Successful practices to help you lower taxes in your investment portfolio
A taxable investment account is any brokerage or trust account that does not come with tax benefits. Unlike Roth IRA and Tax-Deferred 401k plans, these accounts do not have many tax advantages. Your contributions to the account are in taxable dollars. This is money you earned from salary, royalties, the sale of property and so on. All gains, losses, dividends, interest and other income from any investments are subject to taxes at the current tax rates. In this post, we will discuss several successful practices that can help you lower taxes in your investment portfolio
Why investors put money into taxable accounts? They provide flexibility and liquidity, which are not available by other retirement accounts. Money is readily accessible for emergencies and unforeseen expenses. Many credit institutions take these accounts as a liquid asset for loan applications.
Since investment accounts are taxable, their owners often look for ways to minimize the tax impact at the end of the year. Several practices can help you reduce your overall tax burden.
1. Buy and Hold
Taxable investment accounts are ideal for buy and hold investors who don’t plan to trade frequently. By doing that investors will minimize trading costs and harvest long-term capital gains when they decide to sell their investments. Long-term capital gains are taxable at a favorable rate of 0%, 15% or 20% plus 3.8% Medicare surcharge. In contrast, short-term gains for securities held less than a year are taxed at the higher ordinary income level.
Individuals and families often use investments accounts for supplemental income and source of liquidity. Those investors are usually susceptible to market volatility. Diversification is the best way to lower market risk. I strongly encourage investors to diversify their portfolios by investing in uncorrelated assets including mid-cap, small-cap, international stocks, bonds, and real assets.
2. Invest in Municipal Bonds
Most municipal bonds are exempt from taxes on their coupon payments. They are considered a safer investment with slightly higher risk than Treasury bonds but lower than comparable corporate bonds.
This tax exemption makes the municipal bond suitable investment for taxable accounts, especially for individuals in the high brackets category.
3. Invest in growth non-dividend paying stocks
Growth stocks that pay little or no dividend are also a great alternative for long-term buy and hold investors. Since the majority of the return from stocks will come from price appreciation, investors don’t need to worry about paying taxes on dividends. They will only have to pay taxes when selling the investments.
4. Invest in MLPs
Managed Limited Partnerships have a complex legal and tax structure, which requires them to distribute 90% of their income to their partners. The majority of the distributions come in the form return on capital which is tax-deferred and deducted from the cost basis of the investments. Investors don’t owe taxes on the return on capital distributions until their cost basis becomes zero or decide to sell the MLP investment.
One caveat, MLPs require K-1 filing in each state where the company operates, which increases the tax filing cost for their owners.
5. Invest in Index Funds and ETFs
Index funds and ETFs are passive investment vehicles. Typically they track a particular index or a benchmark. ETFs and index fund have a more tax efficient structure that makes them suitable for taxable accounts. Unlike them, most actively managed mutual funds frequently trade in and out of individual holdings causing them to release long-term and short-term capital gains to shareholders.
6. Avoid investments with a higher tax burden
While REITs, taxable bonds, commodities and actively managed mutual funds have their spot in the investment portfolio, they come with a higher tax burden.
The income from REITs, treasuries, corporate and international bonds is subject to the higher ordinary income tax, which can be up to 39.6% plus 3.8% Medicare surcharge
Commodities, particularly Gold are considered collectibles and taxed at a minimum of 28% for long-term gains.
Actively managed funds, as mentioned earlier, periodically release long-term and short-term capital gains to their shareholders, which automatically triggers additional taxes.
7. Make gifts
You can use up to $14,000 a year or $28,000 for a couple to give to any number of people you wish without tax consequences. You can make gifts of cash or appreciated investments from your investment account to family members at lower tax bracket than yours.
You can make contributions in cash for up to 50% of your taxable income to your favorite charity. You can also donate appreciated stocks for up to 30% of AGI. Consequently, the value of your donation will reduce your income for the year. If you had a good year when you received a big bonus, sold a property or made substantial gains in the market, making donations will help you reduce your overall tax bill for the year.
9. Stepped up cost basis
At the current law, the assets in your investment account will be received by your heirs at the higher stepped-up basis, not at the original purchase price. If stocks are transferred as an inheritance directly (versus being sold and proceeds received in cash), they are not subject to taxes on any long-term or short-term capital gains. Your heirs will inherit the stocks at the new higher cost basis. However, if your investments had lost value over time, you may wish to consider other ways to transfer your wealth. In this case, the stepped-up basis will be lower than you originally paid for and may trigger higher taxes in the future for your heirs.
10. Tax loss harvesting
Tax loss harvesting is selling investments at a loss. The loss will offset gains from other the sale of other securities. Additionally, investors can use $3,000 of investment losses a year to offset ordinary income. They can also carry over any remaining amounts for future tax filings.
About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.
Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image Copyright: <a href=’http://www.123rf.com/profile_adamr’>adamr / 123RF Stock Photo</a>
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