As we write this communication the S&P 500 is down 2.4% this week. The Dow has seen triple digit intraday swings. All daunting but OUT OF YOUR CONTROL. What we do know is stocks over the long-term are a HUGELY valuable wealth building tool. Proof clearly depicted in the above chart of stock market growth since 1900.
So What Do We Do...Focus on WHAT YOU CAN CONTROL
After market-risk and inflation-risk, which investors take great strides to mitigate through sound investment practices, taxation-risk presents the biggest obstacle to building wealth. A sound investment strategy not only seeks to generate returns on your capital, it also seeks to preserve as much of your capital as possible to keep it working for you. One of the surest ways to preserve your capital is to reduce the amount of taxes you pay on investment income and gains. By incorporating tax-saving strategies into your investment plan, you can minimize the impact that taxes have on your capital-at-work.
With Your Asset Allocation it’s all about Location
One of the first rules of wealth accumulation is to sock away as much of your income as possible into a tax-qualified retirement plan, such as a 401k, 403b, or an IRA. This gives you an immediate and long-term tax advantage. However, in terms of an overall asset allocation strategy, the placement of various types of investments among your tax-qualified plans and your non-qualified investment accounts is nearly as important as the selection of investments for meeting your particular investment objectives. At its simplest, you should place your tax efficient investment in your non-qualified investment accounts, and your non-tax efficient investments in your qualified accounts.
Non-tax efficient investments include securities and income-producing assets that tend to generate more taxable returns, such as taxable bonds, bond funds, actively managed mutual funds, and dividend-paying stocks. These should be placed in your qualified plans.
Tax-efficient investments include tax-exempt bonds and bond funds, tax-managed mutual funds, exchange-traded funds, broad market stock index funds. These should be held in your non-qualified investment accounts.
Watch What and When you Buy
If you are going to invest in mutual funds within your non-qualified accounts, it’s important to consider the portfolio holdings of the fund, how much the portfolio is turned over each year, and the amount of unrealized gains sitting in the portfolio. About the worst thing a mutual fund investor can do is to buy shares of an actively traded mutual fund with a high turnover ratio that’s sitting on a boat-load of capital gains. These types of funds are notorious for selling off their most profitable stocks, especially to meet share redemption demands, and distributing big gains to their shareholders, which are fully taxable to the shareholder. When that happens, the share price is reduced in some proportion to the distribution which means the shareholder is left with a lower share price and a taxable distribution.
Instead, consider investing in tax-managed funds which seeks to minimize taxes through tax-harvesting or broad index stock funds which are more passively managed.
Harvest Your Losses with Your Gains
If you feel the need to sell any securities to lock in gains, use that opportunity to “harvest” your portfolio for losses that can offset the gains. This can be done each year as a way to keep your target asset allocation in line with your investment objectives. You can use the proceeds of the stocks sold for gains and losses to add to portion of your asset allocation that needs to be increased.
Reduce Net Investment Income to Avoid the 3.8% Surtax
Beginning in 2013, if your modified adjusted gross income (MAGI) is greater than $200,000 ($250,000 for joint filers), your investment income above a certain threshold could be subject to an additional 3.8% surtax. This doesn’t affect investment income earned in qualified accounts, and income from certain investments, such as tax-exempt bonds and “qualified” dividend-paying stocks, are not included in the calculation.
By investing systematically in a well-conceived, disciplined, long-term investment strategy investors can achieve reasonable returns that can compound into substantial wealth over time. However, without consideration for taxes on their investments, the road to wealth could turn into a steep uphill climb. While it’s important to invest in a way that can generate the best possible returns commensurate with the amount of risk you are willing to assume, it’s your after-taxreturn on investments that really matters.
In all matters of taxation, you should seek the guidance of a qualified tax professional to thoroughly analyze the immediate and long-term implications of investment decisions.