You can’t control the markets or a fund’s performance, but you can control the bite of taxes. Because every dollar paid in taxes reduces your retirement nest egg, it pays to be tax-conscious.
Unfortunately, investment decisions are commonly made with no consideration of the tax consequences. While designing appropriate risk-adjusted portfolios is an area in which qualified investment professionals excel, portfolios are often constructed with little attention to tax consequences. That’s a huge mistake that can potentially cost you years of retirement savings.
Most financial advisors and individual investors simply don’t have the time to become experts on the myriad of ever-changing tax rules and regulations that impact investments. However, failing to consider the tax implications can result in your hard earned savings in IRS coffers, rather than your account. To increase your chances of reaching your retirement goals, it is crucial to avoid the mistakes and manage your portfolio for tax efficiency.
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The list below discusses some of the mistakes which I have encountered most commonly in my practice.
Mistake #1 Short term vs. long term gains: Long-term capital gains (securities held for one year or more) qualify for favorable tax treatment, while short-term capital gains are taxed at ordinary income rates. Long-term gains are taxed at:
- 0% if taxable income falls in the 10% or 15% marginal tax brackets
- 15% if taxable income falls in the 25%, 28%, 33%, or 35% marginal tax brackets
- 20% if taxable income falls in the 39.6% marginal tax bracket
(The rates above do not include the new 3.8% surtax on net investment income, which may apply to some taxpayers.)
Solution: Holding an appreciated security an extra day, week or month – to reach the one year holding period – may significantly reduce the taxes due.
Mistake #2 Foreign stock investments held in a tax-advantaged account: If you own foreign investments, the issuing foreign country may withhold taxes on your investment income. U.S. investors can claim a tax deduction or credit for foreign taxes paid, but only if the foreign stocks are held in a taxable account. Since you don’t pay current taxes on investment income in your IRA or 401(k), there’s no deduction or credit currently available for foreign taxes paid on investments held in these accounts.
Solution: Consider the benefits of holding foreign stocks in a taxable account when designing your portfolio.
Mistake #3: Failing to take advantage of tax loss harvesting strategies in taxable accounts: When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both.
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Solution: Take advantage of tax loss harvesting when rebalancing your portfolio each year, or when it makes sense in light of your overall financial objectives. (Be aware of the potential wash sale rules.)
Mistake #4: Failing to take advantage of tax savings and tax planning opportunities in low income years – such as not considering a Roth IRA conversion or realizing capital gains: When you convert a traditional IRA to a Roth IRA, tax is due on the converted amount in the year of conversion. If an investor has lower than normal income in a particular year, this can be an optimal time to convert. (This is not a clear cut benefit since the potential to pay lower taxes must be balanced by the effects of paying taxes in the current year on cash flow, projected income during retirement, and the unknown future of tax rates.)
Low income in a given year can also provide an opportunity to save taxes by selling appreciated securities. Long-term capital gain tax rates are progressive; rates increase as taxable income increases. For taxable incomes up to $73,800 (for 2014), joint taxpayers pay no tax on long term capital gains.
Solution: Consider a Roth IRA conversion or realize capital gains in low income years.
Mistake #5: Failure to strategically allocate investments among taxable and tax-advantaged accounts. Failing to allocate investments strategically among taxable and tax-advantaged accounts can result in huge amounts of investment dollars paid to Uncle Sam, rather than remaining in the investor’s account.
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Solution: Hold relatively tax-efficient investments, such as broad-market stock index funds or ETFs, in taxable accounts while keeping tax-inefficient investments, such as taxable bonds, in tax-deferred accounts (eg: IRAs, 401ks, etc.) and investments with the highest potential for growth in tax-free accounts (eg:Roth IRA). For fixed income investments, investors who are in higher tax brackets may want to consider tax-exempt municipal bonds in non-retirement accounts.
While certainly not the sole determining factor, an effective, long-term investment strategy should at least consider the tax implications of investment decisions. Integrating tax-savvy strategies, as part of a holistic financial plan, can help you keep more of your hard earned savings for your retirement!
Please consult a tax professional who is familiar with your particular situation before implementing any strategy.
Lisa Hay, CPA, is President and founder of Ascend Financial, LLC, a fee-only financial and retirement planning firm. You can follow Lisa on Twitter: @lisahaycpa, connect with her onLinkedIn, or email her at firstname.lastname@example.org.
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