A Young Lawyer’s Financial Guide | Part 6: How to Maximize Tax-Efficiency When Investing

Kitch's Corner:

A Young Lawyer's Financial Guide

Part 5: How to Maximize

Tax-Efficiency When Investing

Just like inflation, taxes can have a significant impact on your portfolio by eating away at your investment returns. While it is unwise for most people to create an investment strategy solely to minimize taxes, it is important that you understand some of the basic underlying taxes that may affect your investments. In this article, I will walk you through some common taxes that investors face, and I will also discuss some simple yet effective strategies that might be useful to think about as you begin constructing your portfolio.

Find a Professional:

Taxes are complex, constantly changing, and take a lot of time to accurately report. For this reason, I strongly suggest that you work with a tax professional. Regardless of how much you earn, a tax professional can help you manage your taxes efficiently, minimize mistakes, and pay less over time. Companies such as H&R Block and TurboTax have premium tax preparation services where you can work with an actual professional. You could also contact your broker (or your bank) or ask someone you know if they would be willing to make a referral. When working with a tax professional, you should try to find someone that holds a Certified Public Accountant (CPA) certification or is an Enrolled Agent (EA) with the IRS.

Understanding Income and Capital Gains Taxes:

Most investors need to understand income taxes and capital gains taxes. Each tax has its own unique rate, and they are very important to understand because they apply broadly to most investable assets that you can purchase. Income taxes are taxes that the government imposes on the income that an individual receives. Capital gains taxes are applied when an investor makes a profit from the sale of an asset (the profit itself is called a “capital gain”). All investors are subject to the same income tax rates and capital gains tax rates on the federal level, but you should look to your local state (and possibly city) for additional tax levies (note that there are currently nine states that don’t have state income taxes).

Investors owe income taxes on both ordinary income (such as your salary) and investment income (such as ordinary dividends, interest, or rental income). The tax rate that you pay is based on your marginal tax rate on both the federal (see tax brackets here) and state city or local levels. Note that some states may apply a flat tax instead of marginal rates. To illustrate, if an investor lives and works in New York City and makes $200K a year in salary after-taxes and $25K of investment income from corporate bond interest payments, then they will owe ordinary income taxes on $225K. Therefore, this investor would be subject to the following income tax rates: 35% for federal, 6.85% for New York state, and 3.867% for New York City. One of the consequences of receiving regular investment income is that it has the potential of pushing you into a higher top marginal tax bracket. In the example above, if you remove the investment income, then the marginal tax rates would be 32% and 6.41% (NYC tax rate would not change) instead.

On the other hand, capital gains taxes are applied to the profits that an investor makes when they sell an asset. Once the asset is sold, this is known as a “realized capital gain.” When selling a stock, bond, mutual fund, home, etc., the profit you make will be subject to capital gains taxes. Since the tax is only applied when a sale is made, the unrealized gain (i.e., the amount that the asset has increased in value while still being held by the investor) of your investment is not taxed.[1] For example, if at the end of the year you own $50K of stocks that don’t distribute dividends, and you haven’t sold any of them, then that $50K is not taxed as a capital gain or income.

If an investor sells an asset before holding it for one year, that is known as a short-term capital gain and is subject to ordinary income tax rates. Assets that are held for more than one year before they are sold get treated as long-term capital gains and are subject to more favorable rates (0%, 15%, or 20%). To illustrate with the same investor in NYC from the example above, let’s imagine that they made $25K in long-term capital gains instead of investment income. In this scenario, that investor would now pay 15% in taxes on that $25K. Compare that to the 35% they would need to pay if it was a short-term capital gain or ordinary income. Generally, since long-term capital gains tax rates are lower than corresponding income tax rates, investors prefer to get long-term capital gains treatment for their investments.

Now that you understand the basics of these crucial tax concepts, the next step is to apply this understanding to your portfolio construction. Here are a few strategies that could be useful as you start to think about investing in a tax-efficient matter.

Strategies:

Although taxes are an unavoidable part of life, the strategies listed below may help the average investor think about being more tax efficient:

1. Utilize Qualified Dividends: A unique feature of many U.S. and some foreign corporations is that their dividend distributions can be “qualified” and therefore receive the preferred capital gains tax rates instead of ordinary income tax rates. However, to get this tax treatment, an investor in common stock must hold the stock for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date. To unpack this confusing requirement, the ex-dividend date is the actual date that a dividend gets paid to shareholders.

Therefore, the 121-day period begins 60 days before a dividend is paid, and to meet the requirement you need to hold the stock for more than 60 days during that period. See why a tax professional is a good idea? Note that preferred stock and mutual fund shares have separate requirements. Before purchasing a stock that distributes dividends, make sure that you look up whether they are qualified or not. Generally, stocks held for short sales or options are not going to be qualified.

2. Add Tax-Exempt Securities: Certain government-issued securities have unique tax advantages. For example, the income received from U.S. treasury bonds and Treasury Inflation-Protected Securities (TIPS) is not subject to federal income taxes. In addition to treasury securities, certain municipal bonds that are available to investors are known as “triple free munis” because they are not subject to federal, state, or municipal taxes. Note that these munis might be less tax-efficient if you live in a state like Florida or Texas, where there is no state income tax. Another cost-effective way for investors to access tax-exempt securities is by purchasing tax-exempt ETFs (exchange-traded funds) or mutual funds. Although each of these securities offers great tax benefits, they typically have lower yields when compared to other income distributing securities.

3. Use Retirement Accounts: One of the most common ways to make tax-efficient investments is through a retirement account. Unlike normal (i.e., taxable) brokerage accounts, retirement accounts are designed to be tax-advantaged. To be clear, you are still responsible for paying taxes in a retirement account, but the critical difference is that you can decide when to make those payments. In a tax-exempt account such as a Roth IRA or Roth 401(k), you make contributions with after-tax dollars and your qualified distributions are tax-free – so after you pay taxes on the income you contribute, if your account grows by 200%, all that growth and income is tax-free. IRA accounts (traditional and Roth) can be started with a broker such as Vanguard or Fidelity and they are not employer-sponsored plans.

In a tax-deferred account, such as a traditional IRA or 401(k), you make contributions with pre-tax dollars and your qualified withdrawals are taxed at the point of withdrawal – so, you pay no taxes on the money you contribute, and if your account grows by 200% you will owe ordinary income taxes when you begin withdrawing funds. 401(k)s (traditional and Roth) are employer-sponsored plans, which means that you can typically get your employer to match some of your contributions. Both IRAs and 401(k)s have contribution limits. This means the limits apply to the total amount in both traditional and Roth accounts. Also, since 401(k)s are offered by employers, many of them limit the type of investments that you can purchase, while IRAs typically allow for much more flexibility.

Although it might seem like a no-brainer to choose the tax-exempt option every time, there are certain limitations and other considerations. For example, Roth IRAs have income limits (although you can do a “back-door Roth IRA”) and Roth 401(k) options aren’t always offered by employers. Additionally, for high-income earners in states with high tax rates (such as New York or California), the tax-deferred option might be more attractive because they offer tax deductions up to the full amount of their contributions. This is because investors contribute pre-tax dollars, so their overall tax bill is reduced by the amount of income they contributed to the plan.

Moreover, traditional 401(k) contributions can help you increase your take-home pay by reducing the amount of your salary that is subject to federal withholding taxes. It’s also important to consider how much income you think you’ll have when you begin making withdrawals – depending on that figure, it might make more sense to defer your taxes until later.

4. Think About the Proper Placement of Investments: A key component of efficient investing is understanding that where you decide to hold your investments really matters. Generally, taxable accounts are a great place to hold tax-exempt securities (U.S. treasury, TIPS, and municipal bonds, etc.), and stocks that don’t distribute dividends. Since tax-exempt securities are already tax-efficient, it makes little sense to place them in a retirement account. For non-dividend stocks, if you are planning to hold them for a long time, then they might be better suited for a taxable account since you don’t owe any taxes on unrealized capital gains. ETFs are a bit tricky, but since they are typically designed to be tax-efficient you can usually hold them in taxable accounts, but it really depends on the specific ETF.

On the other hand, dividend-bearing stocks, corporate bonds, and mutual funds are typically suitable for a retirement account because it maximizes your returns on the growth and income of those securities. With that said, there are other important factors that you should consider. For example, if you need your investment returns now, then a retirement account is probably not a suitable place to keep those investments since there are usually penalties for withdrawing money within a certain period. You should also consider the risk profile of the individual securities. Additionally, short-selling and other high-risk strategies are usually not suitable for retirement accounts either.

5. Tax-Loss Harvesting: Simply put, tax loss harvesting is a strategy that involves the sale of securities at a loss with the intention of using that loss to offset any capital gains. This strategy can be efficient because capital losses (i.e., the loss you suffer from selling the security) create tax credits that can be used against the capital gains of another security – please note that capital losses must be of the same type (short-term or long-term) as the capital gain you intend to offset. Additionally, if your capital losses outweigh your capital gains (in other words, if you suffered a net loss for the year), you can deduct up to $3,000 against other taxable income. If you still have excess losses after this deduction, you can carry them forward.

To illustrate, suppose that an Investor suffers $10K in short-term capital losses and $10K in long-term capital losses from selling stocks, but also has $10K in short-term capital gains, $5K from long-term capital gains, and $5K of investment income. In this scenario, the short-term and long-term losses would be applied in full against their respective capital gains, meaning the investor would not need to pay any capital gains taxes. The investor can also apply $3K in leftover losses to their investment income, so they would only have to pay taxes on $2K. Finally, the remaining $2K in long-term capital losses will be carried forward indefinitely until it is used up. An additional step that most investors take when tax-loss harvesting is repurchasing the asset that they sold at a loss.

The reason for doing this is most likely that 1) the investor believes the asset was undervalued and cheap, or 2) the cost of repurchasing the asset is much lower for the investor than their overall tax burden without the harvesting. According to the Wash Sales Rule, if you sell an asset at a loss and use it as a deduction for tax purposes you are restricted from purchasing that same asset (or another asset “substantially identical”) for 30 days. If you violate the rule, then you will lose the capital loss deduction. Wash Sales violations are extremely common due to the very broad interpretation of “substantially identical,” so it’s recommended that you consult with a professional and don’t attempt to tax-loss harvest on your own.

6. Other Forms of Taxes and Strategies: In addition to income and capital gains taxes, investors should also think about estate taxes, gift taxes, inheritance taxes, and foreign taxes. Also, some other strategies to help minimize taxes that you may consider are the use of life insurance to minimize estate taxes, purchasing assets with trusts and legal entities (sometimes offshore entities) to lower your tax burden, and using an adjusted cost basis to lower your capital gains taxes. Also, check out my article on risky securities for a discussion of the unique tax benefits of mutual funds and ETFs. With that said, the strategies that I’ve discussed should give you a good sense of what it takes to add astute tax management into your portfolio construction.

With the constant mania of market-beating, returns from meme-stocks, crypto, and other investments, many investors are eager to find the next best thing but unfortunately don’t take the time to understand how this will affect them when their tax bills arrive. One of the core principles of being a successful investor and accumulating wealth is understanding how to structure your investments to be tax-efficient. Whether your goal is to save for retirement, purchase a home, or provide for your family, having a plan for how to manage your tax bill will help you achieve these goals faster.

Now that you’ve uncovered some basic strategies, the next step is to evaluate your financial goals, find a tax professional, and start making smart decisions that will increase your yearly returns. While your financial strategy requires more than being tax-efficient, it is critical that you understand these topics as soon as possible so that you can start to improve your bottom line.

[1] Note that while this is currently the law, there is legislation being proposed that would tax unrealized capital gains for investors who make a certain amount of income.