HGC back with more tax tips for you. How do you account for the tax implications of your investments? We know that taxes can take a significant portion of your investment gains, but we don’t always take them into account on the front end. If you ignore the tax consequences of your investments, you’re likely to pay more in taxes than you really need to, so it’s crucial to consider that before allocating your investment dollars. Taxes on earned interest, dividend income, and capital gains all reduce your investing profits.
If you haven’t been taking taxes into consideration, it’s never too late to start. We recommend investing your dollars in ways that are advantageous to your tax goals. Here’s a list of the best ones, in order of advantage!
- Any 401(k) or 403(b) up to the employer match limit. This is the most tax-advantaged account available to most investors. Employers commonly match the first 3-4% of your contributions.
- With employer matching, it’s a guaranteed 100% return on those contributions. You also lower your taxable income.
- These two advantages provide “free money” and are the reason why these retirement accounts are the first step. Reach your match limit before allocating funds to another option.
- Even if your employer only provides minimal investing options, a retirement account with matching is an ideal first step.
- Traditional or Roth IRA. With traditional IRAs, you can reduce your taxable income. With a Roth, your earnings are tax-free. Do the math for your situation and determine which makes more sense. There are certain limits based on income.
- Make additional 401(k)/403(b) contributions until the limit is reached. After making the maximum contribution to an IRA, the next logical step is to make the maximum contribution to your employer-sponsored retirement accounts.
- For those under 50, the maximum is up to $18,000.
- For those 50 and older, the maximum is $24,000.
- 529 account. Contributions are after-tax, but the gains are tax-free when used for qualifying expenses. It can be a mistake to fund your child’s higher education before contributing to your retirement. You can get a loan for college, but not for retirement.
- Health savings accounts. A health savings account can lower your medical bills and your tax bill. The contributions are tax-deductible and the earnings are tax-deferred. Withdrawals are tax-free when used for qualified expenses.
- Unlike a Flexible Spending Account, you can roll the money over indefinitely from one year to the next.
- Taxable investments. Have you exhausted the available tax-advantaged investments? Now it’s time to invest in taxable investments, but with tax-efficiency in mind.
We’d recommend these steps for your spouse, too. But as always, make sure you tailor the list to your needs. If you don’t have a need for a 529 account, there’s no reason to invest in one! On the other hand, if you have short-term needs, such as saving for a house, you may have to bump taxable investments further up on your list. The important thing is to consider the taxes during every step of your investment process.
Once you start making taxable investments, try to seek out the most tax-efficient venues. It may also be possible to hold the least tax-efficient investments in tax-advantaged accounts like 401(k) or other retirement accounts. If you have questions about that, definitely reach out to us.
Here are some other pretty common investments listed from most tax-efficient to least:
- Tax-exempt municipal bonds. The earnings generated by municipal bonds are generally exempt from federal income taxes and are often exempt from state taxes.
- I/EE savings bonds. The interest earned from various types of bonds is tax-free if used for higher education expenses.
- Tax-managed mutual funds that focus on stocks. These funds stick to stock investments, but do so in a way to minimize the tax implications. This type of mutual fund is becoming more common.
- The majority of index funds that focus on stocks. By avoiding bonds, these index funds are relatively tax-efficient.
- Growth stocks. Growth stocks rarely pay dividends. The profits are reinvested in the growth of the company.
- Value stocks. The share price of these stocks is slow to change. Dividend distributions are common and subject to a higher tax rate for most investors. Value stocks are less tax-efficient than growth stocks.
- Balanced mutual funds. The inclusion of bonds in this style of mutual fund creates greater tax consequences.
- REITs (Real Estate Investment Trusts). One of our favorites! These investments are among the least tax efficient. The tax situation is relatively complex behind the scenes. REITs are trusts and subject to tax at the trust level and at the corporate level before distributions are made to the unit holders (investors).
- Dividend payments are typically taxed at the investor’s top marginal tax rate.
- The situation is far more complex than depicted here. The bottom line is that REITs are inefficient from a tax perspective.
- Taxable Bonds. Bond interest and dividend payments are taxed as regular income. If you want to invest in taxable bonds, it’s best to limit their inclusion to tax-advantaged accounts.
- High-Yield Bonds. These bonds are considered to be less efficient due to their higher yield. The higher level of risk indirectly contributes to their lower tax-efficiency classification. You’re unlikely to have access to these investments in your 401(k).
If you’re in a lower income bracket, bonds can be a more tax-efficient investment than stocks. Interest income is generally taxed at your income tax rate. The capital gains tax rate is generally lower than the income tax rate for those with higher earnings. It always pays to do the applicable math and determine which investments are most tax-efficient for your situation, as the rates vary by your particular state and income
level.
While it’s always a good idea to go for the more efficient option, taxable accounts aren’t all bad. They actually have two primary advantages:
- The ability to harvest losses. If you purchase mutual fund shares within a 401(k), you can’t write off the losses you suffer. In a taxable account, it can be advantageous to take your losses and reduce your taxable income by that amount.
- Flexibility. The more tax-advantaged the account, the lower the level of flexibility you’re likely to find. Consider all the investment options available in a standard brokerage account. The opportunities are abundant. You also have the ability to cash out of a taxable account and put the money in your pocket without expensive penalties.
Folks all too often forget to fully account for the tax implications of their investing activities. We see it all the time! It’s always a good idea to maximize contributions to tax-advantaged accounts prior to investing in taxable investments, provided this supports any short-term goals you have. The greater your income, the greater the benefits provided by tax-advantaged accounts, but no matter what, there are good options out there for you.
Thanks for reading, and if you’d like a little help strategizing the tax outcomes of your investment options, we’d love to help you! Schedule a call with us today.