Tax Efficient Investing

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posted on Fri, Sep 01, 2017

One of the most overlooked elements in creating an investment portfolio is the tax efficiency.  If it is set up incorrectly it can cost you significant growth and make it more difficult to reach your end goals.  I fully understand this topic can get confusing quickly and is not nearly as exciting as the new Fast and Furious movie.  I will do my best to keep things simple, I promise!  With that, there are a lot of ways to use the over complicated tax code to your advantage when investing:

  1. Immediate Tax Deductions – The most basic strategy is to utilize tax deferred accounts for money you don’t need until age 59+.  There are a variety of accounts ranging from your company’s 401(k) plan to your own IRA where you can contribute money and receive tax deductions on your income tax return.  Not only do you get an immediate return on your investment, those funds continue to grow tax deferred (all dividends and/or capital gains are not taxed) until you pull out the money in your retirement years.  How much you should contribute to these accounts depends on your cash flow, how much money you need for retirement and your current tax bracket.  It is a strategy that you should spend some time analyzing (or with the help of an advisor) as it will help you save significant money over time.

  2. Certain Investments for Certain Accounts – When you are creating an investment portfolio it should be done in a holistic manner.  Not every account should have the same investment vehicles.  Imagine that you have money in an IRA, a Roth IRA and a taxable account.  Through proper planning you know that none of that money is needed for 30 years and you want a portfolio that is 50% equities (stocks) and 50% low volatility (bonds).  To make it tax efficient you don’t want each of the 3 accounts with the same 50%/50% allocation.  You want the overall portfolio (all 3 accounts combined) in the 50%/50% allocation.  In the tax code investments are tax differently based on the type of activity they produce.  For example, stocks (if done correctly) will produce long-term capital gains and qualified dividend income which is taxed at a lower rate than bonds which produce a lot of non-qualified dividend income.  If you have the choice, like in my example, you want the IRA account to take on the investments which have the highest tax impact (bonds) and the taxable account to hold the investments with the lowest tax impact (stocks).  The reason being is the IRA account is not taxed on any investment activity.  And you want to shelter investments which produce the highest tax activity.

The strategies can get a lot more complex and there are many other ways to save taxes on your investment portfolio.  These basics should help you get started.

Please feel free to contact me anytime to discuss this topic or any other in more detail.