When it comes to investing, there are numerous elements beyond your control: geopolitical conflict, currency fluctuations, and government policy –
just to name a few. Rather than worrying about these external factors, focus your energy on those things you can control, such as proper diversification, low fees, and reducing your taxes as much as possible. With that in mind, here are five ways you can lower your investment tax burden today:
Dividend Portfolio Rebalancing
Rebalancing is a painless way to push yourself to be a contrarian – a typical trait among the most prosperous investors. You do this by selling your best performing investments, using the proceeds to purchase more of your worst performing ones. In other words, if your initial portfolio has a stock allocation of 40%, and through superior equity performance it rockets to 50%, you should sell stock to return to your original allocation of 40%. A more tax-efficient rebalancing method is to use earnings generated by your portfolio to purchase more of the poorly performing investments. This way, you’ll rarely need to sell any investments to rebalance your portfolio, and fewer sales equals lower tax liability.
Minimize Turnover With Index Investing
According to The Motley Fool, managed mutual funds carry an average annual turnover rate of around 85%. At this rate, funds turn over practically their entire portfolio once per year. Why is this a problem? Turnover equals transactions, and transactions are taxable. Unlike managed funds, index funds only shake up their investment mix when the companies comprising their indexes change. This rarely happens, which is why the S&P 500 has an average turnover of around 4% per year. This ridiculously low turnover equates to virtually zero capital gains taxes. Taxes on dividends, of course, are unaffected by turnover.
Selling an investment that represents a significant loss and replacing it with a highly correlated – but distinct – investment allows you to maintain similar risk and return characteristics to those of your original portfolio. These sales generate losses that allow you to reduce your current taxes. You are almost always better off postponing the settling of taxes, because the tax savings produced by tax loss harvesting can be reinvested and compounded over time. Looking for losses to harvest throughout the year provides significantly higher after-tax benefits than harvesting at year-end. Unfortunately, the complexity of these calculations makes it nearly impossible to execute tax-loss harvesting more than once per year, without the help of custom software.
Combine these last two strategies – indexing and tax-loss harvesting – by completing a tax-loss harvest within an index. By directly purchasing all of the stocks within an index, such as the S&P 500, you can harvest the losses generated by individual stocks when they miss earnings and trade down. Direct indexing provides value to investors not offered by index funds and ETFs, since distribution of tax losses to their shareholders is disallowed.
Tax efficiency is key to increasing your investment returns, and the greater your marginal rate, the more important this concept becomes. To maximize your benefits, you’ll want to place less efficient investments in tax-deferred accounts, and tax-efficient investments in taxable accounts. Generally, Real Estate Investment Trusts (REITs), junk bonds, and preferred stocks are highly tax-inefficient, since they all have relatively high dividends or bond yields that are taxed as ordinary income. On the other hand, long-term common stock investments are very tax-efficient, since they are taxed at the long-term capital gains rate when held for over one year. Municipal bonds are the most tax-efficient of all, due to their federal income tax exemption.
Maximizing your investment tax savings requires a comprehensive financial analysis by investment professionals. At Werba Rubin, we’re committed to helping you achieve your goals by making the most of your financial resources, and lowering your investment tax burden.
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