Investment & Tax Strategies Go Hand-in-Hand


by Twelve Points Team

The practice of Personal Financial Planning is endlessly fascinating and complex, with the various planning areas (including: Investments, Income Tax, Retirement, Estate Planning, and Insurance) being interconnected. It could be argued that no two planning areas are more unified than Investments & Tax Planning.

My personal interest in these two subsets of Personal Financial Planning guided my career, which bridged Investments & Tax Planning with time spent as an Investment Consultant at an independent wealth management firm, and as a Manager in the Personal Financial Services (Tax) group at PricewaterhouseCoopers.

While there are a variety of tax considerations an investor must think through in making investment decisions that mesh with the rest of the overall Personal Financial Plan, some are more common and impactful than others, and are presented as tax-based investment tips below:

Invest in Tax-Efficient Accounts…

Whether it’s in an employee retirement plan (e.g., 401K, 403B, etc.), an IRA (Traditional or Roth), an education savings 529 plan, or another type of a tax-deferred account – take advantage of tax-efficient investment growth and the (potential) current-year tax deductions.

  • If it’s an employee retirement plan and the company matches contributions, make sure to contribute at least the maximum percentage that the company will match, and if possible consider contributing the maximum the plan allows. Don’t forget about the “catch-up” contributions available to participants aged 50 and over.
  • As a general rule of thumb, if you anticipate your future tax rate being higher, and you still have a number of years until retirement, choose a Roth IRA or a Roth 401K (if available). While you do not get a current-year tax deduction for Roth IRA contributions, your investments will grow tax-free, and they will also be tax-free when you eventually start withdrawing them in retirement.   Those who are phased out of Roth IRA contributions, due to income limitations, can consider the strategy of contributing to a Traditional IRA and immediately converting it over to a Roth IRA.

…Yet Broaden Your Account Types

It is helpful to have all three main types of investment accounts available in retirement – Taxable, Traditional IRA, and Roth IRA.   Being able to mix-and-match withdrawals from all three types of accounts, in addition to collecting Social Security, and potentially receiving income from part-time employment or other passive income, will allow for most efficient income tax planning – lowering your overall effective tax rate.

Allocate to Tax-Efficient Investments…

Certain investment types or investment managers are more tax-efficient than others; a preference for tax-efficient investments should increase your after-tax rate of return.

  • Interest on U.S. Government Obligations is exempt from state taxes, while Municipal Bond interest is largely exempt from Federal taxes (and when issued in state may be exempt from state taxes).
  • Long-term (over 1 year) capital gains receive a preferential tax rate to short-term gains.
  • Stocks are generally more tax-efficient than bonds.
  • Dividends are generally more tax-efficient than taxable interest.
  • Qualified dividends receive a preferential tax rate to non-qualified dividends.
  • Growth funds are typically more tax-efficient than income funds.
  • When evaluating mutual funds form a tax perspective, prefer low “Turnover Ratio,” low imbedded “Unrealized Capital Gains” and low “Tax-Cost Ratio.”

… And Consider “Asset Location” – the Practice of Matching Investments with an Appropriate Account Type.

Now that you have a handle on which investments are more tax-efficient than others, consider placing your least tax-efficient investments in a tax-deferred account, while locating your most tax-efficient investments in a taxable account.

While investment tax location is important, it should mesh with your overall financial plan. If you’re looking to supplement your pre-retirement income with interest and dividends, then even though these interest/dividend-producing investments are not that tax-efficient, they will still need to be placed in a taxable account, since you generally can’t access your retirement accounts until the age of 59 ½.

Also, be mindful of certain exceptions. For example, while Master Limited Partnerships (MLPs) produce high income, and high income-producing assets should typically be placed in a tax-deferred account, due to special taxation of Unrelated Business Taxable Income, MLPs should typically be held in a taxable account.

Put (Unrealized Capital) Losses to Work

It is a good practice to periodically review your taxable account holdings in an effort to identify investments with unrealized losses.   You may consider selling certain such investments to realize (free up) losses if these holdings are no longer as attractive as they once were, if you don’t foresee them significantly appreciating over the next month, or simply if you’ve identified other investments that you’d rather hold. Realizing these losses helps you offset any potential realized investment gains, lowering your taxes – it’s a technique called “Tax Loss Harvesting”.

One month is mentioned above due to “Wash Sale” rules.   If you’re selling the investment to realize the loss in cases where you no longer think this holding is attractive, or when you’ve identified a better opportunity – you’re in the clear. However, if you’re freeing up a loss by selling the investment that you want to hold long-term (but one which you don’t anticipate strongly appreciating over the next month) then you must wait one month and a day prior to purchasing this security back.

Look into Insurance-Based Solutions

While these solutions are certainly not a necessary part of a Personal Financial Plan, for some investors, insurance and annuities may be an appropriate tool in helping them reach their financial goals.   One of the attractive attributes of insurance-based solutions is their tax-efficiency.

Talk to an Investment Advisor and an Accountant for Specifics Relating to Your Situation

While the above-mentioned tips and general rules of thumb should point you in the right direction, they do not constitute tax or investment advice. Each investor’s personal situation is different, and the appropriate “common” solution might not be the best one for them.   Furthermore, just like investments and tax planning go hand-in-hand, so do investments and insurance, or tax and estate planning, etc.   There truly is no substitute to assembling a financial planning “team” including a financial/investment advisor, an accountant, an estate planning attorney, and in some cases, an insurance specialist.

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