Tax-Wise Investment Techniques
In a previous blog post, we introduced some of the tools of the tax-planning trade. These include tax-sheltered accounts for saving toward retirement, healthcare, and education, as well as tax-efficient tools for charitable giving, emergency spending, and estate planning.
It’s one thing to have the access to the best tax planning tools. It’s another to make best use of them. Make no mistake - tax-planning techniques are just as important as the tools. They’re also more durable when used within a unified strategy across all of your financial interests.
Tax laws are constantly changing these days and breaks come and go – all of this is beyond our control. A tailored, tax-wise strategy in place makes it easier to adjust whenever things changes. And things always change.
The Big Picture
The best tax-planning strategies include meticulous attention to the details, as well as to how each action contributes to your overall big picture.
We consider effective tax planning as a way to reduce your lifetime tax bill—or beyond, if you’re preparing for a tax-efficient wealth transfer to your heirs.
It’s staged on multiple fronts, and it begins with your investment techniques.
One of the most powerful ways to ward off excess taxes is to be tax-wise about your investing. It might surprise you to know that few investors take full advantage of the available opportunities. This includes how you manage your investment accounts, select individual holdings, and buy and sell those holdings.
Managing your investments
- Building: Are you maxing out your contributions to suitable tax-sheltered accounts? The more money you hold in various tax-sheltered forms, the more flexibility you’ll have to avoid or defer taxes that can come with building wealth.
- Managing: Are you carefully considering your asset location, dividing your various assets among your taxable vs. tax-sheltered accounts for overall tax efficiency? Generally, you use tax-sheltered accounts to hold your least tax-efficient holdings, while locating your most tax-efficient holdings in your taxable accounts.
- Spending: Do you have a detailed plan for tapping into your taxable, tax-deferred, and tax-free accounts when it is time to spend your wealth? Cash-flow planning calls for a deep familiarity with the accounts and assets you’ve got; the rules involved in deploying each; and your specific spending goals all while monitoring any changes that could affect your plans. For more about a retirement spend down strategy click here.
As you select individual holdings …
Are you being careful to select tax-efficient options? Even when different funds share the same investment objectives, some may be better than others at managing their holdings. Look for fund managers with solid tax-management methods. These can include:
- Patient Investing: We suggest using managers who patiently participate in their target market’s long-term expected growth – opposed to the “active management” approach which revolves around what a so-called expert “thinks” markets, the economy or interest rates are going to do. Active management has been shown to be a counterproductive and unreliable way to achieve investment goals. Patient investing makes good sense and is typically more tax efficient as it involves less action – action that could potentially be taxable.
- Tax-Managed Investing: When it comes to your taxable accounts, look for funds that are lean towards tax-friendly trading techniques such as avoiding costly short-term capital gains, and more aggressively realizing capital losses to offset gains.
As you buy and sell holdings …
Are you being patient and thoughtful about your trading? Do you avoid unnecessary trading and short-term capital gains (which can be taxed at higher rates)? Are you guided by a personalized investment plan? As a general rule, the fewer trades required to follow your investment plan, the better off you will likely be when taxes are due.
Harvesting Capital Gains and Losses
A solid investment plan help you identify and make best use of tax-loss and tax-gain harvesting opportunities when it is appropriate.
Tax-loss harvesting involves:
- Selling all or part of securities at a loss to offset a capital gains tax liability.
- Reinvesting the proceeds in a similar (not “substantially identical”) position.
- Optionally returning the proceeds to the original position after at least 31 days have passed (to avoid the IRS “wash-sale rule”).
You can then use any realized capital losses to offset current or future capital gains, without significantly altering your portfolio mix.
Tax-loss harvesting typically lowers a harvested holding’s cost basis. So you’re usually postponing rather than eliminating taxable gains entirely. Why would you bother than? More time gives you more control over when, how, or if you’ll realize the gains. For example, you could wait until tax rates are more favorable, or reduce embedded gains over time through gifting, charitable, or estate planning tactics.
Tax-gain harvesting involves selling appreciated holdings to deliberately generate taxable income. Why would you do that? Your goal is to minimize lifetime taxes paid. So you may intentionally generate taxable income in years when your tax rates are more favorable (such as when you’re tapping your portfolio in retirement), and preserve your tax-favored income for years when your rates are higher. Basically, you’re sacrificing a tax return battle or two, in an effort to win the tax-planning “war.”
For more information about other tax planning tools please click here.
Copper Leaf Financial develops wealth management plans that are tailored to you. When it comes to your finances it is critical that tax efficient strategies are woven throughout all your financial planning. Call our office at 802.878.2731 to schedule a strategy session.