While investment decisions should be primarily driven by goals, financial situation, risk tolerance and timeline, tax considerations should also play a role. Using smart tactics like asset location, transaction timing and investment selection can help minimize taxes and keep more of the growth in your investments.
In addition, strategies such as tax-loss harvesting can be a powerful tool for reducing overall taxes. Visit https://www.clarkwealthpartners.com/ for more information.
Asset Location
Asset location is a strategy that can help reduce taxes and improve long-term returns by determining which types of investments are best suited for specific accounts. It considers factors such as an investor’s financial profile, tax laws and investment holding periods to determine which assets should be held in taxable versus tax-deferred accounts.
A growing number of investors are recognizing the value in asset location as a powerful tool to minimize taxes and enhance returns. The concept is similar to traditional asset allocation, which focuses on diversifying investments across stocks, bonds and other asset classes to manage risk and improve overall returns. However, while asset allocation is important for all investors, the importance of effective asset location becomes increasingly critical for individuals nearing retirement or who are already retired.
When paired with a well-thought-out financial plan, asset location can help minimize taxes and provide greater control over the investment process, regardless of changing tax laws and market conditions. It is a key element of an integrated wealth management approach, along with tax-efficient account selection and transaction timing.
For example, consider a couple who has savings in a traditional individual retirement account (IRA), a taxable brokerage account and a Roth IRA. Using asset location, they can maximize their return potential by locating growth-oriented assets in their Roth, where they can benefit from tax-free growth and lower tax rates. Similarly, they can focus on tax-efficient assets in their taxable brokerage account, including index funds and ETFs and separately managed accounts, as well as municipal bonds.
The benefits of asset location may be more pronounced for individuals with balanced portfolios that include both equity and fixed-income investments. Individuals who are preparing for or in the midst of retirement, and those with higher current income tax rates, can reap the greatest rewards from this strategy by positioning their core bond holdings—those that generate regular interest payments—in their tax-deferred accounts while placing equities in their taxable accounts to take advantage of favorable capital gains tax rates.
Asset location isn’t a one-time fix and requires ongoing attention to ensure it continues to be as beneficial as possible. Changing tax laws and changing market conditions both have the potential to disrupt this dynamic, making it essential to review these strategies regularly with your advisor.
Investment Selection
While tax considerations shouldn’t be the primary driver of investment decisions, it is important to take advantage of opportunities to manage, defer, and reduce taxes. This can be done through a combination of strategies including asset location, investment selection, transaction timing, and taking advantage of realized losses. Your Ameriprise financial advisor can help you identify a strategy that fits your needs and investment portfolio.
Investment selection involves evaluating various investment instruments within an asset class to choose the best options. This requires analyzing their trends, historical performance, growth potential, associated costs, and taxation obligations. This helps to ensure effective diversification and lower risk by reducing exposure to a single asset class that could lead to losses.
Once you’ve identified the types of investments to include in your portfolio, you need to determine the weighting each will have. This is known as asset allocation. For example, if your client’s investment goals prioritize growth of capital, your advisor may allocate a larger percentage to stocks than bonds. In contrast, if your client’s goal is to generate income and provide a level of cushion from market volatility, the portfolio may be more heavily weighted to bonds.
Using the right mix of products and accounts can also be a powerful strategy for managing tax efficiency. For example, if your client is saving for future education expenses, they may benefit from investing in 529 savings plans that are exempt from federal taxes. In addition, retirement accounts such as IRAs and Roth IRAs offer tax-deferred growth and withdrawals.
Depending on your client’s unique situation, other strategies can be used to manage and minimize federal income taxes, including tax-loss harvesting, minimizing wash sales, and tax-efficient yield management. These can be implemented in conjunction with other strategies or in place of them to create a holistic approach to minimizing tax drag and maximizing after-tax wealth. This approach can be a powerful complement to your clients’ overall financial plan and should always be executed in partnership with an experienced wealth advisor.
Transaction Timing
Aside from asset location and investment selection, another way to minimize taxes is through transaction timing. This involves careful consideration of the purchase and sale dates of individual investments to avoid triggering capital gains or loss realization. This can also be applied to the management of employer stock plans and individual retirement accounts (IRAs).
The tax impact of these types of transactions is based on the transaction date, which is when ownership officially changes hands. The settlement date, on the other hand, is when the seller receives payment for the transaction. For many investments, the settlement date can be one or two days after the transaction date. When deciding when to buy or sell, advisors take into account both the transaction and settlement dates when considering the impact on taxes.
Investors spend countless hours researching stocks and funds that offer the potential for solid returns, yet they may be overlooking the importance of factoring federal income taxes into their decisions. While it’s true that investing decisions should be driven by goals, financial situation, risk tolerance, and timeline, incorporating tax efficiency can help you build wealth faster.
A common strategy is to manage tax costs by locating investments that generate certain types of taxable distributions in taxable accounts and those that don’t in tax-advantaged accounts. Depending on the nature of an individual’s assets and tax bracket, this can result in significant savings.
Other strategies that can be employed to reduce taxes include tax-loss harvesting and deferral of investment income. Tax-loss harvesting, in its simplest form, involves selling an investment at a loss and then using the realized losses to offset the investor’s overall taxable gains. Investors should be wary, however, of the “wash-sale” rule, which prohibits offsetting losses if the same or substantially similar assets are repurchased within 30 days.
Managing the tax cost of investments should be an ongoing process that includes monitoring tax forms, staying up-to-date on contribution limits for retirement and other investment accounts, and evaluating the order in which investment income is distributed. This is where a strategic partnership with an advisor who specializes in this area can be beneficial. An experienced advisor can develop an active tax management approach that uses real-time, year-round techniques to minimize the tax drag on your investment returns and maximize after-tax wealth.
Tax-Neutral Investments
Tax-efficient investments can help you keep more of what you earn, enhancing your potential for reaching your financial goals. Investing with this perspective in mind should be an important component of your overall investment strategy, and it can make a significant difference to after-tax returns over time.
While there are many tax-efficient strategies available, implementing these can be complex and require ongoing vigilance to maintain. The key is to work with a knowledgeable professional, such as an experienced financial advisor, who can integrate tax-efficient investing into your investment process and ongoing portfolio management.
Our advisors are experienced in helping clients develop comprehensive investment strategies that incorporate consideration of tax efficiency. They can help you understand how various investment options—including mutual funds, ETFs and separately managed accounts—may impact your tax situation. They can also identify ways to reduce your current and future taxes with strategies such as strategic rebalancing and tax loss harvesting.
The underlying assets in alternative funds are usually located offshore, and the fund structures often provide investors with tax benefits such as deferral of investment income and capital gains, or tax relief at the country level where the fund is registered. However, this does not mean that taxable investors in these funds cease to be liable for domestic taxes on their income and realised capital gains; they remain liable for those taxes at the country of registration (Layer 1 tax) as well as at their home jurisdictions (Layer 2 tax).
Investors can further reduce their taxable exposure by gifting shares of their concentrated stock positions to family members who may be in lower tax brackets. This strategy can also help with estate planning.
Tax-efficient investment management strategies can benefit taxable investors in all types of accounts, from IRAs and Roth accounts to taxable brokerage accounts. In particular, if you hold a concentration of stocks in your taxable account, it can be beneficial to review these strategies periodically throughout the year to ensure that they are being implemented appropriately. Strategic rebalancing and tax loss harvesting can reduce your taxable exposure, while still providing opportunities to participate in market recoveries.
