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It’s not just about what you earn – it’s about what you keep. After-tax returns are what really matters. Taxes eat your profits and make certain investments not worth pursuing. Plus, any money you save on taxes can be reinvested. The logic of compounding means that modest tax savings now can, in the long-run, generate far higher returns later. Below is an investor’s guide to keeping the taxman at bay.
Active tax management means thinking about where to put your investments. Whether you’re buying stocks or bonds, consider putting some of them in tax-advantaged accounts, like retirement plans. The most common examples are 401(k) and Roth IRA accounts in the US. Similar schemes exist worldwide.
The advantages are many: With 401(k)s any amount you invest can be deducted from your taxable income. You don’t pay taxes on the gains until you withdraw the funds during retirement –and when you do, it's taxed at your income bracket during retirement, which is typically lower. Plus many employers match your contributions. When you contribute to a Roth IRA meanwhile, it’s after-tax dollars, so you don’t get a deduction. But your later withdrawals are tax-free.
Retirement accounts do come with restrictions. If you withdraw before retirement age, you’ll probably pay penalties. And they have contribution limits, so you can’t stash all of your investments in them.
Because of these limits, you’ll need to devise a strategy for dividing up your investments. Investments with high taxes should go in the tax-advantaged accounts. Tax-efficient investments (more on those below) go in the regular brokerage account.
Passive “buy and hold” investing typically yields lower taxes. Remember, every time you sell an asset you risk triggering a capital gains tax, so it’s important to consider when to sell.
Long-term capital gains are taxed at lower rates than short-term capital gains. Typically the gains on a stock held for less than one year get taxed as ordinary income, like wages. In most jurisdictions, income tax rates are higher than long-term capital gains rates. The gap becomes especially pronounced if you’re at the top of the income bracket.
Take the US as an example: long-term capital gains are 20 percent for top earners. The top income bracket meanwhile is 37 percent. Even after a 3.8 percent net investment tax, the highest capital gains tax you will pay is 23.8 percent, compared to a 37 percent income tax. If your investment is nearly a year old, perhaps you should hold a bit longer.
Of course, capital gains taxes differ by country. You can see different global rates here. Gulf countries like the UAE and Saudi Arabia do not currently tax personal income on capital gains.
Some investments are less taxed than others.
When it comes to funds, passive ones like index funds and ETFs tend to be more tax-efficient because they involve fewer transactions, hence fewer taxable events. Actively managed mutual funds are just the opposite.
Similarly, not all bonds are the same, so check how they’re taxed and figure that in to your returns. Municipal bonds in the US, for example, are exempt from federal taxes and often state and local taxes as well. Treasury bonds get similar treatment. Corporate bonds however do not.
And once again, it depends on where your investment is held. For example, tax-exempt bond income is usually only tax-free when it's held directly, whereas bonds held in retirement accounts like 401(k)s are treated as ordinary income.
If you have a mix of assets and accounts, a wise strategy is to put the less tax-efficient assets, like the active mutual funds and corporate bonds, in the retirement fund, where taxes are reduced. You can keep the low-tax ETF in the brokerage account. Divide and conquer.
Read more about: Mutual Funds Vs. Index Funds Vs. ETFs
Sometimes losses can be used to your advantage. That’s the logic of tax-loss harvesting, when you sell unprofitable assets at a loss intentionally, usually to reduce capital gains taxes that you’ve incurred on other investments. Basically, you can deduct the losses from the gains to reduce your tax bill.
In places like the US you can take this even further: if your total capital losses exceed your total capital gains, you can write off up to $3000 from your ordinary income. Losses more than that can be carried over to future tax returns until you’ve harvested all the losses.
That said, you probably shouldn’t scour your portfolio to sell losing assets just for the taxman. If stocks still hold long-term promise, it may not be worth the tax break. Especially since a good tax-harvesting strategy involves purchasing similar assets to replace the ones you sell. So are you sure you can find better?
Do make sure your sales don’t violate so-called wash sale rules. Basically, your write off is not permitted if you re-invest the money into the same stock or fund within 30 days (or something “substantially similar,” to use IRS language). A tax consultant here is key.
Another wise move is putting some investments in a Health Savings Account (HSA). An HSA is designed to plan for long-term healthcare expenses. The money you contribute is tax-deductible and can be held in stocks, bonds and all types of funds, just like a 401(k). The growth on your assets is tax-free and so is their withdrawal.
It’s always good to help others. Donating appreciated securities (e.g. a stock that has increased in value) directly to charities can be a win-win. You get a deduction on your tax bill while avoiding capital gains on the appreciation. But keep in mind you have to give the security away directly – if you sell it and donate the proceeds, you’ll likely have to pay capital gains.
If you’re going to donate large amounts over time, you may consider establishing a donor-advised fund (DAF). DAFs allow you to get immediate tax deductions for contributions, even if you distribute them to charities later.
Tax-Efficient Investing: Why Is It Important?
Effective tax-saving strategies for investors
Tax-Loss Harvesting: What It Is, How It Works
Nine ways to reduce your taxable income by giving to charity
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