Improve your investment returns with better tax management

It’s tax time, the time of year when some people detract from their financial success by lamenting the tax they must pay on the growth or income their investments generated in the prior year.

Rather than fret about giving some of your investment returns to the government, focus on what you can do to keep as much of your return as legally possible.

Depending on what type of investment accounts you own, you may have some assets that are subject to ordinary income tax, some subject to capital gains tax and some that owe no tax on growth or income. Regardless, you can only spend your money in the after-tax world. Your net investment returns after tax are more important than pre-tax returns. To improve after-tax returns, you may have alternatives for more tax-efficient investment management.

OPTIMIZE HOLDINGS FOR DIFFERENT ACCOUNT TYPES

If all your investments are in pre-tax IRA, 401(k) or 403(b) accounts, there isn’t much you can do to impact taxation. When you eventually withdraw from these accounts, every dollar will be subject to ordinary income tax at whatever bracket/rate is applicable to you that year.

To the extent that you have money in other account types, either non-retirement brokerage accounts or after-tax Roth IRA/401(k), then you gain some ability to manage taxation through an asset location strategy.

Holding all three types of accounts (pre-tax, after-tax and currently taxable capital gains or income in a non-retirement account) can allow the most optimal positioning of investments.

If you have a Roth IRA or after-tax portion of your employer retirement plan, this is the best place to hold investments with the highest expected future return. Since you’ve already paid tax on money contributed to these accounts, this is where you get to keep all your investment gains. That makes it best to place the most aggressive holdings — typically, growth stocks or funds and positions in small caps or emerging markets.

Pre-tax accounts are best for holding income-oriented investments. All types of bonds, real estate investment trusts and dividend-paying stocks are preferable.

In non-retirement accounts, capital gains and income are taxed as they are realized. It’s best to own stock index funds or low-turnover stock funds here. If you need to hold some bonds outside of the pre-tax retirement account in order to get to the preferred weight of bonds in your portfolio, then the bonds you hold in a non-retirement account should, in many cases, be tax-free municipal bonds.

The ultimate impact of these asset location strategies depends on tax brackets and your effective tax rate now compared to the future. Since future tax rates are unknown, this is another reason to own different types of accounts that create tax diversification, perhaps allowing you to lower the effective rate of taxation over time.

Research by Morningstar has suggested that tax efficiency can increase retirement income by more than 20 percent in optimal scenarios.

MORE TACTICS TO REDUCE TAX

If you are charitably inclined, there are two strategies preferable to giving cash. First, if you are over 70½ and have money in a pre-tax IRA, make a qualified charitable distribution. Rather than donating from your non-IRA cash (an after-tax asset), you can make the same payment directly to a non-profit organization with pre-tax dollars from your IRA. If you aren’t yet 70½ or don’t have a pre-tax IRA, donate shares of investments that have unrealized capital gains. Neither you nor the nonprofit will owe capital gains tax, making this a superior form of giving compared to a cash contribution.

If you are not exactly a buy-and-hold investor for the long-term, strive to hold positions with gains in brokerage accounts for at least one year. If you sell before the 366th day of ownership, you will have short-term capital gains which are taxed at ordinary income rates, not the lower capital gains tax rate. Unless you are certain that the investment is going to decline in value, reducing your gain before you reach the one-year holding period, it will likely pay to be patient.

When you hold investments that decline in value in a non-retirement account, you can sell and utilize the loss to offset capital gains elsewhere. Given strong markets of the past decade-plus, there have been fewer tax-loss harvesting opportunities. But be mindful when you have the chance to re-position your holdings to reduce taxes.

Another underutilized option is converting currently pre-tax retirement account money to after-tax Roth IRA dollars. Doing this requires you to accelerate taxation to the current year. But if you are currently in a lower tax bracket than you expect to be later when withdrawing, or when your heirs withdraw from the account, this is a strategy where it can be beneficial to pay more tax now.