Now that taxes are on your mind, take another step toward building wealth by protecting the investments you already own from the taxman’s clutches next year and beyond.
For most investors, the importance of having a tax-efficient portfolio only becomes apparent when Uncle Sam presents them with a steep bill, something many taxpayers may be discovering now after the gains in last year’s torrid stock market. But that’s a bit like bolting the barn door after the horses have escaped. Instead, investors should consider tax efficiency every time they invest by holding that asset in the most appropriate savings vehicle.
[See: 11 Steps to Make a Million With Your 401(k).]
Even then, a tax-efficient strategy may require periodic tweaks and changes, because tax laws evolve over time. In fact, tax-efficient portfolios require a forward-looking mindset, with investors having to think ahead, sometimes many years ahead, to lay the groundwork for preserving future wealth. Financial advisors say spending a few hours now mapping out a tax-minimizing strategy can save you thousands in the future.
Maximize tax-advantaged savings. If reducing your current tax liability is high on your to-do list, the first place to start is to maximize savings into employer-sponsored plans like 401(k)s and 403(b)s if those are available, says Paul Gaudio, senior vice president at Bryn Mawr Trust’s Wealth Specialty Office in Princeton, New Jersey. Contribution limits for 2018 are $18,500, with the catch-up contribution for people over 50 an additional $5,500, he says. “By all means, max those out,” he says.
Traditional individual retirement accounts also allow investors to shelter $5,500 a year from taxable income, and 2017 contributions can be made until April 17, making this one step you can take now to cut your tax bill. Taxes are due on 401(k), 403(b) and IRA money when it’s withdrawn during retirement.
Consider a Roth IRA conversion. This move saves investors taxes in the future versus now. Investors can convert savings from a tax-deferred vehicle like a traditional IRA to a Roth IRA and enjoy tax-free withdrawals in retirement, says Michael Windle, financial advisor at C. Curtis Financial Group in Plymouth, Michigan. Even investors whose income levels are too high to invest directly into a Roth can benefit from a conversion.
Under the new tax code, Roth conversions are permanent and can’t be undone the way they could in the past. Still, Windle says Roth conversions remain a good option for people who think their income tax bracket will be the same or higher in retirement. To convert traditional IRA savings into a Roth, investors must pay the income tax on the funds moving into the Roth with non-retirement savings; otherwise, using IRA money to pay the tax bill triggers a 10 percent penalty for people younger than 59½, he says.
Consider a conversion when the traditional IRA has lost money because of stock market swings — that helps reduce the tax burden while converting, and when the market rebounds, those new earnings will now count as tax-free withdrawals in retirement, he says. Also, when converting to a Roth, check the ceiling on your tax bracket so that you don’t accidentally get pushed into a higher tax bracket, he says.
[See: 7 Things That Can Derail Your Retirement Investing.]
If converting the entire account will push you into a higher tax bracket, or you can’t afford to pay the income tax on the full amount with outside funds, do a partial conversion. “The sooner you can get into the Roth, the longer it’s going to grow tax-free versus tax-deferred,” he says.
Harvest your losses. No one likes to lose money, but those losses can offset taxes on gains from other investments. Tax-loss harvesting requires selling a money-losing investment to reduce capital gains elsewhere. Investors can use losses to reduce up to $3,000 of ordinary income per year. Use market swings to take advantage of this strategy while remaining invested, says Ivan Hernandez co-founder of Omnia Family Wealth in Aventura, Florida.
For example, let’s say an investor owns a broad market exchange-traded fund like Vanguard Total Stock Market ETF (ticker: VTI). If that investment produces a loss, the investor could sell it and buy a similar ETF like the SDPR S&P Trust ETF ( SPY).
“You haven’t gotten out of the market, but you’ve locked in a loss and you are still completely participating in whatever may happen in the market,” Hernandez says. “It may go down more; it will return up. But that loss is like this little gem that you can use to offset a future gain to reposition the portfolio.”
Place assets in a tax-appropriate account. The type of account where the assets are held is just as important from a tax perspective as what you hold. When constructing a diversified portfolio, give some thought to whether an asset belongs in a taxable brokerage account or in a tax-deferred account. Hernandez calls asset location the “low-hanging fruit” when investors are trying to optimize their tax efficiency.
Put stocks you plan to hold for more than a year, mutual funds with a low turnover rate and municipal bonds in taxable accounts, says Tammy Surratt, president of Legacy Family Office in Estero, Florida.
Use tax-deferred accounts for short-term holdings, like stocks you may not hold for a year that otherwise would be taxed as short-term capital gains, which have a higher rate. Income-producing investments like real estate investment trusts also belong in a tax-deferred account, she says. If REITs are held in a taxable account, the cash flow they generate will be taxed as income.
Bunch your charitable deductions. When the new tax law doubled the standard deduction to $12,000 for single filers and $24,000 for married couples, and limited mortgage, state and local taxes to $10,000, it made it harder to count other traditional tax deductions like charitable donations.
However, financial advisors say people can still donate to their favorite charities and qualify for deductions if they are savvy about how they do it. To get the deduction, Surratt recommends “charitable bunching,” or combining multiple years of donations into a single year.
[See: 8 Steps for Investing a Tax Refund.]
To make that easier to swing financially, donors can make their traditional 2018 donations now, and then make their 2019 donations earlier than usual in December, and have both donations count for the same tax year, Hernandez says. For example, a donor who typically gives $10,000 to charities annually could bunch two donations into a single calendar year for a total of $20,000. When that donation is combined with the $10,000 deduction for mortgages, a married couple filing jointly would be pushed over the standard deduction threshold and could start itemizing all their deductions, he says.
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5 Ways to Minimize Taxes in a Portfolio originally appeared on usnews.com
