals get taxed at ordinary income rates. For this discussion, we are going to assume that the annuity is funded with after-taxes dollars; meaning you paid taxes on the money invested before you put it into the annuity.
Types of deferred annuities
Deferred annuities come in three basic types:
- Fixed – In a fixed annuity, the issuing insurance company offers a fixed rate of return. Typically, they guarantee the first year and a minimum rate. Each year, they will declare a new one-year rate. Fixed annuities are the safest of the bunch., The assets of the issuing company back them. It's important to choose a highly rated, financially secure company for your annuity.
- Fixed index – In a fixed index annuity, the company ties your rate to some sort of index. Many use the S & P 500. Rather than get what the index returns, you will get a percentage, called the cap or participation rate, that will be less than what the index returns. They usually come with a minimum guaranteed return as well. Be sure you understand the crediting methods before investing.
- Variable annuities – Variable annuities have investments that are more like mutual funds. Called sub-accounts, you can choose from a menu of funds that mirror funds available outside the annuity. Returns in variable annuities come from the returns of the underlying sub-accounts chosen. One of the main criticisms of variable annuities is their high expenses. Underlying expenses can be from 3% – 5%. The higher fees come from some of the additional features offered (guaranteed income, death benefit, etc.).
What are the tax advantages?
Earnings grow tax-deferred as long as they remain inside the annuity. In some cases, withdrawals have favorable tax treatment.
Here are two ways to withdraw money from annuities.
- Straight cash withdrawals – Here, you would submit a request for your withdrawal to the insurance company. Keep in mind, if you do so in the first few years, you could pay an early withdrawal penalty (more on that below). For these withdrawals, the IRS says that earnings come out first. The tax on the earnings is at ordinary income tax rates.
- Annuitization – When an annuity is “annuitized” the total account value converts to a lifetime income. There are other annuitization options as well. You might withdraw over ten years, add a survivor benefit, etc. When annuitized, there is a tax advantage. The IRS considers part of the payment return of principle and does not tax it. The remaining portion gets taxed at ordinary income rates.
Almost all annuities have early withdrawal penalties. The penalty period ranges from 5 – 8 years and can be quite high. Be sure you don't need this money until after the surrender period expires.
Like IRAs, withdrawals before age 59 1/2 come with an additional 10% penalty. There is a lot to consider when investing in annuities. Be sure to analyze all aspects of the annuity chosen carefully.
Having a diversified portfolio means owning multiple asset classes. That's the starting point.
Another way to help that portfolio be more tax efficient is through something called asset location. Most people have both taxable and tax-deferred investment accounts. Asset location is the process of deciding which investments go into which type of account. Here's how that might work.
Interest rates on taxable fixed income investments get taxed at ordinary income rates. That could be as high as 37% plus the additional net investment income tax of 3.8%. If possible, it's best to put these investments in a tax-deferred account like a traditional or Roth IRA. Earnings grow in these account tax-deferred. Taxes on those earnings are at ordinary income rates when withdrawn. Delaying the tax by placing them in these accounts can save a lot of money over time.
Real estate investment trusts (REITs) distribute income every year in the form of dividends. Unlike qualified stock dividends, tax rates on income from REITs are at the higher ordinary income rates. Placing these investments in tax-deferred accounts will save money on taxes every year as well.
You may own real estate properties as an investment. Be sure to understand how the income gets taxed here. There are ways to make this income tax-advantaged that are outside the scope of this article.
Capital assets like stocks, ETFs and mutual funds should be in taxable investment accounts (individual, joint, trust, etc.). Why?
Most companies owned in funds or outright throw off qualified dividends. That means you get the favorable dividend tax rate of either 15% or 20%. If you hold these investments for more than one year and sell them, your tax rates are at the lower capital gains rates.
A downside to the asset location strategy may come from how you manage your portfolio. If you maintain your asset allocation by looking at all accounts as one portfolio, the asset location decisions are fairly easy.
If, however, you manage your portfolio based on the bucket strategy (each account tied to a specific goal) asset location may be more difficult. You may not be able to allocate across taxable and non-taxable accounts. If you're investing for a purpose in a particular account and the account gets depleted to pay for that goal, it's all likely in a taxable account.
To the extent possible, allocating your investments across taxable and tax-advantaged accounts may increase after-tax returns.
OK. That's probably enough for today. There are a lot more details and layers we could explore. Maybe we'll do that in a future post. For now, I hope you learned some things to help increase your returns.
You have heard the well know axiom, “It's not what you earn. It's what you get to keep.” Paying attention to the types of investments you own, how long you own them, and how you allocate them across taxable and tax-advantaged accounts are a few of the things you can do to keep more of what you earn. Owning tax-advantaged investments like municipal bonds (or funds), annuities, and other tax-advantaged investments are yet another way to do the same.
I don't know about you, but I like to keep more of what I make. Following these guidelines provide a way for you to do that with your investments.
Now it's your turn. Do you take advantage of any of these strategies? Do you pay attention to which accounts hold which investments? What other things are you doing to increase your after-tax returns?
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