Many investors don’t fully understand how to manage their portfolio to minimize their tax burden—no need to worry, we are here to help. The key to tax-smart investing is proactive, strategic planning. Here are some tips from us on how you can ensure your investments are tax-compliant and that you are maximizing savings wherever possible.

Tax diversification

This refers to the process of divvying your investments between different accounts (based on tax treatment).

• Tax-efficient investments- Tax efficiency is the percentage of pre-tax return realizable on a bond, stock, share, or other financial instrument, that a taxable investor can claim after paying his/her tax liabilities. Individual stocks held for more than one year, stocks or mutual funds that pay qualified dividends, municipal bonds, etc. are examples of investments considered “tax-efficient”. These investments should be held in taxable accounts while...
• Less tax-efficient investments are better held in tax-advantaged accounts (any investment, account or plan that is exempt from taxation, tax deferred, or offers other types of tax benefits). Some examples?- individual stocks you plan to hold for less than one year, real estate investment trusts and taxable bond funds.

However, if all your investments are in a 401k or IRA, you can concentrate on asset allocation and investment selection rather than tax diversification.

What are the benefits of tax diversification?

• Putting investments in different accounts adds value while you accumulate wealth in life and allows you to defer taxes in some cases, too.
• With a Roth IRA, you can completely eliminate taxes on investment returns.
• If you’re unsure about what tax bracket you’ll end up in down the road, diversifying investments by tax treatment can be extremely valuable, since you’ll have options when it comes to taking money out in retirement.
• Tax diversification can help your charitable giving efforts as well. Different accounts receive different types of income tax treatment, like if you give appreciated securities from your taxable accounts to charity, you qualify for a full fair market value (FMV) deduction (assuming securities were held for at least one year), and additionally you won’t owe capital gains tax on the gift either.
• You can augment your estate planning goals through tax diversification as well. Leaving appreciated securities to your heirs will allow them to a step-up in cost-basis after you die.

Other investment tips...

Periodically rebalance your investment portfolio- This helps maintain your strategic asset allocation. It helps to focus your rebalancing efforts on your tax-advantaged accounts to avoid long or short-term capital gains taxes. Allocating new funds to underperforming assets will also help balance out your portfolio in a tax-efficient manner.

Consider active trading- This is an investment strategy that takes advantage of short-term movements in price and often focuses on stocks, currencies, options, and derivatives (financial instruments in higher demand). Many consider this tactic less tax-efficient and better fit for tax-advantaged accounts. Keep in mind that realized losses in your tax-advantaged accounts cannot be used to offset realized gains on your personal return.

The secret to strategic investment planning is knowing the ins and outs of all your taxable accounts and accordingly, knowing which investments are best suited for each account. Questions on your investment planning? Contact us today.