3 Tax Saving Strategies for Your Portfolio

At tax time, it can become painfully obvious how much of your hard-earned money is sent to the government. Income from your investments can be a big contributor to your tax bill. Wouldn’t it be nice if we can keep more of the earnings from your investments?

Good news: there are some things you can do to lessen the tax bite.

Here are three strategies that may reduce your tax bill and allow you to keep more money to spend or invest for future growth:

1) Make Your Portfolio More Tax-Efficient

Instead of buying the same funds in each of your accounts, you can purchase more tax-efficient assets in your taxable accounts (i.e. individual and trust accounts) and less tax-efficient assets in your tax-deferred accounts (i.e. IRAs and 401Ks). From a tax perspective, this type of portfolio construction minimizes the impact of taxes.

Constructing portfolios in this manner can increase your after-tax return by up to 0.75%, according to studies conducted by Vanguard. The strategy is most effective when the taxable and tax-deferred accounts are similar in size and you are in a high marginal tax bracket.

Examples of tax efficient investments are: Passively managed stock mutual funds, exchange-traded funds, and municipal bond funds. Passively managed funds tend to generate less taxable income because they are not actively trading to beat the market. Municipal bonds generate interest that is exempt from federal taxes, and exempt from state taxes as well if the bondholder is a resident of the state that the bond is issued in.

Tax-inefficient investments include actively managed stock funds, higher yielding bond funds, and REIT funds. These can generate a lot of taxable income, dividends or capital gains, so when possible, we want to buy those in tax-deferred accounts.

2) Optimize the Withdrawal Order for Your Spending

Withdrawing from your investment portfolio can generate a lot of taxes or a little taxes, depending on which accounts you are withdrawing from. When you own multiple account types including taxable (individual or trust accounts), tax-deferred (IRAs or company retirement plans) and tax-free accounts (Roth IRA or Roth 401K), you face important decisions about how to spend from these accounts. By designing and implementing a withdrawal strategy that minimizes the total taxes paid over the course of your retirement, your after-tax wealth is maximized. This strategy can extend the longevity of your portfolio.

When planning, we should keep several key thresholds in mind. For example, if your annual income is below $44,000 as a couple, only 50% of your social security income is taxed. If your income is below $170,000 as a couple, you are not subject to Medicare Part B and Part D premium increases. You may also want to maintain a level of income that keeps all the income at or below a certain tax bracket (perhaps 15% or 25%). By distributing a planned amount from your taxable or tax-free accounts, you may be able to keep your annual income below these thresholds, saving you significant amounts of money over time.

Once again, the strategy is most effective when the taxable and tax-deferred accounts are similar in size and the investor is in a high marginal tax bracket.

3) Harvest Losses to Offset Gains

Tax loss harvesting is the process of selling an investment at a loss, while simultaneously purchasing a similar investment as a temporary replacement. Doing this allows you to capture the tax loss while maintaining the same asset allocation in your portfolio. This strategy reduces your tax liability because realized losses on investments can be used to first offset taxable gains and then to reduce ordinary income up to $3,000 per year.

Note: Tax loss harvesting is not without risks. By buying a new investment, the investment’s cost basis and holding period are reset, which can result in higher future taxes.

Building Tax Saving Strategies into Your Financial Planning

The three tax saving strategies for your portfolio discussed above should be integrated into your comprehensive financial plan. After careful contemplation of your personal circumstances, one or more of these methods can be applied to maximize your after-tax wealth.

To learn more about building tax saving strategies into your financial planning, please contact us.

About Monica Ma

Monica Ma, CFP®, CFA® is an advisor and the chair of the Investment Committee at Blankinship & Foster LLC. She helps clients build sound investment portfolios and develop strategic plans to reach their goals. Since Monica is passionate about sharing her knowledge with women and retirees, she co-leads the firm's Wise Women and Living Wisely Educational Series. Monica is a member of the International Community Foundation's Investment and Finance Committee. She has been living in San Diego since 2008 and enjoys travelling and cooking with her family.

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